Fairfax Letter March 2014

[JBird]

So, don't take my bearishness as a sign that I'm giving up all hope.  It's just that I'm taking it very seriously now whereas before I was brushing off the naysayers.

 

Interesting. What changed your mind?

[ERICOPOLY]

So, don't take my bearishness as a sign that I'm giving up all hope.  It's just that I'm taking it very seriously now whereas before I was brushing off the naysayers.

 

Interesting. What changed your mind?

 

I have a vague understanding that the astronomical increase in credit in China over the past few years (not just absolutely, but relative to their means) has been one of the horses pulling the cart (the global economy).  They create all that credit (money) and import things from all over the world. 

 

And look at a chart of increasing margin borrowing in the US and stock prices. 

 

There is like no room for bad surprises.  And the kind of bad surprise that can come out of China could very well be what tips Europe into deflation -- they are so close already.  Perhaps even the US.

 

Look at our profit margins... where does all that come from?  It's got to be hit pretty hard by something like decreasing demand for our exports from economies in Europe and China.

 

But anyways... I'm going to make about 75% gain over next two years if we muddle through and BAC goes to $22.  I'll probably do just as well, perhaps better, if Russell 2000 goes into Great Depression 2.0 mode.  So, I'll just eat popcorn and hope for the former (I don't want to live in a depressing time where we have widespread misery).

 

[tombgrt]

So, don't take my bearishness as a sign that I'm giving up all hope.  It's just that I'm taking it very seriously now whereas before I was brushing off the naysayers.

 

Interesting. What changed your mind?

 

I have a vague understanding that the astronomical increase in credit in China over the past few years (not just absolutely, but relative to their means) has been one of the horses pulling the cart (the global economy).  They create all that credit (money) and import things from all over the world. 

 

And look at a chart of increasing margin borrowing in the US and stock prices. 

 

There is like no room for bad surprises.  And the kind of bad surprise that can come out of China could very well be what tips Europe into deflation -- they are so close already.  Perhaps even the US.

 

Look at our profit margins... where does all that come from?  It's got to be hit pretty hard by something like decreasing demand for our exports from economies in Europe and China.

 

But anyways... I'm going to make about 75% gain over next two years if we muddle through and BAC goes to $22.  I'll probably do just as well, perhaps better, if Russell 2000 goes into Great Depression 2.0 mode.  So, I'll just eat popcorn and hope for the former (I don't want to live in a depressing time where we have widespread misery).

 

 

Isn't the increased margin borrowing running parallel with increased stock portfolio values? Obviously there is higher margin borrowing at peaks than at lows when looking at it percentage wise but I wonder how big a piece of the complete picture it is.

[frommi]

So you lagged into a straddle on IWM? Thats absolut brilliant! What expiration date did you use?

[thefatbaboon]

I just can't for the life of me figure out what would make interest rates go up.  >:( (USD, EUR, YEN).  Spikes, sure, I can see some reasons, but sustained increases….?

 

It's annoying.  I feel it's blinding me to potential downsides in the market. 

 

 

[Cardboard]

I really like both of your posts Frommi and Ericopoly. Shorting is certainly a tough thing to do and as you said Ericopoly recently, the power of retained earnings over just a few years can make the best actual short thesis look quite foolish quickly.

 

While I like my holdings, I feel like I can't count on a raging bull anymore to help them reach fair value. And if we still have a raging bull, it could be a few areas doing really well while value stays flat. So I really like the way you have hedged Ericopoly, but keep in mind that some parabolic move may still form in the more frothy areas of the market while BAC stays flat.

 

Staying flat while everyone is partying feels actually as bad if not worse as going down with everyone else. However, at this point, the risk of staying flat after all these years of large gains may be worth accepting.

 

Cardboard

[tiddman]

Isn't the increased margin borrowing running parallel with increased stock portfolio values? Obviously there is higher margin borrowing at peaks than at lows when looking at it percentage wise but I wonder how big a piece of the complete picture it is.

 

Yes on one hand, people buy more aggressively in an up market and probably buy more stocks on margin.

 

On the other hand, when stock values are high, people borrow against their stocks more and use those funds for other purposes.  I know lots of people that use their taxable stock account as a sort of slush fund, and use margin to handle one-time expenses or other investments.

 

The bearish view is that increases in stock values are being driven primarily by margin debt.  I am not sure that's true but this probably contributes to it.  I am not sure what percentage of the overall market is represented by retail investors with margin accounts, I would guess a fairly small portion.

[prevalou]

http://oldprof.typepad.com/a_dash_of_insight/2014/03/missing-indicators-and-confirmation-bias.html?utm_content=bufferfa3d9&utm_medium=social&utm_source=twitter.com&utm_campaign=buffer

[ERICOPOLY]

So you lagged into a straddle on IWM? Thats absolut brilliant! What expiration date did you use?

 

The IWM $120 strike call is 2015.  Now, if this market breaks significantly either way I should be able to roll it to 2016 somewhat inexpensively (due to skewness).

 

Had FFH done that 4 years ago when IWM was at $65, consider how inexpensively they could have been rolling the calls along with the market up so much.  It would be practically free to roll a $65 call these days.

[ERICOPOLY]

Here's an analogy.

 

Two clydesdales are in a harness pulling a cart up a hill. A veterinarian has been blood doping them and giving them steroids, etc....  The cart is barely moving. 

 

One of the horses is beginning to look tired.  Do you want to be walking behind the cart?

[Cardboard]

Well, that is a good one.  :)

 

Just don't forget that Watsa probably thought the same thing 4 or 5 years ago and back then the cart was even moving slower.

 

So you did the right thing by buying these protective calls against your short since who knows when the cart will go on reverse or crash down the hill!

 

Cardboard

[ERICOPOLY]

Just don't forget that Watsa probably thought the same thing 4 or 5 years ago and back then the cart was even moving slower.

 

I know, but there is some legitimate measurement of why he hasn't been proven correct yet:

 

quoting his letter:

. Since 2009, the Chinese banks have grown by the equivalent of the entire U.S. banking system or 15% of world GDP.

 

 

Since 2009, the easing by the Federal Reserve combined with the explosive

growth in China, backed by higher interest rates, has resulted in huge inflows (‘‘hot money’’) into China.

The near unanimous view that the renminbi would strengthen has resulted in a massive carry trade where

speculators have borrowed at low rates across the world and invested in China, almost always backed by real

estate. The shadow banking system in China – i.e., assets not on the books of the major Chinese banks – is

estimated by Bank of America Merrill Lynch to be approximately $4.7 trillion or 51% of Chinese GDP. Oddly

enough, prior to the credit crisis, the U.S. had $4.5 trillion in asset-backed securities outstanding or

approximately 31% of U.S. GDP. You know what happened then. When the flows reverse in China,

watch out!

 

 

It's rather staggering.  The very thing that has thus far worked against him is actually making the final chapter a doozy.  However, I don't know how many chapters so I hedge with calls.  I don't want to be like Kyle Bass and his clan that short JGBs and keep getting stymied for years and years.

[goldfinger]

Can't the Chinese government fight the tape with almost 3.5T$ in reserves, given how interventionist it has been in the past?

[frommi]

Yes they can but they devalue their currency with that action. I would say its happening right now.

[ERICOPOLY]

Can't the Chinese government fight the tape with almost 3.5T$ in reserves, given how interventionist it has been in the past?

 

Very impressive.

 

Okay, I have no idea if the following is true given the source but...

 

Since Lehman Brothers collapsed in 2008, the level of private domestic credit in China has risen from $9 trillion to an astounding $23 trillion.  That is an increase of $14 trillion in just a little bit more than 5 years. 

 

In fact, it is being projected that Chinese companies will pay out the equivalent of approximately a trillion dollars in interest payments this year alone.  That is more than twice the amount that the U.S. government will pay in interest in 2014.

 

http://www.zerohedge.com/news/2014-01-21/guest-post-23-trillion-credit-bubble-china-starting-collapse-%E2%80%93-what-next

 

 

I don't know, maybe those high interest payment are on unproductive assets (like for example empty real estate developments).  There must be some source behind the low ROE.

[gary17]

this is a question that i've been thinking about

 

it seems like because the chinese government has artificially kept the chinese yuan low relative to the US dollar, over the years it had to buy US dollars (i.e., sell Chinese yuan) to keep the Yuan low....  the US dollars that they have been buying = the foreign reserve in $US.....  and all this fund belongs to the Chinese central bank... 

 

So in theory, if the yuan were to collapse - they could just start buying Yuan and sell US dollars....  the reserve, at $3.3 trillion US is mostly in the form of US government bonds ... so they'd start selling the bonds.... which would increase the yield on the bonds... (?)   

 

so our current quantitative easing is about 85B at the peak per month... so  3300B would be a 3 year QE program if that's where the Chinese government wants to start inject the money back into their economy.....   

 

is it this simple?

 

Gary

 

Official international reserves assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or fiat currency as IOUs). Thus, the quantity of foreign exchange reserves can change as a central bank implements monetary policy,[2] but this dynamic should be analyzed generally in the context of the level of capital mobility, the exchange rate regime and other factors. This is known as Trilemma or Impossible trinity. Hence, in a world of perfect capital mobility, a country with fixed exchange rate would not be able to execute an independent monetary policy.

A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower) and thus the central bank would have to use reserves to maintain its fixed exchange rate. Under perfect capital mobility, the change in reserves is a temporary measure, since the fixed exchange rate attaches the domestic monetary policy to that of the country of the base currency. Hence, in the long term, the monetary policy has to be adjusted in order to be compatible with that of the country of the base currency. Without that, the country will experience outflows or inflows of capital. Fixed pegs were usually used as a form of monetary policy, since attaching the domestic currency to a currency of a country with lower levels of inflation should usually assure convergence of prices.

In a pure flexible exchange rate regime or floating exchange rate regime, the central bank does not intervene in the exchange rate dynamics; hence the exchange rate is determined by the market. Theoretically, in this case reserves are not necessary. Other instruments of monetary policy are generally used, such as interest rates in the context of an inflation targeting regime. Milton Friedman was a strong advocate of flexible exchange rates, since he considered that independent monetary (and in some cases fiscal) policy and openness of the capital account are more valuable than a fixed exchange rate. Also, he valued the role of exchange rate as a price. As a matter of fact, he believed that sometimes it could be less painful and thus desirable to adjust only one price (the exchange rate) than the whole set of prices of goods and wages of the economy, that are less flexible.[3]

[wisdom]

If the Chinese govt sells treasuries - the prices on treasuries would drop and a large amount of the reserves could disappear.

 

In addition, the spike in interest rates would kill any recovery that is taking place across the world.

 

With the total amount of debt outstanding any increase in interest rates would be damaging to any recovery.

[wisdom]

http://www.bloombergview.com/articles/2014-02-17/china-digs-itself-deeper-into-dollar-trap

 

the dollar trap - why the Chinese reserves in US treasuries are trapped

[Cardboard]

Ericopoly,

 

Did you buy straight IWM puts in your non-margin accounts, like retirement accounts, where you can't short to hedge? I guess in these you would not have to worry about the early taxation issue that you mentioned.

 

Cardboard

[gary17]

 

Interesting. On the other hand though the US government owns most of the treasuries.... I believe China owns a relatively small amount.

 

http://www.bloombergview.com/articles/2014-02-17/china-digs-itself-deeper-into-dollar-trap

 

the dollar trap - why the Chinese reserves in US treasuries are trapped

[ERICOPOLY]

Ericopoly,

 

Did you buy straight IWM puts in your non-margin accounts, like retirement accounts, where you can't short to hedge? I guess in these you would not have to worry about the early taxation issue that you mentioned.

 

Cardboard

 

 

I don't manage any of the assets in my Roth IRA anymore (as of January).  I am leaving it for others to manage.

 

I have another 18.5 years until those Roth IRA assets are tax-free.

 

So, my intent focus is on making it another 18.5 years living solely off of my taxable funds.  I'm pretty sure it won't be an issue -- I can sustain my current rate of spend even if I don't make another dollar in returns again (I just need to match inflation and not lose money). 

 

 

 

[Cardboard]

Hi Ericopoly,

 

Actually, my question was flawed: you are not using IWM to hedge at all your BAC position or essentially your long portfolio. IWM is a straight short with capped downside, while BAC is your long with capped downside using its own puts.

 

The other trades: sell BAC covered calls, sell SHLD puts (with high volatility and premium) are simply ways to raise cash to reduce the cost of the 2 "trades" above. The only risk left I guess, other than treading water, is for you to be forced to buy shares of SHLD or close the position at a loss. Do I now understand it all right?

 

That is actually brilliant and shows the power of concentrating in a few large caps: easy to hedge them with 100% correlated puts. Very useful in times like these. I can't do this with my portfolio with most being small caps that do not have options. So to get a similar "barbell" strategy I would have to short twice as much IWM as you are or find some other short/put strategy for my long exposure.

 

Cardboard

[ERICOPOLY]

Hi Ericopoly,

 

Actually, my question was flawed: you are not using IWM to hedge at all your BAC position or essentially your long portfolio. IWM is a straight short with capped downside, while BAC is your long with capped downside using its own puts.

 

The other trades: sell BAC covered calls, sell SHLD puts (with high volatility and premium) are simply ways to raise cash to reduce the cost of the 2 "trades" above. The only risk left I guess, other than treading water, is for you to be forced to buy shares of SHLD or close the position at a loss. Do I now understand it all right?

 

That is actually brilliant and shows the power of concentrating in a few large caps: easy to hedge them with 100% correlated puts. Very useful in times like these. I can't do this with my portfolio with most being small caps that do not have options. So to get a similar "barbell" strategy I would have to short twice as much IWM as you are or find some other short/put strategy for my long exposure.

 

Cardboard

 

Yep, I think you summarized it well. 

 

I am expecting income from dividends and expiring volatility that I have sold.  Instead, of trying to live on that income, I'm spending it all on hedges.  This way, I utilize the full value of my income rather than letting a large percentage of it get confiscated by the government taxation authorities.  I want unrealized deferred capital gains, not taxable income.

[Phoenix01]

 

Yep, I think you summarized it well. 

 

I am expecting income from dividends and expiring volatility that I have sold.  Instead, of trying to live on that income, I'm spending it all on hedges.  This way, I utilize the full value of my income rather than letting a large percentage of it get confiscated by the government taxation authorities.  I want unrealized deferred capital gains, not taxable income.

 

That is the FFH strategy!

 

[moody202]

 

Then all the BAC is hedged at $15 and $17 strike.  I've also written some SHLD puts.  I've closed out my C position and am contemplating the same for JPM. 

 

What is your JPM position?