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Unnatural Acts
With some trepidation, last night I called up a guy who manages a hedge fund (with some of my money in it) and asked, “So, how’d we do?” He says, ”We’re down 3% for the month. We got creamed on our longs but we were hedged, so the net was not so bad.”
I say, “Gee that’s great news! So you were long puts?” He gave a surprise response:
"No puts. We were long a bunch of long dated Treasury zero coupon bonds."
My guy’s defensive tactics worked very well in September. I think there was some of the biggest % moves in history in bond land. Consider this chart. Zeros were up 25% while the S&P was down 8%.
This trend has been going on for months. This chart looks at the last three. Note that Zeros are up 50%! Note also how tight the inverse correlation is.
I find this troubling. While I can get comfortable with a balanced portfolio where bonds counter cyclically provide a natural hedge, I do have trouble with hedge funds using the bond market as a synthetic “Put” against long equity exposure.
The reason for my concern is the leverage that is involved in creating a viable hedging mechanism. Based on recent results the hedging ratio of long zeros as a hedge against long stocks is about 3 to 1. So a billion of stocks is “hedged” when a $350mm long zero position is coupled with it. A zero has the duration equivalent of 4+Xs a straight ten-year. So another way of thinking of this is that to “hedge” $1 of S&P one would need to “own” (It's all leveraged) about $2 in ten-year bonds.
I think this an unnatural act of a sort. Leveraged bets in bonds are just that. A bet on bonds. They are not supposed to be a hedge against equity exposure. But they are. So what does that mean?
I conclude that we are in a bubble for bonds. There are people who own them for the wrong reasons. It’s speculation, not investing, that’s driving the bond market. So we are in the worst kind of bubble. A speculative one.
Please don’t read this as a recommendation to get short bonds. It’s not. I think we are in a bond bubble, but I don’t see that changing anytime soon. That said, a final thought from the fellow who runs money.
We’re concerned that our hedges are going to decouple. Interest rates can’t go much lower from here. It’s possible that global stocks can go down and US interest rates don’t follow suit.
If that happens we will have to respond. We may be forced to unwind the zeros and just buy more traditional insurance. The problem is that the alternative is very costly.
What he is saying is that he would be a net seller of Treasuries with a long duration and a net buyer of equity put protection. By itself, this would tend to exert downward pressure on stocks and also downward pressure on long dated bonds.
Where’s the Good News?
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Be nice to see a fuller ZH analysis on this. Tyler?
Sanders is misrepresenting the amount. The 16 trillion is the gross total of all the loan TRANSACTIONS and not the net outstanding.
even the net must be gross after having cut out the net to let out the smelly fish in their trillions.
FWIW, here are my last 2 blog posts re: 3rd quarter results & next targets for the USD/CAD and for the major indices:
http://strawberryblondesmarketsummary.blogspot.com/2011/09/im-officially-crazyor-should-i-say.html
AND
http://strawberryblondesmarketsummary.blogspot.com/2011/09/who-won-pinball-game-in-3rd-quarter-of.html
I am a little confused...someone "else" manages "some of your funds"? I thought that was what you did.
Absolutely. It would be nuts to think I could do it by myself.
This is 24/7/365 if you are active. It "hard" work, especially of late.
Yes, I also do my own things.
Danny has returned, and he manages some funds in return for Bruce letting him swim in his pool.
Lol
And Danny has blossomed into a handsome youth who with the right training will make a good cabana boy one day.
Going out today to see if I can find about 10 one ounce gold bars and when that's done, am hitting ATMs for as much cash as possible. Thirty year zero coupon bonds are definitely not on my shopping list, for any reason.
My kind of investor!
All's quiet on the Japanese front...don't expect U.S. rates to go up first....
<<I conclude that we are in a bubble for bonds.>>
Good article. Thanks.
The problem is merely spotting a bubble is useless without timing. Many saw the housing bubble for what it was as early as 2004, but if you shorted housing you lost your shirt over the next three years. Many of us knew quite some time ago that Netflix was a bubble, but until very recently, you'd get killed shorting it. Look at Linkedin: P/E over 1,100; complete bubble. Go ahead; I dare anyone to short that sucker...
Merely acknowledging that bonds are in a bubble is only a small part of the picture; how much longer can that bubble continue to inflate before it bursts?
And if there is a flight from equities, the money will have to flee somewhere - likely bonds.
The market can stay irrational longer than you can stay solvent.
I agree. Better to short Bruce. First it was MHFT. Then it was the Greek guy from Canada.
http://www.youtube.com/watch?v=rWOIFxeE81E&feature=player_detailpage
"The market can stay irrational longer than you can stay solvent."
This be some serious wisdom, bitchez. Listen up.
One of the few sensible things Keynes said.
Actually now does look like a great time to short linkedin :P. I feel safer with my SRTYs though.
Agreed, and furthermore, I think small investors are unnecessarily hesistant to jump in on the last 1/3rd of a trend.
Manage risk: position sizes, stops, etc. But definitely get in there. What's easier, predicting the next bull market at it's very inception, or noticing that something is happening after it is well underway? All the hobbiest investors here are managing portfolios that are 3 orders of magnitude smaller than what the pros are handling. That means you are more nimble. Use that to your advantage!
Rationality is for people with no imagination. That's the rub. And why the market will never and has never been completely rational: it is contaminated by hope, fear, and other emotions, just like the robots that........nevermind....
This is not a hedge. The correllation could break down at any given point, and you could have a loss on both legs of the supposed "hedge."
I think it's inexcusable for someone to claim that buying puts as a hedge is "too expensive." There's no way to ever know if options are "too expensive" unless you have a crystal ball and you will be able to forecast actual volatility compared to the current implied volatility. And anyway, you can buy effective protection against big moves pretty cheaply using either out of the money options or spreads.
The guy running this hedge fund sounds like he's relying on luck.
Unless you are buying two sides of the exact same trade you're always relying on a correlation which can break down at any given moment ... death and taxes and all that.
Luck? To some degree. But it was not so hard to call a bond rally over the past three months. Bernanke flat-out said he was doing something two months ago. His mouth piece, Jon Hilserath, told us what would happen. We got a Twist. That was written in stone.
So, not just luck.
The point is that this "hedge" is not likely to continue to be a hedge.
You say puts are cheap. I say they are expensive. Vix is at 40, meaning put premiums are high. When it was working, the long Zeros had a positive carry, while puts just have decay.
Zeros, as you say, are a very imperfect hedge. But in the last few months it was the best place to play defense. The next three? I'm not so sure.
then why did the treasury market get wiped out when he actually bought treasuries MASSIVELY during QE1 and QE2? you're out of your depth and clearly either a: have no economic background or b: are simply ignoring those who do. we've known all year that the US economy is slowing due to Fukushima and Europe. THAT's why the Treasury market soars--that an the fact that the USA has had no true recovery to speak of which caused the Republicans to take back the House last fall (another treasury positive result.) The question isn't "why are treasuries rallying" but "how far they will go." Tom Keene lied and said 1.75 on the ten year when the market had it's first...i'm not sure i want to use the word i'm thinking of right now...anywho while a bald faced lie at the time it did hit 1.76 about a week later. There's a reason he had that number in mind although i can't say either he nor i understand it other than "it was in the ether." i would gather it has something to do with bank capital regulations and simple "solvency" as interest rates across the curve plunge to at or near zero. Basically Warren Buffet's "financial weapons of mass destruction" being detonated and the attendant results.
Here's an idea - if you want to "hedge" some equity exposure , then sell some of that equity exposure. Its really not rocket science. All you gamma geeks thinking you can stay one step ahead of the market are going to get wiped out when the 6 sigma events start appearing every other day. Your correlations and hedges and theories will get sucked into a black hole along with your capital. Keep it simple stupid.
I kind of agree, to an extent. I think the guy's logic may go like this: I like this, and I like this other thing too. By happenstance, they tend to hedge one another, at least for now. This way I can avoid spending x on a hedge. You say it's spurious logic, I say you're right but it is very typical "strategery" when running a big book. Sometimes it works, sometimes not. Finding value (whether it's vol, correlation, skew, whatever) is difficult and somewhat of an art form.
If the guy didn't understand there is a correlation issue, that would be disconcerting. Otherwise, it's just another bet that semi-didn't-non-work.
Look man, I agree that these are two complimentary long positions. But a HEDGE is a different animal. This isn't a hedge. If you wanted to hedge your equity position, you could have bought deep out of the money puts cheaply. You could have even bought them as ratio spreads.
And yes, the hedge fund is relying on being lucky that the correlation holds. It could break down instantly and you could lose money on both legs of the trade. By defininition that is not a hedge.
Do you think paying 2 and 20 for this strategy makes sense? I do not.
I don't know. It's all about results. Maybe the guy is good at it. Maybe slippery "hedges" are his specialty. You never know.
The profits (or lack of them) will tell us if the guy is good or bad.
Sorry, but looking at results only is a fallacy. If this guy was laying bets for you at negative expected values (on average) in Vegas and happened to luck out with a payday, you'd be pissed at how he'd handled your money even though he happened to have brought home the bacon (this time).
All financial markets are a negative expectation game, because you can (in theory) not obtain market returns withou giving up some frictional trading costs. And yet some guys play the games successfully - on a regular basis. So generating profits is a business of taking the market's distribution of gains and losses, and somehow filtering out a subset of those returns that impact your account favorably, while not allowing the unfavorable. It's a challenging thing. It's an art form, not science. But it is possible and it is done. I would argue that the only way to discern the value of the trader is to consider returns after they've hit the account.
So let's consider what you said about Vegas (neg. expectation game). You'd be pissed off. I would say, how did you perform? Maybe he's got some idea that's unexpected or unusual. Did you know that one of the most successful commodities forecasters (Arch Crawford) is a guy who uses astronomical cycles to somehow forecast herd psychology. (That's crazy, right?) My question is "how has he done?" The answer is that he apparently has done well. Your response would be, "no I'm looking for a strategy with credibility," and you would have missed the profits.
Anyways I don't think I really disagree with you but I have to say it's a pleasure to interact with nonidiots here so, hats off anyway.
Have a good Saturday.
Seize Mars,
Thank you for your respectful reply. I have two issues with your approach. The first is that correlation is not causation. So I expect that Arch Crawford is just lucky, and I don't want to invest my money with someone who is just lucky (past performance is no indicator of future performance).
Secondly, I disagree that the entire market has a negative expectation value. I think there is just enough inefficiency in the market that those who do their homework, reading securities filings and doing street checks can profit off of the "Free riders" that are just trading off of intuition and hoping to get lucky.
In the end, results matter, but I believe you have a better chance of obtaining good results if you play smart instead of just hoping to get lucky.
Hope you enjoyed your weekend. See you in another thread!
If i blow up (financially speaking) the city of Las Vegas is the Casino the winner? Start from there and i'll think you'll understand why so many "smart people" are so wrong all the time.
Looking at ZROZ, I see 106.66M of assets and a daily trading volume of 68,969 (though most trading days are far less). As of about Aug 1st, it was at about $72 and closed yesterday at $110 with a yield of 3.69.
Thing is, this ETF has only been around for a year (Oct 30th), so there's no history of reversion or, maybe more importantly, redemption at LTCG inflection.
All this is great news! It means I'll be able to continue to follow your reporting well into your old age! Keep up the good work.
Been following Hoisington and Gary Shilling's lead into LT UST. Zeros up big. Not enough to offset PM losses, but eases the pain.
I don't think people own bonds for the wrong reasons. Ok I'm a bond bull and yes I'm an MMT guy so "the natural rate of interest is zero" but even if you don't buy that, there's lots of fundamental support. How about a belief that the US is repeating the same mistakes as Japan, along with a historical chart of their bond yields? Couple that with EUR and CHF taking themselves off the table as safe havens, the collapse of PMs and commodities as China stops printing vigorously, and the massive US fiscal tightening that is due either by super-committee or failing that by auto-pilot, and a risk-free yield starts to look better and better.
When does it end? I have no idea. That's what stops are for. In the meantime the trend is your friend, like everything else.
Ye Ye:
Because in japan everyone is a psycho-serf to the one-party government and practically everyone in Japan old enough to own money 'invests' in japanese sovereign debt.
US Debt, on the other hand, actually finds significant foreign buyers, and in spite of Ben Bernanke's promises, eventually he's going to be facing a world market that says "fuck your couch", and there will be nothing he can do about it.
I expect interest rates on Treasuries to fall into the negative range before that happens, however. This may be sooner than many of the people here expect, as well :P.
Won't lower yields and expectations of smaller price adjustments as zero approaches be countered with higher leverage, ie more bonds to maintain the hedge...fuel on ze* fire.
*ze fire stabeeleetee
This is the nightmare scenario, but it makes perfect sense in a low-savings, capital destruction environment. Stocks plummet but rates soar as investors pull out of the longer bonds. It will be a race into cash as assets across the board collapse. Not "cash" on your brokerage statement. Actually cash. Money markets and all types of funds will break the buck.
What the heck is "actually cash"? Are you recommending storing the paper kind? If you try to put it back into the bank or brokerage account you will have to report it as income and pay taxes again. Seriously. The IRS does not allow you to tell them that you've been storing a pile of paper currency. People have made that very expensive mistake before. Google it.
Paper currency of any significant amount will be outlawed in a few years. The digital kind of cash will be all that's allowed.
CapaitalistRock,
The IRS does not allow you to tell them that you've been storing a pile of paper currency. People have made that very expensive mistake before. Google it.
Uh why?.
Just make sure when you remove it from your accounts, you get recipts(IF your talking banks),of where you withdrew it.
Proof it was already taxed.I would like to see that,especially if you have a Withdrawal recipt.
The important quesiton is what is the percentage of such trades to the total amount of the comparative treasuries. I do not think it is meaningful. Yet, I agree that treasuries are in a bubble, which is not going to deflate any time soon.
BK might not want to suggest to short bonds but for those who didn't get in on the gold band wagon (and those who did), short bonds. Maybe not today, maybe not tomorrow but they are ripe for it.
Helicopter Ben is giving us all the information anyone would need to make profiting from this like stealing candy from a baby.
Wish they (powers that be) would just fire themselves and get out of the way so we could make an honest living.
countupir...
" Maybe not today, maybe not tomorrow but they are ripe for it. "
You are recommending that we short US Ts but offer no time frame? Ask Bill Gross how that worked for Pimco.
"Helicopter Ben is giving us all the information anyone would need to make profiting from this like stealing candy from a baby."
The Fed beige book contains some meeting notes, thoughts and comments... It does not contain promises...and, nothing the Fed says is chiseled in stone.
If you invest based on what the Fed says it's going to do you are setting yourself up to be cut off at the knees... maybe not tomorrow or next month, but eventually you will become food for the sharks with inside info.
Good points. It is always a chore to keep up with the best info that isn't insider info which is the best I have to work with.
Homework doesn't end.
...setting yourself up to be cut off at the knees... maybe not tomorrow or next month, but eventually ...
Except if you are using OtherPeoplesMoney, in which case what's the downside risk?
plus you're betting against the market not the Fed. The market responded first..all the Fed did was make an announcement. Big whoopdy-doo. Either way it's still dry powder for an equity rally provided profits can be maintained. These are "capital gains" and once sold can be reinvested in the equity market as well. This is not to say they don't get reinvested in treasuries however. (Frankly i still don't understand why that is done--but the fear of you sovereign debt defaulting is a good reason if your a CB'er.) I say there is still massive amounts of risk tolerance in the US capital markets given the devastation caused by Fukushima and what appears to be the breaking apart of the European currency union.
so we could make an honest living
And that is the heart of the problem. Fortunes are made from inside information, unavailable to the great unwashed.
Trust in the system and individuals has long been lost and cannot be conjured up by tarnished "leaders".
"Investing" without inside information is simply gambling!
Everybody has "inside" contacts somewhere and will take advantage of such information when an opportunity arises. TPTB are no different than any one of the great unwashed. "Mates rates" and nepotism are everywhere throughout every economy.
Stop looking in other people's pockets and just get on with your own life.
Precisely Kayman.
Fox, henhouse and all that jazz.
ORI
My 9/11 Bush Photo Insight
Gee Bruce they front ran Ben on the 30 year. Why are you shocked.
Shorting 30 years ? Gee why would anyone do that till late 2012 because Ben just said he's keeping long rates down till at least then.
Mixing the obvious with some hedge's hedge strategy is missing the Macro view.
Gee look at the IBM DIA pair.... New highs. Write about that wackiness
Am I allowed to panic now?