Schaeffer's Media Outtake: A Big Bet on Inflation
Can last year's star manager repeat his success?
6/22/2009 1:45 PM
"Mark Spitznagel made a fortune predicting the 'black swan' that hit markets last year. Now the relatively unknown hedge-fund manager is emerging from the shadow of his collaborator, Nassim Nicholas Taleb, with a big bet inflation will soar. The 38-year-old Mr. Spitznagel managed the Black Swan funds to triple-digit returns last year with a bet on volatility. The returns have brought a flood of cash, sending assets for his firm, Universa Investments LP, rising to $6 billion from $300 million ... 'Black swan' alludes to the once-widespread belief that all swans are white -- proved false when European explorers found black swans in Australia. A black-swan event is something extreme and highly unexpected. Mr. Spitznagel's winning streak now will be tested. Universa is poised to make a huge wager that will reap big rewards if inflation surges. Inflation is on investors' radar thanks to extensive economic stimulus efforts ... The new fund, expected to start trading in July, will place bets on options tied to assets expected to benefit from a big leap in prices, including commodities such as corn and crude oil, and options on shares of oil drillers and gold miners. It also will short Treasury bonds, likely to weaken in an inflationary economy ... The inflation bet marks a change for Universa. Typically, Messrs. Spitznagel and Taleb don't have an opinion about the near-term direction of the markets or economy. Rather, they argue, investors tend to underestimate the risks of major market swings. The latest wager is more of a directional bet that regulators' efforts to prop up the financial sector and the broader economy will spark inflation."
(The Wall Street Journal – "Black Swan Trader Bets Reputation on Inflation" – 6/17/09)
Schaeffer's addendum: Stock market history is replete with examples of players who experience success in a specific investment niche and for some reason to decide to move out of their "success zone" with very unhappy results. Renowned plain vanilla value investor Warren Buffett, who once referred to derivatives as "financial instruments of mass destruction," decided at a very inopportune time in early 2008 to sell put options on the S&P 500 Index. Hedge funds severely curtailed their short selling activity, just in time for last year's bear market. And pension funds – those bastions of "down the middle" stock and bond investing – were badly burned not long after they fell in love in recent years with "alternative assets" such as commodities and real estate.
Now come Messrs. Spitznagel and Taleb – who were masters of the "agnostic" approach to market direction and who instead focused on (and profited handsomely from) the market's under-pricing of volatility – with a multi-billion dollar bet "on options tied to assets expected to benefit from a big leap in prices, including commodities such as corn and crude oil, and options on shares of oil drillers and gold miners." In other words, this is very much a directional call and has very little to do with so-called "black swans." If a surge in inflation is "highly unexpected," someone forgot to tell those who have been pouring money into precious metals ETFs at an unprecedented pace and bidding up the price of gold coins to huge premiums above their bullion value.
Discuss this article:
Post your own comment
"Fund managers have moved to overweight equities for the first time since December 2007 as hopes of an economic recovery remain intact despite a sell-off in bonds and rising yields, a survey showed on Wednesday. The monthly poll by Banc of America Securities-Merrill Lynch showed a net 9 percent of the respondents are overweight stocks. This means the difference between equity overweights and underweights is 9 percentage points. In May, fund managers were a net 6 percent underweight stocks ... The survey found that global growth expectations rose further, with the growth composite indicator hitting a six-year high of 78. A net 7 percent of investors believe global recession is likely in the next year, compared with 70 percent just two months ago ... 'While investors are finally overweight equities, risk appetite remains relatively constrained. Investors seem happy to underweight defensives at this point, but overweight conviction is tightly concentrated on just two sectors; energy and technology,' said Gary Baker, the bank's head of European equity strategy."
(Reuters (ft.com) – "Funds move to overweight stocks – Merrill poll" – 6/18/09)
"The big problem for many investors at the moment is that the information they accumulated during a quarter of a century of global disinflation is just not relevant any more. Whatever comes next as the financial crisis plays out, it cannot be disinflation ... While it is possible that inflation will rise to low levels and stabilise, it is at least as likely that it will overshoot old targets. Indeed an overshoot in the long run looks probable as a mixture of inflation, exchange rate depreciation and taxation are well documented responses by elected governments to high and rising public debt levels. Although it is many years since investors have had to cope with a similar scenario, cope they did in the dreadful 1970s ... Our new inflationary wave will transfer wealth from the consumers of goods in the west to the producers of goods in the east. This time investors have the flexibility to position their capital to benefit from that wealth transfer. It is in these same Asian jurisdictions that banking systems remain strong and government interference in capital allocation unaltered through the recent crisis. The east will become increasingly attractive to free market capital as western governments become mired in the capital and wealth allocation business in the west ... The disinflationary era is over. Will it be you or someone else who puts that in the price?"
(Financial Times – "Get ready for inflation" – 6/9/09)
"Options on stocks and currencies show 'strong warning signals' that the recent rally for both may be poised to end, Citigroup Inc. said. The VIX, which tracks the cost of using options as insurance against declines in the Standard & Poor's 500 Index, has risen even as equities trade near seven-month highs, according to New York-based Citigroup ... 'We are seeing a disconnect between what's happening on implied volatility and underlying price action across a host of markets,' Citigroup chief technical analyst Tom Fitzpatrick in New York and strategist Shyam Devani in London wrote yesterday. 'It suggests to us a real danger that a good consolidation/correction to a lot of recent trends may be near.' The S&P 500 closed at a seven-month high of 944.74 on June 2 and slipped to 931.76 yesterday. The gauge has recouped 38 percent since March 9 on speculation $12.8 trillion pledged by the government and Federal Reserve will help end the recession. The VIX, a gauge of expected swings over the next 30 days, is up 7.7 percent at 31.02 from its eight-month low on May 19. The measure hasn't closed above 34.50 since May 4 ...'Our fear is that complacency is back in the market and the low volatility has fueled a lot of these moves,' the strategists wrote. 'This pick-up in volatility seems to be warning that nothing is one-way forever and when you start to believe that it is when you get hurt.'
(Bloomberg.com - "VIX, Currency Options Signal Rally May End: Technical Analysis" – 6/4/09)
"Hedge funds, decried by many as quick traders, have played catch-up during the market rally since March. The average fund was 45% 'net long' as of May 19, or had investment holdings valued at 45% more than its bearish 'short' positions, according to Hedge Fund Research. That figure is up from 33% earlier this year, but still is far below its 55% level a year ago. Funds are less bullish now than they were just before the market crumbled last fall ... Many funds are skeptical the economy has entered a new period of growth that justifies high equity multiples. Others fear dislocations from governments shoveling money at problems ... If stocks keep surging, hedgies might have to jump in with two feet, giving the market another lift. But their continued hesitancy should be a sign of caution for investors."
(The Wall Street Journal – "Hedge Funds Caught Too Short by Rally" – 5/30/09)
"Which companies should supplant Citi, GM and maybe Alcoa? For Citigroup, the obvious choice is Wells Fargo (WFC), with a stock-market value of more than $113 billion. GM's logical successor is Toyota Motor (TM), the world's largest auto manufacturer. It produces one of the top-selling cars in the U.S., the Camry, and most Toyotas sold in the U.S. are made in North America. But while there is no explicit rule barring foreign corporations from the Dow, and while auto manufacturing accounts for a smaller chunk of the economy than it once did, including Toyota would certainly deal a blow to the nation's psyche. Technology once again is the stock market's largest sector, surpassing financials and representing America's great hope, as the nation loses its comparative advantage in manufacturing. Three tech giants with market values of more than $100 million -- Google (GOOG), Apple (AAPL) and Cisco Systems (CSCO) -- could be Dow candidates ... To be sure, joining the Dow 30 has been analogous to an athlete's gracing the cover of Sports Illustrated. American International Group (AIG) was added in 2004; just four years later, it was yanked -- after being rescued by the Fed last September. And Microsoft (MSFT) and Intel (INTC) joined the DJIA in late 1999, just a few months before the tech bubble burst. Pfizer (PFE) has lost more than half its value since joining the average in 2004."
(Barron's – "What Now, Dow 30?" – 6/1/09)
The accompanying daily chart shows the Russell 2000 Index (RUT) rally has stalled shy of its declining 200-day moving average. And then there's that pesky round-number resistance at the 500 level, as illustrated by the intraday chart.
"Analysts at Goldman Sachs Group have identified 10 stocks that qualify as 'structural winners,' which means they are positioned to take advantage of global economic trends, and therefore generate outsized returns. Among them are Adobe Systems, Amazon.com, BlackRock, CVS Caremark, Monsanto, Teva Pharmaceutical Industries and Visa ... Investors who want to buy these stocks, with the aim of owning them for two to three years, can sell 'strangles' to help offset the cost of doing so. Strangles involve the sale of call options and put options. Calls convey the right to buy a company's stock, while puts convey the right to sell it. By taking short positions in both contracts, traders collect a premium and stand to make money as long as the stocks trade in a certain range.
The next test for the S&P 500 Index (SPX) is its 40-week moving average, in the 943 neighborhood. The 40-week is currently about 1.5% above Friday's close.
"US Treasury yields soared on Thursday after a 30-year government bond auction saw poor demand, highlighting the balancing act facing central banks seeking to keep interest rates low while selling record amounts of debt. The investor appetite for relatively safe government bonds has diminished as US stocks have rallied on signs that the pace of the downturn has slowed. However, the rising rates threaten central banks' efforts to encourage people and companies to borrow and thereby stimulate growth. The 30-year Treasury yield rose to 4.30 per cent on Thursday from 4.10 per cent the day before after bids at the government auction came at lower prices than expected. The 30-year Treasury is now at its highest level since last November. The rise in bond yields has raised questions about whether the Federal Reserve will step up efforts – which began in March – to keep yields down through direct purchases of government bonds ... Mortgage rates have been following the government bond yields higher. A 30-year fixed-rate mortgage averaged 4.84 per cent last week, according to a Freddie Mac survey, compared with 4.78 per cent the week before. Earlier in the year, long-term mortgage rates fell to well below 5 per cent, following the Fed's purchases of mortgage debt and Treasury debt, a strategy known as quantitative easing. This prompted a wave of mortgage refinancing. This can reduce monthly payments and has given many Americans more cash to spend or save."
(Financial Times – "US Treasury yields soar on poor demand " – 5/8/09)
Schaeffer's addendum: While the rise in 10-year rates is certainly a concern from the standpoint of the sustainability of the economic recovery – and one that the Fed may need to soon address – what is unmistakable from the accompanying chart is that over the past two years, rising rates have been consistent with rising stock prices, and falling rates with falling stock prices. There is no guarantee that this relationship will continue, but it is a trend in motion.