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divination

Perhaps more surprising than the results itself was the market’s reaction to Britain’s exit from the European Union: for such a momentous event, it was very mild, not getting materially out of recent trading ranges, and with the FTSE100 (though a poor proxy for the British economy) back where it was before the vote at the time of writing, with only the rather modest GBP re-rating remaining material.

Portfolios almost unchanged

I couldn’t find any noticeable distressed prices in my watchlist(s) and only sold Panmure Gordon, in the Stamp collection, on the grounds that being a small broker focussed on the London small cap market may not be very promising, as business is delayed or shifts to other places. Companies I hold are are biased towards exporters and  otherwise not UK-centric stocks, which has worked reasonably well despite the London listing bias.

Is the market right?

Is the market dominated by trading noise, or is it successfully predicting that Brexit will have little negative impact? Uncertainty will certainly be there but the outcome is hard to predict. Negative scenarios are all other the press, but one can imagine a few positive ones as well:

  • On consumer confidence, ex-UK consumers will probably ignore it, or plan holidays to the UK. UK consumers might prove stoic, optimists perhaps balancing pessimists. It’s hard to imagine that it wouldn’t at least slow down the housing market (in transaction volumes if perhaps not prices).
  • Business investment should be down, from some plans being frozen or moving elsewhere, though the outlook seemed pretty positive before the vote, down a bit from there may remain positive.
  • Sterling devaluation, if it persists, which is not a given, may help a bit. It could also remain at a sweet spot: big enough to help but small enough not to trigger enough inflation for the Bank of England to have to tighten monetary policy. Indeed, business investment slowing down may be all the tightening that’s needed.
  • Last but not least, there may be positive impact from EU re-focussing (see below).
Doc Marteens with Union Jack toe

Britain kicks arse? (credit: I Ransley via Flickr)

The European Union becomes the Eurozone

A potential positive side-effect of Brexit is that it might help refocus the European Union on improving its institutions, in particular finishing off building the Eurozone.

The United Kingdom was perpetually only half-way in, making the whole system an unwieldy variable geometry construction, both adding complexity and slowing down integration as exceptions piled up, and other member states had a strong incentive to get their own special case deals. When membership was irreversible this made sense, but if it turns out leaving has a precedent, that is not an unmitigated disaster, then there’s a way out. Then, variable geometry need not be inside the EU but between EU membership and the various forms of association around it (e.g. Norway or Switzerland style deals).

This enables the EU to become the Eurozone: the Eastern European states are committed to join; Denmark is de-facto in economically as they operate a fixed exchange rate system with the Euro; Sweden entry seems permanently suspended due to a failed referendum, but then they, or other reluctant members, could choose to either come in or leave and get a UK style deal.

So we have both a simpler and clearer framework institutionally, and an incentive to escape the current deadlock on Eurozone construction, as the choice between further integration or dismantlement becomes clearer and clearer. If this works out, it could be of great benefit to everybody, including the UK, which would be (much) better off with prosperous partners.

As a short term little bonus, if some business, financial or otherwise, moves from London to the continental financial centres, it’s a mini-Keyneysian stimulus programme for the Eurozone, which may help accelerate the recovery process.

Maybe the whole world will in the end need to thank UK voters for their selfless, if unwitting, sacrifice.

I’ve been an oil bear since last year, which has worked out quite well so far. It may be a good time to summarise my case. I should have written about it earlier, as it’s starting to become mainstream!

Demand and supply

On the demand and supply front, the big shock is increased from US shale. This is well known, but it seems to have taken some time to make an impact. Besides, many US exploration ventures are funded by a lot of debt, so not flexible as they could be — they’ll keep pumping as long as operational cost are break even. Exploration and setup costs are sunk costs, and leveraged structure prevent waiting for better times. Rapid technological improvements in extraction add to the price pressure.

Shale also applies to natural gas, which has seen it’s own supply boom, likely taking market share for some oil applications (NG vehicles?). For electricity, renewables have been getting from insignificant to a minor player, which is also more competition.

On the demand side, it seems merely steady, or facing downward pressures (“China”, austerity). With all that no surprise the price has to come down.

Besides known reserves are vast on a human lifetime scale. If we keep facing static or slowly increasing demand, speculative exploration could be totally suspended for thirty years or more, and the world would be unlikely to run out. This is a challenge to new exploration, which is merely adding to the glut.

Politics

On the politics side cartel agreement seems harder to obtain than in past cycle bottoms. US producers and OPEC agreeing seems very improbable. Even the recent partial deal between Russia and Saudi Arabia — keeping production at the current relatively high level — might be difficult to maintain as producing more to compensate for lower revenue per barrel will be a temptation difficult to resist.

Climate change policies may work out in reducing demand (at least some).

Cycle timing

Commodity cycles — over-investing when prices are high and under investing when they are low — tend to be quite long (5-10 years) as it requires project planning to flow through to reality on the ground and there’s lot of inertia around.

There are several signs of not being at the bottom, like high volatility, media interest, bullishness of traditional oil sector investors although this may be turning.

A strong contango (higher prices on contracts for future deliveries) is a sign of probably excessive hope, and keeps supporting production at above-spot prices — until it doesn’t.

The money shot

Not making any precise forecast, but let’s say that WTI is probably going to stay in a range $20-$35 until at least the end of 2017, with perhaps short lived escapades on both sides of the range.

Back to the trading floor

This post is really just an excuse to make a portfolio update less boring: in addition to selling BP and Total, as previously discussed, I’ve sold Petrofac. Although they seem well equipped to survive a downturn, the market will probably ignore that for a long while (the name of the company may be a curse). I’ve added more Amec Foster Wheeler, which is a more diversified (and further diversifiable) engineer at a distressed price (hence being underweight in the portfolio).

This is despite not being supposed to do significant sector bets in the Obliquity portfolios, but I make an exception in order to minimising regret: I’d be pissed if I’m right on oil while owning sector losers. It’ll be easier to accept missing a sector rebound (if possibly costly).

On the trading front, I’m short contango and long crude carriers (the speculators will need storage, while the carriers’ share prices have been moving down with oil) via options.

Looking back at my short tipping exercise from February this year, the results are remarkable:

Stock Symbol Performance Feb 2 to Dec 12
Globo GBO -27%
Quindell QPP -91%
Wandisco GBL -69%
Naibu NBU -79%
Judge Scientific JDG -48%
Mean -63%

So that’s a full hit, every stock in the set declined markedly and £100 invested equal weighted in this short portfolio would have returned £63 profit in less than a year. Unfortunately shorting is a pain due to the unlimited downside if you get it wrong, and I haven’t actually shorted anything. I did get the time frame wrong, given that we didn’t have to wait for 2016 to see results. In a real portfolio I would have probably exited all the positions by now, except perhaps Globo which may have some more downwards potential.

Fireworks

Fireworks (credit: Maciej Lewandowski on Flickr)

The small cap markets are missing an instrument for limited risk shorting, for instance put options, perhaps with fewer strikes than normal options  — e.g. a logarithmic ladder —  and fewer expiries — quarterlies would be more than frequent enough. It could be either something tradable like certificates or spread bets, or as an OTC keep-to-maturity product. The market for this is small but a niche operator could do well. They could hedge by selling discounted call spreads (calls with truncated upside at the put strike) to bulls to match their put portfolio with a small amount of capital needed to market make the inventory. With the right risk management this is a low risk business that can be operated with no price risk, and it would offer a more useful service than open ended spread betting. Shorting is essential to functional markets.

That said there are some mitigating factors: it has been a bear market for small caps, during which basket cases often don’t do well. They can conversely do spectacularly, for a while, during bull markets, which can be quite testing for shorters. That said the iShares MSCI UK Small Cap ETF, as a proxy for the market, is flat on that same period so a hedged long/short portfolio would have returned about the same. That hedge may not work fully in case of a short squeeze or bullish market where the basket cases race far ahead.

Having not made divination posts for a while, let’s make a new prediction, that the price of Bitcoin will go down markedly in classic currency terms in the next 3 to 6 months.

Transaction acceptance means net bitcoin selling

The reasoning is pretty simple: one of the main happenings in the Bitcoin world recently has been increased acceptance at legitimate vendors like Dell, Overstock, Expedia (for hotels) and others. Bitcoiners see that as a success and, ironically, some Bitcoin holders see it as doing something of civic value to buy at vendors that accept Bitcoin.

But what happens when someone buys a laptop from Dell with Bitcoin? There is no sign of Bitcoin becoming used in the business supply chain, where it doesn’t really solve any material interesting problem, so Dell will immediately convert the Bitcoins to dollars to pay their employees and suppliers. Indeed one of the reason vendors are accepting Bitcoin is that payment processing intermediaries make that easy by doing it for them and “removing the Bitcoin risk” from the vendor: they price in dollars (or another classic currency) with the payment gateway, and get dollars paid by classic wire transfer.

What happens on the buyers’ side: will people buy Bitcoins to buy Dell laptops? It seems unlikely. Dell is probably more trustworthy than most operators in the Bitcoin ecosystem, and you don’t want anonymity or pseudonymity when buying a laptop: you want them to know your address and deliver the laptop there. So there’s basically no reason to pay using a classic method to get Bitcoin and then use those shortly at a legitimate vendor. So who’s gonna buy Dell laptops with Bitcoins? My guess is mostly people who for some reason or other had accumulated Bitcoins, legitimately or not, and now have an opportunity to spend it on something more useful than Bitcoin t-shirts, and also see it as a “good” thing for the ecosystem.

And then came momentum

As it happens Bitcoin has been on a downward trend since its peak for several months, and has also seen a further boom in “mining” activity. Bitcoin mining, like its real world namesake, is one of those activities which tends to be structurally loss-making as it’s very hard for rational investors not to be outnumbered by innumerate optimists. Volatility and a downward trend may accelerate some of these past optimists giving up on accumulating mining proceeds, and exiting through transactions, which might provide some comfort (product + civic value) even if nursing a net loss.

Raw momentum regardless of mining (“it’s going down because it’s going down”) will also tend to put a further downward pressure, so basically we have a fundamental trend towards sale of Bitcoin created by transaction acceptance, amplified by momentum and mining dynamics.

Absent any new net buyers of Bitcoin, it’s hard to see how it could go anywhere but down on a simple demand and supply basis. It’s hard to think of a source of new net buyers. Most people who may be interested in Bitcoin at this stage — where it has acquired some maturity but is still an emerging underground tech — have probably already jumped in and are sustaining steady-state flows. I just don’t see any new major demand source coming in to offset transaction-driven sales.

Show me the money

So to quantify the prediction for verification, let’s say that BTC/USD will touch US$ 250 (approximately halve in value from now) for at least one day at reputable exchanges before April 1, 2015.

(Disclosure: I have a few pennies on downward Bitcoin bets at shady blockchain betting operator bitbet.us — not a recommended counterparty or investment. Note that if I win I get my payoff in devalued Bitcoins, which, if my fellow gamblers don’t discount that effect correctly, as I expect them not to, will be a pyrrhic victory.)

I’m outrageously late for making seasonal new year predictions, and sorry for a title that sounds like Business Insider, but I want to keep a record to see if I have some predictive power. So, I would like to introduce my 5 best London-listed stocks to short, not for 2014 but for (end) 2016 — three years is a good time frame for short theses to develop, one year may not be enough for failure and they could easily keep being supported by momentum.

Ninenteenth century train crash with steam locomotive going through the wall of an end station.

The track was a bit too short. (source: Wikimedia)

I’m not short any of these stocks (or any individual stock at all) as in real life shorting is a major pain and I would only do it when a limited risk instrument (e.g. options) is available at an affordable price, which is not the case for this set.

That said I’m also not long these stocks, which is really half the value of the Obliquity strategy: there’s probably more insight in what I don’t buy than what I do (I’m short relative to an all inclusive market index). These are just some of the more egregious examples — there’s also stuff I don’t like for more mundane reasons.

For accounting the success or failure of these choices, I plan — if I remember by 2016! — to check the total return of an equal weighted short position in all 5, including dividends and capital actions. Should a stock be delisted, the exit value should be the closing price on the market day following the day the delisting was announced. Suspended stocks should (probably) be considered to have exited at zero.The drawdown allowance is hard to decide in advance, minimum would be 2x I’d say (so allow £2000 running loss for £1000 notional short position for the full portfolio).

Globo

Lots of accounting trickery with the headline product a me-too product nobody uses. Matthew Earl has written more than I could dream to about it.

Quindell Portfolio

The business model seem mostly about enabling insurance fraud, layered behind piles of creative accounting, all run by characters that do not inspire great confidence. If the business doesn’t fail, the likeliness of their leaving anything on the table for outside shareholders seems low.

WANdisco

Don’t you love the name? Spinning open source software they do not own or author, and selling add-ons of limited value seems both gross and ingenious. There’s probably enough mugs who don’t understand open source to have them run for a while and have the principals exit at a judicious time…

Naibu Global International

A Chinese shoe manufacturer, which despite the name doesn’t export outside China (why not? not starting well, are we?) and is a field of red flags hinting at possible accounting or corporate structure misrepresentation. It’s already heavily discounted relative to published accounts, so failure is largely already priced in, but I think the end game is delisting or the price languishing further down.

Judges Scientific

This is actually a much more legitimate business than any of the others here, but I’m not a fan of private equity masquerading as an operating business. Brilliant financial engineering, but I fear that the acquired businesses, left to their own devices, with founders pacified with a cash windfall, or retiring, may not prosper. Also the window it exploited where it was possible to buy private companies in this sector at a massive discount to a public market valuation could close as both sellers and competing buyers wise up to it. Combine that with it being a fashion stock on the back of past successes, and it seems more likely to go down than up in my view.

An Abundant World is asking in a comment what evidence I have for my claim we’re at a peak in the “low risk” behaviour, aka that we are at or just going past Peak Pessimism.

I was tempted to just answer “gut feeling”, and it’s largely that, but digging around I think I have some facts to back it up to some extent. Note though that it’s of course a biased selection in favour of my argument, and it’s not hard to find some counterfactuals. How they balance is where it’s hard to do any better than gut feeling.

The US investors “rotation” (from bonds to equity)

The argument has been made repeatedly and better than I can by the Reformed Broker who has close contact with key constituencies like his clients (high net worth individuals) and industry insiders. This also seems consistent with the general background noise in US-centric media.

Corporate deleveraging is (mostly) over

One great advantage of doing stock picking is that it forces you to be in touch with how businesses are doing on the ground — if through the rose tinted glasses of management reports. My view is somewhat biased because I’m primarily looking at UK-listed corporations. So this is subject to a “London view” bias, even if I select primarily companies with a world or at least European presence. This limitation notwithstanding, I have observed that the sharp change of mood in 2008-2009 from “leverage is good” to “we have too much debt” has essentially run its course. This seems equally true in the relatively few non-UK large caps I look at. The U-turn was sharp and violent — and with everybody doing it at the same time, it’s no surprise there’s been a world recession — but now it seems to me that most companies (which could afford it) have reasonable balance sheets, and more importantly now debt is at reasonable levels (or below reasonable if you’d put it in an a mathematical optimisation framework, for tax reasons if nothing else) management seem to have switched their mindsets from “reduce debt” to “keep it under control”, which is just a notch away from proactive optimism-driven investing.

Bubble virgins

That idea came to me from an article in Handelsblatt about German youth’s (people in their twenties) preferred savings vehicle being the plain bank savings account (which as we all know pays inflation at best, if you chase special deals). This made me realise that there’s a whole generation that has grown up without participating in any sizeable financial craze. The last properly bubbly event on the financial markets was the dot com/tech bubble, which is a good decade ago now. Outside Germany, this younger generation has seen a property bubble in many countries, but mostly as spectators, and it should be easy to sell them that non-property asset classes are different. I think this is a great tail wind for any potential financial asset/sector bubble. It would be a great surprise that this generation doesn’t get to take their turn at the “this time is different” game, like every one previous.

The nominal yield effect

While this is really just an iteration of the money illusion, lot of people are enamoured with the idea that bond (risk free) yields “have to go up”, just because the nominal yields are lower than average they’ve seen during their (investing) lifetime — conveniently, outside Japan you can pick any period and it works to some degree or other whatever backward looking period you choose. This is another push towards “high risk” assets, just to escape the expected “reversal to mean” in “risk free”. This view is based primarily on nominal optics (good luck trying to extract a fact-based narrative from these people) and as such a background force away from anything “risk free”. Being a nominal effect it’s also immune to fundamental changes: it applies regardless of changes in any fact-based scenarios on rates paths.

The 3/5 year rear view mirror effect

Many financial tools, and most forms of historical performance assessment exercises are by convention based on looking at 3 to 5 year time periods, or shorter. This means that the 2009 trough will soon drop from the charts and all people will be seeing is a perennially up trending market, with the odd gentle correction to avoid frightening those who, rightly, would run away from exponential growth.

Troll fatigue

That’s the simple observation that inflationistas, gold bugs and other survivalists are getting increasingly unable to justify why Armageddon is taking so long to happen. Enough defections at the margin, of the less vocal followers, is a great push towards less risk free investing.

Small anecdotal fun “evidence” here: Zero Hedge is going out of fashion apparently.

Structural reforms work slowly

This is perhaps most relevant to the Eurozone: the main problem with structural reforms as a policy tool is that they work very slowly and they often make things worse first. For example on core/peripheral wages convergence we’re probably 2/3 done, but it took 5 years to get there. Export-centric policies are disastrous in the short term when everybody tries concurrently, but once it starts taking effect and there’s a bit of external demand (e.g. US/Japan/Core demand for peripheral Europe) the operational leverage is great. This also relevant to the US where the sequester is essentially a supply side structural reform in its effects.

Conclusion: it’s windy here

Many other things could go wrong, and I’m not clear about what’s happening in China and Emerging Markets, though there as well lot of negative views have limited potential to get much worse. There always can be exogenous disasters, but I think we do have a fair few tail winds pointing to animal spirits going back into positive territory, in the “next several years” kind of time frame — I’m not trying to predict what will happens this Christmas here.

I’m adding a new category, divination, for predictions. Macro predictions are a mug game, of course, but I sometimes feel I make fair calls, so it’d be good to keep a public record, in order to prove scientifically that I’m actually as crap at it as everybody else.

Image of street performer looking at a crystal ball

Not your blogger (credit: Hadouken@Wikimedia)

Claim 1: new stock market peak before year end

So the prediction of the day is that the current market correction is not far from its bottom as the short term pessimism bubble reaches a peak. It wasn’t that big a correction anyway — stocks going back where they were 2 months ago, real yields crossing zero!, big deal all that — and the fundamental situation seems to be fairly OK. Monetary policy may not be optimal but it’s not too much in the way either, and the perceived dangers seem to be mostly storms in a teacups. Apart from that cyclical forces seem to be pushing up. To quantify the prediction, let’s say that the stock markets will touch May record highs again at least once before December.

Claim 2: Greek bottom in 2013 or 2014

I looked up my past predictions and have really only made one post with one previously, about Greece, in Febuary 2012 which was overall approximately correct. They even improved point #2 as the EU is now funding Greece through debt relief via accounting tricks (the buy backs last year, maturity rollovers, rate discounts, etc) which are actually an improved way to do what I was suggesting.

To make a new prediction for Greece I would say that nominal GDP will bottom this year or next (to be checked a couple of year afterwards, say end 2016), for similar reasons as the world markets bouncing back. At some point every body who has survived that long will probably keep going, the primary budget balance puts the Greek government in a better negotiating place, and with sentiment, at some point you can’t get much more desperate, and then the only way is up (however slowly).

Disclosure: long 17500/18000 December Nikkei call options spread, which is in part a play on the first claim; no position on Greece.