Excerpted from the latest weekend notes from One River Asset Management, courtesy of CIO, Eric Peters
“People are no longer investing, they’re speculating,” said the CIO. “Is that wrong?” he asked, not waiting for an answer. “Depends on what you’re speculating in.”
Investors are implicitly worried about further price gains, they’re not really forecasting future fundamentals. “Investing is about estimating an asset’s fair value based on fundamentals, then forecasting what others will be willing to pay for those fundamentals.” But you can assign almost any value to the latter, and this means that for periods of time, fundamentals need not matter.
“There are a number of things that you’re absolutely meant to speculate in,” continued the same CIO. “It’s just that the universe of these opportunities is rather narrow relative to what people think it is.”
Paying a lot for everything is quite obviously foolish, but that’s where we are today. The only truly cheap asset class left is implied volatility. “People should be speculating in venture capital. Which is not to say that you can ignore price and value, but at least with venture capital you have a chance to make a lot of money.”
“Unfortunately, few people have access to venture opportunities,” explained the CIO. “Unlike decades past, new companies need very little capital to execute their business plans.” Years of regulation have discouraged smaller firms from going public. So the big platform companies gobble them up in private transactions.
“By owning Google and Facebook investors get access to innovation through acquisitions. Buying these big platforms is like buying closed-end venture capital funds. It’s one of the few ways to own a piece of the future.”
“We are investing as if 1987 will happen tomorrow, because it will,” said the CIO. “But we need to be long, or we’ll be out of business,” he explained, under pressure to perform. “So we construct option trades that are binary bets.” Which pay X profit if stocks rally, and cost Y if markets fall. No more and no less.
“What you do not want is a portfolio whose losses multiply depending on the severity of a decline.” That’s what most people have today. “At the last stage of the cycle, you want lots of binary bets. Many small wins. Before the big loss.”
“Are we at the start or the end of the ‘Don’t know what I’m buying’ cycle?” asked the same CIO. “No one knows.” But we’re definitely within it.
“When their complex swaps drop 40%, and prime brokers demand more margin, investors will cry ‘It’s not possible!’ But anything is possible.” The prime brokers will hang up and stop them out.
“LTCM traded things they didn’t understand. They sold volatility swaps, which they thought were tethered to reality, subject to gravity. In theory, they are. But like many such things, they’re simply numbers on a screen.”