I rarely make predictions because I hate being wrong. But I shall make this prediction to help make my short positions profitable. Except that you can’t wash your car to make it rain. So here goes. 

As long as there is serious skepticism about the fundamental underpinnings of the current equity market rally, as long as there are sufficient bears in the market, as long as omens of Armageddon abound, the current bull trend will be sustained as the flow of capital is modulated and drip fed into equities.

Once the perma bears throw in the towel, once the perpetual prophets of doom call an end to the bear market, once the skeptics swing to the side of optimism, then the rally will fade and the market will fall. Until then, the trend is your friend.

Take care, however, for the voices of optimism are rising. As recently as 1 month ago, investors were acutely pessimistic and expecting the worse recession since the Great Depression. With equity markets over 20% above the lows in March, suddenly the green shoots of optimism are sprouting. Once optimism rises to a crescendo, it is likely that markets will snap back to reality again.

Do I know where valuations should be? Do I know what are the fundamentals underlying the markets? At best, I have a hazy view. At worst, I haven’t a clue.

But I do know what it is like to be an emotionally driven speculator bereft of sextant or compass, and sailing in the mist.

The innovation that was accused of being a New Paradigm in the late 1990’s in the wake of the Internet boom and subsequent bust brought amongst other things the concept of Just-In-Time management of inventory and production processes. This has introduced volatility into the cash flow and earnings generation of a large swathe of the economy. The rise of financials as a share of market capitalization of equity markets around the world in the last 10 years (2008 excepting of course), has also resulted in more volatile fundamentals. As credit default rates increase as the economy continues to deteriorate, the value of contracts will be subject to increased riskiness, order books and the value of companies will become more uncertain.

Fundamentals will be volatile. This is not a call for a recovery or continued recession. It is simply an observation that the future for the underlying value of enterprises is uncertain.

Equity and credit markets price fundamentals. At least that’s the theory. Over a longer period. However, pricing is transmitted via psychology and interpretation. Pricing is therefore uncertain and volatile at its own level. If fundamentals are also volatile, however, as is the case today, what hope do equity and credit markets have of pricing in these fundamentals.

For my money, I would be prefer traders over fundamental investors. At least until things change for better or for worse.

In the recent investor surveys a number of hedge fund strategies stand out as strategies which investors expect will do well going forward and which they intend to increase their exposure to. Among these are distressed credit, global macro and CTAs. Of the three, distressed debt hedge funds had a poor 2008 whereas macro and CTAs did well. The naïve reasons for favoring distressed debt are that the world is in recession, default rates are expected to surge. Quite what condition the companies are in when they do file is another matter. I have no comment about CTA’s.

Investor expectations about macro are interesting. They expect macro to perform well in 2009 and beyond. Given the nature of macro investing, this implies that investors have some sort of macro view, at least loosely. If it is volatility in markets in general, then the probability of loss is enhanced as much as the probability of gain. Manager selection is of course paramount and what allows investors to generate more gains than losses out of volatile markets. Risk management at some level requires the investor or their manager to scale leverage to take into account underlying market volatility in the first place. These are more technical matters.

It seems that there is a tendency for investors to chase returns, to prefer strategies or managers which have been doing well recently. We can critique this approach in general or we can look specifically at the preference for macro in 2009. The clear macro trends that macro managers capitalized upon in 2008 were:

• Short rates would fall, long rates would rise. (Clear)
• Rates would reflect public balance sheets. (could take some time to manifest)
• Exchange rates would reflect risk aversion, thus strong JPY, strong USD. (not so clear)
• Credit spreads would widen precipitously. (Clear)
• Equity markets would fall. (Clear)
• Volatility would rise (Clear)
• Long rates would eventually fall as deflation risk set in. (not so clear)

Whether these were clear before the fact we cannot tell. Maybe macro managers were smart enough maybe they were lucky. We hear about the successful ones. Many of the trades were event driven, signaled by the collapse of one financial institution or the rescue of another or some narrow escape.

In 2009 what are the macro trends that managers could capitalize on?

• Short rates go to zero and stay there. (Clear)
• Long rates fall further. (not so clear)
• Weak USD (not so clear)
• Equities will fall (could take some time to manifest)
• Credit spreads recover (not so clear)
• Volatility will remain high (not so clear)

Where are the catalysts and events? There are the various rescue plans but these are for the moment limited to the housing, banking and asset backed markets in the US. Default rates will most certainly rise. But these are events more traditionally traded by ABS specialists and distressed credit investors. Where are the big macro events? One could argue that all the big macro events are behind us and that the path of the economy now follows the excruciating process of deleveraging, consolidation and repair, and releveraging. If so, where are the easy pickings for macro? Investors are likely exhibiting serially correlated expectations based on the recent performance of the strategy class and will likely end up disappointed.

Macro managers work by forming a view of the macroeconomic conditions that will unfold and then take bets to reflect those views. Whether they be in relative value or directional macro trades, whether they are long and short different parameters of the same market, most macro trades are expressed in the levels. For example, a curve steepener long 2s and short 10s, is betting on the levels of the 2 yr rates and the levels of the 10 year rates. Fewer managers trade the gamma of these markets as part of a macro strategy, an approach that adds a dimension which may be useful in a year when the traditional macro pickings are less obvious.

14 April. Retail sales numbers in the US disappointed. Retail sales less autos shrank 0.9% against a forecast of 0.0% and a prior of +0.7%. Advance retail sales were -1.1% versus a forecast +0.3% and a prior -0.1%.

PPI numbers were also reported. PPI Ex Food and Energy rose 3.8% YOY versus a forecast 4.0%. The PPI Index fell 3.5% YOY against a forecast fall of 2.2%. Monthly numbers were negative.  All in all the numbers were not indicative of inflation and if anything signalled deflation risk.

The reaction of the equity market was an immediate dip. European markets which were up about 1.5% at that point quickly fell to down 1.5%. They have since recovered.

The news is bad. Retail sales numbers missed by a mile. PPI numbers signalled deflation risk. How the markets finally close today will be interesting. If they shrug of the bad news, then sentiment remains buoyant and the rally may extend a bit furter. Otherwise the downdraft is likely to be substantial as we move into 1Q results season and have nothing but bad news to look forward to.

Black Swans?

1. 1. Whatever you do, whatever they do, whoever they are, whoever you are, economic cycles will survive. See my article of 2 April 2008. The path of economic growth and the role of central planners.
   2. People learn from their mistakes. The next mistakes they make will be fiendishly novel and clever.
   3. If it is breakable it will break. It is nearly impossible to say when this will happen. In the meantime, it all looks pretty unbreakable.
   4. Trying to make it unbreakable is like getting people to learn from their mistakes. New ways to break stuff are quickly found.
   5. After it is broken, an arbitrary number of people will tell you they told you so, and for an arbitrary number of reasons. Some of these will actually be people who did tell you so. Of these most of them have been telling you so for the last 12 centuries and so would have almost surely been right eventually. Of those who only recently told you so, before the fact, most of them just got lucky. The others are probably the ones who broke it in the first place.
   6. An arbitrary number of persons will tell you how to make it unbreakable. Some of these will be people who told you so. You can recognize them, they are the loudest.
   7. If after considering their solutions you think some of them sound reasonable, refer to 4 above.
   8. Bad things will happen, they always have and they always will. So will good things. The trick is to avoid letting the bad things completely destroy you. So that you will be around for the good things. And when bad things happen, some of the bad things will happen to you. The only way to avoid all the bad things is to avoid all the good things as well, since we never really know if something is a good thing or a bad thing until it’s too late. If you think that everything that happens is a good thing, the next bad thing that happens will be the last thing that ever happens to you. If you think that everything that happens is a bad thing, the last thing that happened to you will be the last thing that ever happened to you. And that’s no way to live.