Category Archives: Investment Advice

How You Can Be Right and yet Still Be Wrong

The Big Short is a recently released movie based on the real life investments of three US hedge funds and their managers:  Michael Burry, Mark Baum and Charlie Geller/Jamie Shipley.  All three funds bet against the US subprime debt market which collapsed in 2008, propelling all three funds’ portfolio values to astounding heights as the rest of the US market crashed and burned.

Michael Burry who ran Scion Capital LLC was the first to discoverin as early as 2005 how certain bonds that were supposed to be conservative, low-risk investments were actually based on subprime mortgage dealsthat had an inherently high risk of default. Convinced of this fact, he went about to createan instrument by which he can bet against those subprime deals.  He was able to persuade Goldman Sachs to sell him credit default swaps that would enable him to profit from a collapse of specific deals he considered particularly susceptible.

At that time, Goldman Sachs agreed to sell him the credit default swaps because they thought he was likely to be wrong.  Burry’sbet went against commonly accepted valuations at that time.  And for the next few years it seemed Goldman Sachs was right.  Mortgage bonds continued to rise up until 2008.

For an agonizing while, Michael Burry was wrong. Before his fund posted any gains, it first sank in the deepest of reds. It got so bad that his investors threatened to sue him already.  Burry even started questioning his model, thinking that the whole US financial system was rigged as the bond values he expected fall, even rose in seeming defiance of logic.

Fortunately, however agonizing though it was, Burry stuck with his guns.  Finally, his predictions came true and the subprime debt crisis exploded in 2008.  Burry’s investors, no doubt suffering excruciating distress over the past few years since the fund bet against the mortgage bond market, finallybegan to see their gains. As the bond market started to free fall, their hedge fund’s average gains skyrocketed, reaching as high as 489% as of 2008.

What can we learn from Michael Burry’s story? You can be right and yet still be wrong.

Right Decision, Wrong Decision Road SignIn Burry’s case, he was dead right about the collapse of the bond market.  But what he couldn’t predict was the exact timing of the collapse.  As John Maynard Keynes said, the markets can stay irrational longer than you can stay solvent.  A lot of Burry’s clients, as they began to lose confidence in their hedge fund’s strategy, already wanted out. Scion Capital almost became insolvent before the bond market started to actually act rational about the subprime debt situation.  In such cases where you are right about a fact but not exactly right about the timing, you better be sure you have the stomach and the funding needed to stick it out until the end – until the event you are betting on actually takes place.

Michael Burry isn’t alone in falling into such a predicament. Some reputable names in the investment world are actually, currently in the same situation.

Take the famous investor Jim Rogers, for example. Rogers motorcycled around the world to find the best investment opportunities.  He sold his New York apartment and relocated to Singapore mainly because he believes that the US economy is facing an impending collapse.  Jim was bullish on emerging markets, especially China and so has most of his portfolio tied up in that market. However, the Chinese economic growth toutedby everyone actually ended with a crash last year, with the Chinese market collapsing in late 2015 and again just a few days into 2016.  Rogers might still be right.  But for now, he’s wrong.

Marc Faber is another example. Known for his gloom and doom outlook for the US economy, he invested in gold and recommended againstinvesting in bonds. Unfortunately, the market went against him for a while as gold prices dropped and bond prices performed well in 2015.  This year, Faber has said that he thinks investing in bonds is now a better option than investing in the stock market.  Is Faber right about his gloomy outlook for the US economy?  Will gold actually become a brilliant investment if Faber’s prognosis comes true – leading to multiple gains that would far outweigh all current unrealized losses?  Possible.  But for now, he’s wrong.

goldman sachsWhat should you do if you find yourself in the same situation?  If these legendary investors found themselves wrong for a time, how much more the typical, ordinary individual.

Like these brilliant men, what we advise at LOM, is you should revisit your model and assumptions.  If you find that some factors did not turn out as expected, then you should adapt.  Be a dynamic investor. You can’t be “married” to your investment.  You have to cut your losses if you are wrong.

But if you believe that your model and investment assumptions are still solid and it’s only a matter of timing, then you need to brave it out.  Of course, solvency is a key factor that will determine if you can last.  If you are highly leveraged, then you might not have the luxury of waiting it out.  You need guts and a stable source of funding so you can wait it out when you are right – but just wrong at the moment.

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A Comparison of the Chinese and the US Stock Markets

Although China’s stock market is relatively new, its enormous size makes it a huge and overwhelming force in the world economy.  China’s two stock markets, Shanghai and Shenzen, combined, fall only second to the size of the New York Stock Exchange.

china stock market

The Chinese government has no qualms about blatantly intervening in its stock market whenever necessary.  In its desire to spur trading volumes, it has in past years, opened up trading to the retail sector, fostering an environment of easy credit that has allowed investors to borrow a total of 365 Billion USD.  Even more unsettling is the fact that many of the new accounts that have opened since 2014 were opened by inexperienced investors who decided to invest just to participate in the stock market hype.From farmers to taxi drivers, these new investors exert a heavy influence on the stock market.  Despite government intervention, they were still able to cause the market to plummet in August last year and now in 2016.   6% of Chinese investors are illiterate, according to a Deutsche bank report, while around 60% left school at age 15.

It’s easy to look down on the Chinese stock market. Right now it seems fashionable to castigate the Chinese government for artificially pumping trading volume even if business and economic fundamentals would have resulted in much lower yet safer trading levels.  Fake bags, fake buildings, fake food, fake businesses and a fake stock market.However, when you glance out across the ocean to the United States of America, you see a similarly flawed stock market.

When the US real estate bubble popped in 2008, the US government had to intervene to prevent the banks from failing.  The US government resorted to printing new money to bail out the big lenders.  All the years since then, the US stock market (and the world market) has been on a significant uptrend with investors partying on easy credit.  However, a lot of analysts see that the stock market party is almost at its end.

Both the Chinese and US stock markets have been tinkered with by their governments.  The Chinese government intervenes as a matter of standard procedure, with zero transparency.  The United States government acts like it has been cornered into intervening just so it can shield American citizens from pain and save the world from financial Armageddon.  Through the years since 2008, the US and most national governments have been kicking the can of pain down the road by engaging in some mild form of market intervention via their economic and central bank policies.

What makes the predicament of the Chinese economy different from that of the US?  Well apparently, the Chinese economy could even actually be in a better state than the US.

Even with the huge absolute number of retail investors trading at the Chinese stock markets, these astounding figures only NY Stock Exchange closes with record highrepresent a small participation coming from the Chinese economy as a whole. The people who recently got wiped out from investing in the Chinese stock market, as sad a story as they are, only come from a small percentage of the country’s population. Hence, the Chinese economy is not fatally exposed to its stock market. In contrast, a huge percentage of the US population is exposed to the US stock market.  A stock market crash will debilitate the US economy and most of its people’s lives.

Another stark difference between the US and Chinese markets is the condition of their governments’ foreign reserves and budgets.  The US is the world’s biggest debtor nation and it owes China big time.  China can single-handedly crash the US economy by selling its US Treasury Bills.  The US can’t do much to China except pretend to scold it a bit for its belligerence in the South China Sea.  It’s a bit of a farce when the US says that it will defend China’s neighbors from China’s imperialistic trespassing in the disputed territories of the China Sea.  When you consider its financial state of affairs, the US can’t even defend itself- it’s economy – from the Chinese.

In conclusion, although it seems China is the greatest threat to world markets right now, it is not the weakest link in the chain of stock markets and economies.  The US seems to be a better candidate for that.  No one likes a redux of the Great Depression.  However, by delaying financial pain via economic policies and government maneuvering – by kicking the can down the road- governments are just making the pain harder, albeit postponed for the meantime.  No one really can tell how long this can go on.  Both the US and China are intervening in their markets.  The Chinese are socialists and authoritarian, but with a lot of gold reserves and receivables from the US.  The US, is democratic, magnanimous to all individuals, but spends more than it has and is a debtor to China.

Makes you wonder who should be learning from who.

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