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Inflation hedging

Skilled investing is about preparing for the unexpected. It's called HEDGING. Those who ignore history are condemned to repeat it but those who rely on history blow up. Long only is inappropriate for the modern, volatile world. Economic cycles are getting shorter. Higher frequency rebalancing and tactical asset shifts are mandatory. Is your portfolio prepared for the possibility of negative stock market and real estate returns in the long term? How much scenario analysis have you done based on Dow falling to 1,000 by 2030 however unlikely that "might" be?

Short selling is mandatory. Long buying is optional. Inflation, stagflation, reflation, biflation or deflation? Construct robust portfolios for all possible, even unlikely, scenarios. Anyone who thinks conventional economics can explain the emotional non-linear processes underlying financial markets is headed for BIG problems. Investors would be advised to have lots of shorts as we enter what is clearly going to be a severe bear market, own plenty of puts and have SUBSTANTIAL portfolio weightings in LONG volatility sources of return.

Recently I was asked to show some pension and endowment CIOs how speculative bubbles form, why intelligent rarely means rational and how market prices can far exceed intrinsic value. I auctioned a $100 note, offering it to the best bid with the covenant that the 2nd and 3rd highest bidders MUST also pay but receive nothing. Sure enough $5, then $10 bids started off but it was not long before the bids went ABOVE $300! This despite them being professional investors with an alphabet soup of qualifications after their names and knowing, with certainty, that the asset's value was $100. If the security's worth is uncertain the behavior is even MORE extreme.

The actions of those who bid $90 and $95 when someone bids $100 are fascinating. They are facing a certain loss or they can elect to fuel the bubble and likely lose more eventually. Price and value have little connection when emotions control the game. Markets NEVER accurately reflect the value of a security. All markets are informationally inefficient and every participant is IRRATIONAL. The only variable is the degree of irrationality.

Some might say such an auction is not a model of how markets function but many herdlike investors behave like that ESPECIALLY towards the END of bull markets, like now. Many managers are scared of being that losing bidder. The cost of not being the winning bid can be high. The danger of a winning bid can be even higher. Real estate, private equity and long only equity or credit funds watch out below! Prudent men - where are you?

Some who invested in subprime CDOs may have suspected they were overpaying but bought anyway due to the risk of underperforming "peers". Buying China at 6,000 or USA Dow at 14,000 might have looked good compared to the possibility of having clients redeem from you to go into another fund that did take that risk. I know plenty of investors long Japan Nikkei from 39,000 because every economist and stockbroker said it was going to 100,000. They are still waiting. Not that we will likely be seeing such stock market index levels again. Auctions lead to not only winner's curse but also loser's curse.

Adding fuel to the fire of auction based securities markets is the moral hazard when the risks of overpaying are not adequately punished. The "Greenspan put" was exercised last month so apparently everything is now fine? Time to dump those "expensive" hedge funds as the five year old bull market just got more rocket fuel? Not quite. The probability of recession must have been considered dire, more likely a certainty, to warrant an immediate cut of 50bp. But can the cure for easy money be to provide more easy money? Could we be setting up for a despression? In the stagflation of the 1970s the ONLY investment products that performed were, of course, good hedge funds. Long only stock AND bonds fail miserably in such times and will this time ALSO. In the deflation of Japan in 1990s the only performance came from proper absolute return strategies.

September has historically been the worst month for stock markets so the data miners won't be happy that it turned out to be such a strong up month. The last quarter of the year is HISTORICALLY the best so it will be interesting if we get a reversal of that trend also. According to the "experts" there is little chance of a bear market since Ben Bernanke will be there with another cut if anything bad happens. But options, like auctions, are not free and the "Bernanke put" might yet cost investors a high premium if and more likely WHEN it leads to stagflation.

With so many manager searches decided on the basis of recent performance, the danger of not being the highest bidder can be significant. As well as stock and bond markets, auctions dominate asset sales ranging from private equity deals to distressed debt and it can often seem safer to be the winning bidder than the also ran. You have to be in it to win it so therefore it pays to bid high so as to avoid the "expense" of not winning. Research, due diligence and the cost of information gathering and analysis are also borne by losing bidders. Ultimately however, as we are already seeing with LBO leveraged loan syndications or real estate speculators, some end up wishing they had never participated in the game at all. That is why markets oscillate between ecstasy and ennui and why stability is inherently unstable.

The faith in the power of the authorities is probably storing up problems for the future. Several individual investors have insisted to me that China stocks can't go down because of the Olympics next year. Really? Similarly USA stocks won't go down because the Fed is the Fed. Irrationality again. If only the causality of central bank and government policy on financial markets were so simple or direct. "Don't fight the Fed" usually proved true in the PAST but does not mean the Fed or other central banks WILL win.

August non-farm payrolls were not -4,000 but were actually +89,000! What confidence would investors have in a hedge fund that first said it lost 0.4% and then "revised" to +8.9%? The error in economic reports is so high that it is a wonder so many pay attention to the initial number. Inflation, in particular, is MUCH higher than the "core" inflation numbers are showing. If anything I suspect the rate cut decision came down to the risks of doing something aggressive (50bp) versus not (25bp). In the short term it is perhaps safer to give the crowd what they want even if it could be VERY wrong in the long term. Not very long from now the Fed will have to RAISE rates, heavily.

The recent volatility nicely demonstrated the value of quality hedge funds particularly the opportunities created out of crisis and possible recovery. Buying and holding is not optimal compared to shorting before a problem is generally realised and then buying as the crowd overreacts to those problems. Now that the Bank of England has effectively "guaranteed" the deposits at Northern Rock and UBS, Deutsche, Citigroup, Merrill Lynch and other banks have "warned" on earnings, are the credit problems really over so quickly? Super SIV fund? ABX at new lows? Have they REALLY valued everything correctly, i.e. at a price SOMEONE ELSE will buy with their own REAL CASH? NO!

Underlying the credit situation is a bear market in many areas of real estate that is NOT going away anytime soon. Lending without awareness of risk has similarities to Japan in 1980s; unconstrained lending and optimistic default assumptions and massive loans backed by collateral that historically had never dropped steeply in price. There were many false dawns and credit "recoveries" but Japanese real estate just kept going down.

Overlending is like the second bidder dilemma. Getting the deal looks better than completely missing it and underperforming your competitors' loan book or sales of mortgage originations. Perhaps other countries have learnt from Japan but more likely they haven't. The bailouts and proposed super SIV fund sounds suspiciously like one of the many temporary "price keeping operations" or "solutions" implemented by the Japanese authorities in the 1990s.

The so-called hedge fund meltdown didn't seem to last long. Just a month ago there were supposed to be wholesale redemptions because of the "apocalyptic" August (-1.5% including the blowups and all the non hedge funds that wrongly get included in these "indices") but now apparently everything is fine. Hedge fund inflows continue and the firms that "calculate" hedge fund redemptions admit they did their sums wrong just like governments can't seem to count new jobs accurately. The main lesson of last quarter was losing 20 or so investment products out of over 10,000 (0.2%) that purported to be hedge funds and whose assets were quickly bought by real hedge funds and the "discovery" that some public domain alternative investment strategies are now a tad crowded.

August was a bad month for hedge funds but September was one of best months ever for hedge fund performance though how some strategies will do if stagflation does show up will be interesting. Recency bias is perhaps the most pernicious disease in finance. Funny how many supposed long term investors worried about just a few weeks of hedge fund turbulence. Now with the September data point in, all is forgiven at least until the next drawdown. I find the common reaction to good hedge funds in a temporary loss to be silly. A good stock that goes down is a buying opportunity; a GOOD hedge fund that has a rough period is also a buying opportunity.

New strategies that are not crowded performed well. NEW quant strategies were able to make money out of OLD quant strategies. Real credit hedge funds and short sellers took advantage of the long biased credit crowd. Carbon trading, shipping freight and property derivatives have all created new alpha opportunities. Many established strategies were affected despite the previous appearance of being independent. Investors demanding transparency has led to significant strategy know-how leakage and trade crowding to less-skilled firms.

Interesting how the market gets LESS efficient and MORE irrational as more "smart" money enters the field; precisely the opposite of what "should" happen. That is because the smartest money gets to arbitrage the money that isn't as smart as it thinks. There is MORE alpha available than ever before; it just requires higher skill and uncrowded methods to capture it. The investment universe offers a universe of opportunities and the more "hedge funds" there are, the better chances for the GOOD hedge funds to make money out of BAD hedge funds.

With the hedge fund industry still so TINY at $2.5 trillion AUM, compared to the much larger future demand, the scope for new funds, new strategies and new asset classes is clearly going to continue to grow. It won't be a straight line of course but I wouldn't consider the hedge fund industry mature before $25 trillion AUM so there is clearly a lot more industry expansion to go. There are so many NEW ways and NEW products appearing to make money in global markets. Today there is $64 trillion money being "managed" mostly not very well. Look for the AUM in mutual funds and hedge funds to exchange places over the next decade.

Global economies and developed stock markets are so correlated these days that Federal Reserve decisions almost amount to Central Bank of the World decisions. You have to wonder how much longer dollar pegged currencies like the HK$ and Middle East petro currencies will want to get dragged down by the subprime US$. I wouldn't want to sell my oil or gold for dollars unless they happen to be Canadian or Australian notes.

It is a shame Hyman Minsky didn't ever receive the "Nobel" Prize in Economics. But then if he had, the equilibrium, efficient market cult would have had to return theirs. The recent Minsky moment is a reminder of the PERMANENT instability of markets. And the inevitability of bull AND bear markets overshooting. Stock markets start by climbing a wall of worry but then clamber over it due primarily to the fear of being the losing bidder in the auction scenario I described above. Later on markets descend a cliff of chaos. Risk appetite, like pride, is always highest before a fall.

In many parts of the world there are still $300 bids for $100 securities going on right now. Am I therefore bearish? I try to stay on steamrollers not collect nickels in front of them although I jump off if there is a another steamroller approaching from the other direction. So am I bullish? Not on the stock or credit markets, of course, but on the ongoing availability of alpha generating opportunities and the existence of fund managers with the skills to identify them.

The ONLY thing to ALWAYS be long of is alpha; everything else needs to be hedged, especially beta. There are potentially some bigger steamrollers rolling into view and in the opposite direction to the always bullish "stay in for the long haul" zealots. Get hedged and get SHORT of equities.

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