Sunday, March 13, 2011

Another Victim of FICC Groups

  • Where the Past Problems Generated Profits and Troubles
  • Seven Immutable Laws of Investing
  • The Currency Game
  • The Interactions of Man and God
  • Paper Money, Deficits and Hyperinflation
  • We Are All Players-The Best Defense is a Good Offense

Where the Past Problems Generated Profits and Troubles

In an earlier era there was, in theory, a sharp distinction between brokers who were meant to act as un-conflicted agents and investment bankers and other dealers who were viewed as principals using their capital to enrich themselves. This theoretical distinction disappeared years ago, and its disappearance was reinforced by the combining of commercial banking activities with those of underwriting and market making. Out of this stew came the last financial crisis, through the sale and securitization of mortgages and similar debt instruments. The groups within the large financial conglomerates are labeled “FICC,” which stands for fixed income, currencies and commodities. Past blog posts have mentioned the growing attraction of the commodities segment to “investors” (really speculators) and the firms that service them. My concern with this blog are the $4 trillion dollar a day currency markets.

Seven Immutable Laws of Investing

This weekend I read an excellent piece by James Montier of GMO which many of us knew as Grantham, Mayo, Van Otterloo & Co. The seven laws are the following:
  1. Always insist on a margin of safety
  2. This time is never different
  3. Be patient and wait for the fat pitch
  4. Be contrarian
  5. Risk is a permanent loss of capital, never a number
  6. Be leery of leverage
  7. Never invest in something you don’t understand

While we all should obey these seven laws all the time, for many of us this could lead to very little investing on our part. However, I urge all to apply these rules to their thinking when addressing the investment in currencies as an asset class.

Currencies can be traded by themselves in original form or through derivatives. This week, Barron’s published two articles that focused on currencies. The first piece focused on the growth of the market, some of the reasons for the growth and the use of ETFs to play the game. (An interesting point was made that it was better to short a currency ETF than to buy a bear-focused currency fund.) What the article did not stress was how much of the FX trade was leveraged by the use of various forms of derivatives or “margin” purchases. The second article was an interview with Ray Dalio of Bridgewater Associates, which has $90 billion under management. This interview focused on the difference between large deficit producing countries/currencies and those that have small deficits. Dalio favors the latter. I would suggest that unless you are in the FX markets everyday because you are hedging a stream of operating transactions, that currencies as a separate asset class fails the Seven Immutable Laws of Investing. Future exchange rates are not guaranteed or even have the same sense of reliability as do the maturity value of high quality bonds. Money has been traded around the world since the beginning of recorded time as noted in the Bible. Therefore, this time is not different.

One rarely sees a “fat pitch” (a perfect, or “too good to be true” pitch) that is advertised; note the FX dealer ads on the financial networks or popular press articles. The reason I mentioned shorting an ETF that is long a currency, is that is a contrarian move. From my own viewpoint, the short interest on the ETFs that hold Canadian and Australian dollars suggest that these may not be contrarian enough to be safe. Many of the academically trained participants in the market will look at the past movement of a currency and calculate the standard deviation around a 36 month trend line, and label this volatility as risk. Whereas risk is the permanent loss of capital, occurring when a government dramatically changes what its currency is tied to.

The second derivative of risk is not just the loss of capital, but the loss of the productive use of the capital. The problem with leverage, either through direct borrowing or through the use of derivatives, is that there is always a payment date that can be extremely inconvenient. Unless one clearly understands the real political pressures on the various central banks and how they in-turn apply pressure to their principal dealers, I would suggest that there is a lack of understanding that makes currency trading problematic.

The Interactions of Man and God

There are two old sayings that are worth remembering: “Man plans and God laughs” and “Man proposes and God disposes.” As long term investors, we try to think about the future, matching future streams of income with spending needs. In the past, many employers and their employees felt secure in terms of retirement on the basis of an average compound earnings rate on their capital of 8% or higher, with an inflation rate of 2%. That is not the world we live in today nor for the last several years. Not only were the forecasts very wrong, most investors did not have strategic reserves that could be applied to adjust the returns to meet some or most of their spending needs. The problem with reserves are that they don’t earn much money; effectively zero today, adjusting for published inflation. Even if we were smart enough to build strategic reserves, the removal of this capital from the higher earnings pools will reduce the overall return on the entire capital base and therefore a cut in spending plans will be required. That is an extremely difficult message for us to get accepted by various investment committees and wealthy families.

Paper Money, Deficits and Hyperinflation

One of the attractions of using currencies as an asset class is to escape too much reliance on any one currency, read US dollars. As most currencies today are not convertible into hard assets by their individual owners, the name of the game is to gravitate to those other paper currencies that have substantial excess earnings power that the issuing government is not spending. The current trends are not favorable either for the US or the UK, and many feel most of Europe, beyond Germany and Switzerland, is beyond hope. The US deficit is approaching the tipping point of 20% of federal government spending. Beyond 20% there is a very strong historic trend to go into hyperinflation, which will make most fixed income investments unsalable. (Thus, one can see why the FICC groups are building up their sales forces in the commodities and currency arenas.) If there is some chance of hyperinflation, one can see the investing public as reluctant to commit to what is probably a fairly priced, large capital equity market.

We Are All Players- The Best Defense is a Good Offense

In this blog, my intention is to cast doubt on adding to one’s present investments, suggesting the need for strategic reserves and altered planned spending. I further recognize that the earnings on today's strategic reserves don’t help the unavoidable spending needs. In response to these dilemmas, my training from the US Marine Corps makes me search for a good offense as a best defense. While I have some ideas to be shared at a later date with my clients first, I am not comfortable that these are the best or perhaps not even good moves on the offense.

I appeal to this blog community to suggest currently good long-term investments or sound strategic reserve elements that can be used for a narrow base of clients or shared with this entire blog community.

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