Friedberg Mercantile Group Q1 Commentary: Views On Asset Allocation And Gold In A Stagflationary Environment

Tyler Durden's picture

First Quarter Report 2011 (PDF)

Dear Investor,

It gives me great pleasure to report to you the financial activities of our hedge funds for the quarter ended March 31, 2011.

The Friedberg Global Macro-Hedge Fund and the Friedberg Global Macro-Hedge Fund Ltd. lost 4.3% and 4.1% for the quarter respectively but remain up year over year — the former by 11.4% and the latter by 11.5% (all figures in U.S. dollars). The statistics we present below are drawn from the larger Friedberg Global Macro-Hedge Fund Ltd., but the comments below apply equally to the Canadian version.

After exhibiting extreme weakness well into the quarter, our portfolio was showing signs of recovery by the first week of February, and managed to end the quarter on an upbeat note even though returns for the quarter were negative, as noted.

No material changes were made to the portfolio as we became even more persuaded than at the end of last quarter that the outlook dictated a very cautious stance towards the global economy. Stagflation in the months and years ahead is becoming an ever more compelling possibility. Central banks in the U.S. and the U.K. continue to show a pronounced and misguided reticence to return to less accommodative postures even as consumer prices begin to reflect the surging prices of internationally traded raw materials. As we have not tired of saying, these highly sensitive commodities respond quickly to excess money creation, and excess money creation has occurred as a result of maintaining interest rates pegged to the floor, well below inflation rates. This portfolio effect is aggravated by the fact that emerging countries are reluctant to allow their currencies to appreciate in the face of massive dollar inflows, intervening instead to maintain roughly unchanged nominal parities. These countries’ enormous accumulations of reserves lead to local money supply surges, which in turn lead to more buying of energy and food commodities. Finally, the financialization of commodities, made easier by a record of historically attractive risk-adjusted returns and low carry costs, adds a further destabilizing element to this scenario.

Importantly, this inflationary episode, which threatens to last as long as the U.S. does not raise nominal interest rates above present rates of inflation (or, more to the point, real rates above the growth rate of the economy), has serious recessionary consequences, especially when wage and salary costs lag prices. In other words, what is being touted as a constructive element, the fact that labour costs are not showing signs of inflation, is reason to believe that the economy will soon be hit by another wave of retrenchments, as consumers are hit by shrinking real paycheques. Recessionary pressures in the U.S., adumbrated by downward revisions to second-quarter GDP forecasts in recent weeks, are being reinforced by economic weakness in the U.K., which is already undergoing a more severe bout of inflation, and the Eurozone (with the exception of Germany), which is in the grips of extremely high unemployment and negative growth per capita and stifled by excessive debt, rising taxes, and, believe it or not, low money supply growth. Consider, too, that most of the emerging markets are engaged in belated and not always conventional forms of monetary tightening in a desperate but ultimately futile hope of reducing inflationary pressures without disrupting real economic growth, and the resulting mix, you might guess, can only spell global economic trouble.

What, then, does a prudent portfolio look like in this threatening scenario? It should be long inflation-linked government securities, for reasons of safety and because of the excess returns that come from inflation in energy and food costs, two leading edges in the recent surge of commodities. To put their attractive features in perspective, the breakevens of the TIPS of February 15th, 2040 express an average inflation expectation for the next 29 years of only 2.73%, modest when one considers that consumer prices in recent months have been running at 5%-6% per annum, just two years after the Great Recession and while unemployment hovers around 9%!

Consider whether you would be willing to entertain a football-type bet that inflation will run at less than the breakeven (the “spread”) and soon you will realize that the bet is much too risky, and that you would probably want to add to the spread a minimum of 50 to 100 basis points above the breakeven before you were willing to bet that inflation would be contained, in order to protect yourself against the eventual monetization of the impossible-to-repay federal debt. If you agree, then long-term TIPS are indeed too cheap and yields ought to be trading much closer to where five-year TIPS are trading, minus 15 basis points; that is, you ought to be paying to receive a negative real return, simply because you have no way to guarantee that a security, any security, will successfully cover the expected rise in the cost of living. In sum, not only are we likely to receive substantial inflation-linked payouts from these instruments, but a move towards substantially lower real yields will also produce very significant capital gains.

Through the Global Opportunities sector we have acquired, via repo’s (at a cost of one quarter percent per annum), a significant amount of TIPS, adding to those already held in the fixed-income sector and bringing total TIPS exposure to 104% of the fund’s capital. The market has finally begun to take a less sanguine view of inflation in recent weeks, with the result that breakevens have climbed and real yields have begun to fall, taking inflation-linked long bond prices well off the lows reached on February 10th, 2011.

The prudent portfolio should also be long gold, for reasons that we have explained so many times in the past, namely, the return of gold to the monetary system. Not only are Asian central banks inevitably seen adding to their meager holdings but now it turns out that individuals worldwide, by continuing to add gold to their portfolios, are de facto turning gold into legal tender. We note with interest that Utah has recently passed legislation to make gold legal tender in the state and that other states are preparing such legislation.

Traders understand very well that increased supply in the hands of the public eventually creates a market that is liquid, deep, and competitive. The more gold circulates, the greater its chances of becoming accepted as money. This is a stealthy, totally unexpected and highly significant phenomenon, one that promises to erupt onto the financial scene with dramatic force over the next few years. More than 70% of our portfolio is exposed to gold; fluctuations in its price understandably have a significant impact on our NAV.

We continue to maintain a substantial long position in Bunds, the 10-year German bond, equal to approximately 94% of the fund’s capital, notwithstanding the fact that the trade has been a disappointment so far. Yields climbed to 3.35% from 3.15% during the first quarter, continuing an upward trend begun September 2010, as the belief gained ground that Germany was writing a blank cheque to bail out the weak members of the Eurozone, an event that would clearly damage its good credit standing. In recent weeks, the German electorate has given strong signals that it is not willing to provide support over and above the Merkel government’s initial commitment, that it will not back a joint Eurobond and further dilute its credit standing, and that it will insist on extracting meaningful austerity measures and drastic fiscal reforms from sovereign Eurozone borrowers — demands that, in all likelihood, will not be agreed upon by these debtors and will certainly never be met. It is almost a mathematical certainty that debtor countries will not be able to grow out from under their debt unless they can effect a real devaluation, i.e. deflation, to the tune of 25% to 40% vis-à-vis their hard-currency northern neighbours of Germany, Netherlands, Austria, and Finland — an almost impossible and unreasonable expectation. In our opinion, we are very close to a total breakdown of the painfully constructed bailout package put in place by the E.U. early last year. It is a matter of months if not weeks before Greece and/or Portugal unilaterally bolt out of the E.U., unable to grow out of their debt, unwilling to endure more austerity measures, and despondent over not seeing an end to their debt servitude. Given this scenario, Bunds are likely to regain much of the ground they have lost.

A second reason for the recent rise in yields has to do with the worsening outlook for inflation in the Eurozone, to which the ECB has responded by raising the lending rate by 25 basis points. This problem has us unconcerned, firmly convinced that inflation will neither be validated nor become entrenched in the Eurozone because of the low rate of growth in broad money over the past 18 months. In sum, we believe that (synthetic) Bunds, stripped of euro exposure, continue to represent excellent investment value, all the more so when funded with short rates, as we have done.

Two other major areas of concentration deserve special comment. The portfolio is short equities in line with the idea that stagflation will be detrimental to corporate fortunes. Our short bets are focused on Brazil, India, the U.K., Spain (via a single stock, Banco Santander SA), and Australia (via National Australia Bank Ltd. and Westpac Banking Corp.). These bearish bets are partially offset by long positions in Ireland (via a single stock, Bank of Ireland), the U.S. housing sector (via two ETFs), the U.S. energy  sector (via a single stock, Newfield Exploration Co.), and the Japanese Nikkei index, a very recent, post-earthquake, acquisition. Net of the long position, short bets represented 59% of the fund’s capital, a reduction from its exposure at the beginning of the quarter. A heavy long position in Credit Default Swaps (CDS) on Portugal, Spain, Italy, Brazil, and Venezuela rounds out our largest commitment. I should note that CDSs and a short position in Fed Funds, hedging against a rise in interest rates, represent as much as 2.2x exposure out of a total exposure of 6.88x (see inside exhibit). Maximum losses on these positions can be ascertained in advance and do not carry the risks usually associated with leverage. The portfolio’s leverage is only barely higher than it was at the end of last quarter and, for all practical purposes, is not much higher than average. On the other hand, favourable outcomes hold significant capital gains potential.

Reviewing actual results for the past quarter, we note that the Global Opportunities sector contributed close to 95% of the fund’s quarterly loss. In that pocket, the leveraged position in Bunds represented the largest single loss, followed closely by the long position in CDSs, gold (essentially the cost of carry and the decay on the long call position), the short positions in the Australian banks, Banco Santander SA, and S&P 500 futures, and the long position in Bank of Ireland. The Fixed Income sector and the Currency sector contributed modest losses, though these were pretty much offset by gains made through our long commodities exposure, managed by Covenant and augmented/complemented by us. The market-neutral U.S. equities program managed for the second consecutive quarter to overcome the low-dispersion/high-correlation phenomena and produced a respectable gain.

The Friedberg Asset Allocation Fund and the Friedberg Asset Allocation Fund Ltd gained 1.1% and 1% for the quarter and are up 14.8% and 15.8% year on year, respectively (in U.S. dollars). Here, too, positions did not vary much, if at all, from the end of December, with gold representing approximately 55% at quarter-end, Bunds 9.80%, TIPS 21%, equities 9.40%, and commodities (crude oil) 5.30%. We are satisfied that these funds broadly replicate our macro views while being able to operate in deep and extremely liquid markets. Self-imposed restrictions on short-selling and leverage lower volatility and risk, though likely at the expense of dramatic returns. The risk/return profile of these funds suits many of our more mature clients and, consequently, these funds have been very well received, with combined assets reaching $114,000,000 as at the end of March.

Besides those unimaginable “unknown unknowns,” the coming months will also see a good quota of “known unknowns,” a fact that you would not appreciate simply by observing the complacent behaviour of default swaps, global stocks, and options. This complacency itself is perhaps reason enough to believe that we are about to face a very troubling quarter.

Thanking you for your continued trust,

Albert D. Friedberg

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Racer's picture

Genocidal ChairSatan's trickle down p!ss eCONomy... the final outcome unfolds

slaughterer's picture

Friedberg?  My god, soon ZH will be shining its spotlight on Doug Casey.

Soul Train's picture

Ultimately, the dollar will continue its crash course. And American sheople will wake up, and realize that they need to change the structure of the Federal government somehow. Perhaps segment the country??? Not that big of a deal people.

The Federal Reserve is not a Reserve and is Private. And Americans have bought into the money cartel for almost 100 years! Way to go, JP Morgan, you did a heck of a job pulling the wool over the sheoples eyes.


Hey, anybody know what the end game is in Iraq and Afghanistan? It's worse than the Vietnam fiasco, and Americans are so fat and dumb and afraid they'll lose their 401k and McMansions that they have lost their moral compass.


Not good.

plocequ1's picture

Too late. Man hasn't found his true character and wasn't able to keep himself from entering the Abyss. There is no turning back. Look to God.

DoChenRollingBearing's picture

+ 2

I completely agree we are in the Abyss, and that we cannot get out.

Probably OK with Him if you help to take care of yourself by buying some gold...

The time to prepare was yesterday!  But, preparing today will be better than waiting around until tomorrow.

nmewn's picture

"Probably OK with Him if you help to take care of yourself by buying some gold..."


The Lord helps those who help themselves.

Hacked Economy's picture


Had a spirited discussion here on ZH about a month ago with a couple of other members who were very antagonistic about God even being mentioned on this site.

Tell you what...regardless of what stripe you might be, it's a sure bet that - as the financial house of cards begins to crumble on a large scale - more and more people will be saying...what?...

"God help us!"

web bot's picture

I would agree.

The problem is there is NO solution to getting out of this mess, unless we're willing to contemplate default, or backing away from the world reserve currenty status. Over 50% of US debt is < 3 years to term, so the moment interest rates start to rise, we start to see the federal debt go hyperbolic within a short period of time.


Al Gorerhythm's picture

Tell him for me he needs a shit load of money if he wants to join the party and watch out for politicians and merchant bankers. 

Diogenes's picture

They've already lost their McMansions, their 401Ks are going fast and they are still sitting on their ass with their feet up in front of the TV. If they haven't wised up and got mad yet they never will.

Pegasus Muse's picture

The trouble with most of Americans is they are treated like mushrooms.  MSM intentionally keeps them in the dark and feeds them endless amounts of shit.  

If you are not on the internet reading, learning and figuring out things for yourself, you are destined to be royally screwed.  

DoChenRollingBearing's picture

Friedberg covers a lot of turf in his post, and they put money in CDS and other things I would never consider.  So I limit my comment to gold.

I would recommend to everyone to buy & hold 5% - 10% of net wealth in PHYSICAL GOLD.

Dejean Splicer's picture

I would not make that recommendation until Gold hits $3274/oz. My models are telling me that is the best time to buy. But % ownership at that time is more towards 46.7% of total AUM.

Wait for it. It is the tipping point.

~D'jean Splicer

DoChenRollingBearing's picture

I buy gold when I have money come in.  I hardly even care about the price (I do check it to make sure I am not getting ripped off at the coin shop), it has always seemed "expensive" every time I have bought through the decades.

I am not sure I understand your logic of waiting for POG to reach $3274.  Why not front-run that price right now at just under $1500?

Dejean Splicer's picture

Oh, just a little thing called risk reward.

DoChenRollingBearing's picture

Dejean, the Bearing kindly asks you to expound further...  

The risk / reward seems rather good to me here.  Yes, I recognize that the E.E. may bash gold down, but how far?  Not far would be my bet.  The WORST I could realistically see happen would be $1050, the "India Put", the price India paid a year or two ago for their 100 tonnes from the IMF.

U of Texas just took delivery of $1 billion of "physical" gold, although it is not clear exactly how their gold is allocated nor if they can actually extract it out of HSBC's vault.

If/when gold does get to $3274 (or anywhere near), the FOFOA's Freegold may be very near.  The move to $55,000 may be very swift.

The Bearing always likes learning more about Au.  Also 52100 steel.

Dejean Splicer's picture

Dovetail Marty's analysis into your work but be sure to account for .gov intervention as it has blow his work to shreds unless you know what you're looking for, adaptations of Kondratiev wave specifically Juglar's fixed investment cycle.

DoChenRollingBearing's picture

Thanks Dejean, I will check out your link.

I like M.A.'s work (been following him for 18 months or so), but it seems, what, too deterministic?  He does have an awesome knowledge of history and monetary history as well.

.gov intervention is a problem no doubt.  I do not know how to factor that in, until I see what they try.  The guru I follow (FOFOA) says that .gov is not likely to try and confiscate gold as they will need private owners of gold to recapitalize our economy.

Granted, there are lots of other ways .gov can interefere with the price of gold.



Wow, Martin Armstrong has been prolific since I regularly read him.  Your link provides a vast amount of material, which will take some time to read and digest.  Thanks again for doing the good thing of helping to educate the Bearing.

Dejean Splicer's picture

Right on. But it's not only Marty. Focus on understanding Kondratieff P.R.D.E work and understand how .gov (Keynesian's) alter the natural order of free markets.

Hacked Economy's picture

I tend to lean toward Bearing's method of buying now rather than waiting until it's at least twice as expensive (wink!)

I hold primarily silver (the po' man's white gold), but am seriously thinking about beginning a foray into some of the serious yellow stuff as well.  Won't be a lot, as my finances allow, but we all hafta start somewhere...

Diogenes's picture

If you invest 21.32% of your money in gold now when it hits $3274 it will be 46.7% of your wealth.

dearth vader's picture

What news moved up the yen against gold and silver at 17:12 EST so suddenly, the US$ keeping steady, and sinking the EUR, CAD, AUD and GBP?

redpill's picture

He may make some valid points, but I tend not to listen too closely to financial types who have to start out their letters describing how much money they lost during the quarter.  I can do that very well without any advice.

doggings's picture

I think its par for the course with hedge funds, the good ones just win more than they lose these days. the not so good ones are all gone already, destitute or shut up shop and got out in disgust. 

disabledvet's picture

maybe.  certainly economic growth estimates are being downgraded due to Fukushima and the incompetent response to Libya to date and Europe in general.  I don't see a recession call (yet) and indeed if equity markets are good for anything it's as a predictor of growth coming out of a downturn.  interestingly "i havn't seen much of a recovery" even with a doubling of the S&P which certainly is true in most of the American people's lives as well.  Still it does go to show "you'd better get a lot of deflation in here" if the American people are going to change their views on "how we're doing" since "they all took a pay cut" and "got a phuck you very much" as the economy recovered..."from the recipients of the bailouts" no less.  I'll take the war and the inflation if that's the alternative...and hope that our government will do everything they can to hold on to every benefit possible for the American people--and when I see men like David Petraeus (hopefully next Secretary of Defense) it sure gives me a lot more hope than Jamie Dimon running around saying "tax me!  tax me!" but never saying "this bonus pool is a phucking crime against the American taxpayer."  btw "if there's any hope i saw 100,000 head of beef while driving on i-40 back from Cali" this week.  maybe i will have steak tonight.

LawsofPhysics's picture

We should have been raising rates incrementally a long time ago.  The Fed has now painted everyone in the western world into a corner.  The easy money has to keep flowing for two reasons.  First the "mark to unicorn" accounting becomes more and more shaky as more and more people start realizing there are no unicorns and triggering a collapse of the interest based bullshit derivatives market that is well over a hundred trillion.  Moreover, how would the debt be serviced?  Now things get interesting. Are we all becoming Japan?

SuperRay's picture

5% - 10%?  how about 30% - 50%, with more accumulation as the dollar failure becomes increasingly obvious?

DoChenRollingBearing's picture

SuperRay, if your question is directed to me, almost any mainstream money manager says 5% - 10% in gold is OK.

I am at 12% (all PMs combined), a month ago I was at 11%.  Most of that extra 1% has come from higher PM prices, a little from recent buying.

The cautious (paranoid?) Bearing does not like the idea of putting more than, say, 30% of his wealth into any one asset class.  Diversification is one of my favorite words...

Hacked Economy's picture

Very wise.  The smart money says that PMs are going to rise quite a bit higher, but there are two things I've learned from my younger years:

1) "I'm not so concerned about the return on my money as I am about the return of my money."  [Samuel Clemens]

2) "Never bet or invest any more money than what you can afford to lose, just in case the worst happens..."  [my father]

My PMs are currently at about 11% of my overall portfolio.  I'm working to make it 25%, which is about what a healthy government should be operating at.  But all things in moderation...and with a level head....

Pegasus Muse's picture

I adhere to Eric Sprott's investment philosophy.  He says if you find something you truly believe in and you know in your gut is the right investment, go for it.  He is more than 90% invested in PMs (bullion), miners, and other natural resource stocks.  He calls gold the investment of the last 10 years and silver the investment of the next 10.

I'm 66% in bullion, split 50:50 gold:silver, with rest in PM miners and other natural resource stocks.  It's been a bumpy ride but an interesting and profitable one. 

Hacked Economy's picture

No doubt you're going to do pretty well.  When I say my "portfolio", I include my 401(k), which I stopped contributing to some time ago (and started using that monthly contribution money to buy physical).  Unfortunately, my plan doesn't allow for any diversification into any type of PM (not even SLV i-Shares), or even a hardship withdrawal.  I'd rather take the withdrawal, eat the taxes, and use that money to get into some more physical and some choice junior mining stocks I believe will peform well and give me a MUCH higher rate of return than the 401(k) ever will.

Besides...if the economy goes down the flusher, then the 401(k) might not even be there for me anymore.  The physical PMs would be the only portion safe from being obliterated from the Keystone Kops at the Fed.

Oh well.  Ya work with watcha got and do the best you can.

Rainyday_man's picture

+1 if you ain't a $ billion endowment, 25% and up is better choice.

LawsofPhysics's picture

We should have been raising rates incrementally a long time ago.  The Fed has now painted everyone in the western world into a corner.  The easy money has to keep flowing for two reasons.  First the "mark to unicorn" accounting becomes more and more shaky as more and more people start realizing there are no unicorns and triggering a collapse of the interest based bullshit derivatives market that is well over a hundred trillion.  Moreover, how would the debt be serviced?  Now things get interesting. Are we all becoming Japan?

SuperRay's picture

we'll be japan after Indian Point springs a leak...

Big Corked Boots's picture

Deducting 1 star for making me look up the word "adumbrated."

Just say WTF you mean. I'm not impressed with that there fancy writin'.

Edit: ___ plus 68 = 68. Math even a congressman can do.

Diogenes's picture

adumbrated (comparative more adumbrated, superlative most adumbrated)

  1. (comparable) Obscured.
  2. (comparable) Foreshadowed.
  3. (heraldry) Depicted on a shield as an outline instead of as a solid figure.
[edit] Verb"


He either obscured something, foreshadowed somethng or depicted it on a shield as an outline.

I'm certainly glad we cleared that up.

rodocostarica's picture

I dont get it. This hedge fund is strongly geared towards gold and has negative first quarter returns? Hows that work out?


sudzee's picture

"followed closely by the long position in CDSs, gold (essentially the cost of carry and the decay on the long call position),"

Losses on gold position? Just buy the frikken physical. 

PulauHantu29's picture

Great article. Thanks. Gold is the safest (imo) but I have added USO for oil since I don't see oil going down much in the future for a number of reasons. Same goes for palladium which is controlled by Russia and S Africa and with every one of the 3 billion + INdians and Chinese wanting a car.






Good luck to all ZH'ers.

Tapeworm's picture

Look at USO compared to WTIC or Brent.

Big Corked Boots's picture

And good luck to you and your PALL longs. Three billion potential car owners are going to remain potential in a bleeding global economy... just sayin'.

lasvegaspersona's picture

Being a small and nimble investor (speculator) I have enjoyed the last 6 months (very much thank you) being in AGQ a Ultra (2x) Silver fund. I have tripled my $$ and every so often I change some paper to real. I too believe that diversification is wrong when you are experiencing the trade of 5 lifetimes. I would prefer if gold was doing the heavy lifting but silver is doing it now. 

About a year ago I read a book on gold. It presented the 10 commandments of gold. #11 was "Never Trust Silver" I laughed. Afew weeks later I jumped into silver and while there have been a few  weeks of heartache I am soooo happy I'm in. I have a few trigger points where I get out but lately there has been no safe exit points. 

It kills me to buy more shares at almost 4x what I paid for the first ones I bought but hey "It is only fiat".

I would not encourage anyone to follow what I am doing but until silver quits I can't quit it. 

If anyone could prove to me that the dollar can survive I'll behave and buy a nice balanced diversified portfolio. I keep trying to find an argument that makes me believe I am wrong because what I am doing is reckless. I simply can't hear one. Until then I remain heavily in one asset watching hourly for the time to jump out. 

While diversification is safe, more money can be made in concentrated investments. 

BTW no one else's livelihood depends upon my  thought process.

mccoyspace's picture

AGQ all the way. The ProShares ETFs are like the crack cocaine of investing.