Why A Hedge Fund That Has Been Short For Three Years, And Wildly Profitable, Remains Short

One of the most flawed misconceptions about the New Paranormal in which central bank intervention to levitate markets and protect from plunges is not only heretical but demanded (to paraphrase Rick Santelli) is that one has no choice but to be long stocks (and judging by all the equity "experts" opining on fixed income for the past 5 years, short bonds) in order to generate profits.

That is utterly false as the simple case study of $2.2 billion in AUM Horseman Capital Management clearly shows.

As can been seen in the following chart showing the fund's gross and net exposure, the hedge fund flipped net short at about the ttime the recession started (and long before Bear and Lehman) then went long in early 2010 and flipped back short in 2012, where it has remained for the past 3 years.

 

Suicide? Not at all. In fact ever since going net short, the fund has returned on average 16% per year, outperforming about 98% of its peers.

But how can one maintain such a stunning track record with a preponderance of shorts in a market in which central banks have injected $22 trillion in liquidity to prop it up (and in the case of China are arresting stock shorters and sellers)? Simple: by having a long-bond pair trade, something most one-track mind equity pundits don't realize is a perfect natural hedge to rigged markets.

So is Horseman tired of being contrarian and is it eager to join it zombified central-bank frontrunning (and market underperforming) peers?

Not at all.

Here is the latest strategic and market commentary from Horseman's June letter:

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Your fund made a small positive return for the month. The majority of the returns came from the short book and currency book, while the long book and the bond book detracted from returns.

I caught up with an old friend from university, who had gone into science. I could tell that he did not think finance was an appropriate use for my grey matter. I tried to make it sound more appealing to him, by trying to explain things in a scientific way. “Markets” I told him, “have their own Heisenberg principle. The best stocks to buy are those that are least liked, and the worst ones are the ones that have risen substantially and people are most excited about.” He remained unconvinced.

After more questioning, I had to admit that I did a lot of short selling. “So you make money when other people lose money?” I was asked. To which I had to answer in the affirmative. “Isn’t that evil?” I then gave my usual answer of business cycles, and how things would fall in value anyway, so I provide a service to my clients. But I could see that my questioner was not convinced. And on reflection, perhaps I was not convinced either. The reality is I love finding a good short, and profiting from the bad investments, foolish business plans, or misguided policy choices. It’s fun for me. I accept who I am. I am the bad guy.

I always think about short selling as picking the moment of peak delusion just before reality sets in. Peak delusion, so to speak, almost always centres on some key economic variable that typically has been in such a long up cycle that investors have come to believe it is secular rather than cyclical. Dot-com in late 90s, US housing up to the financial crisis in 2007, peripheral European bonds until 2011 or commodity prices until 2012.

While markets gyrate according to the whims of Greece’s government, the trading of China’s stock market seems to me far more intriguing and actually far more important. Chinese policy makers generally get what they want. However, despite official efforts to prop up the stock market, including interest rate cuts and forcing lower margin requirements on brokers, equities have remained weak this month. Perhaps, things will turn around but if investors begin to lose confidence in the Chinese government’s ability to control the market, then they just might lose confidence in other parts of the China story.

For me the key issue is that Chinese workers now look expensive relative to their productivity. Hence exporters from China are suffering. Property also looks expensive, and even though there are signs of rising property prices, domestic Chinese steel prices fell almost every day last month. Even adjusting for collapsing iron ore and coal prices, Chinese steel margins hit new all-time lows. I have trouble matching up collapsing steel prices with China successfully inflating the economy.

In my view, Chinese authorities needed a strong stock market to help attract or keep money invested in China as they cut interest rates. Certainly most countries that have cut interest rates in the last few years have seen a weaker currency. China has cut rates but not had any currency weakness – which strikes me as odd. Unless the stock market turns around soon, I would expect the Renminbi to begin to depreciate. A weakening Renminbi in a period of slowing global trade volumes would be very deflationary. Most commentary I read suggests people believe that the bond bull market is over and reflation is the way to go. I suspect we may well be at “peak China” and “peak reflation trade” at the moment.  

After spending the last few months being knocked back by the markets after a strong January, it is time for me to be the one who knocks. Your fund remains long bonds and short equities.