Opportunities Funds Commentary

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UPDATE
Trident Investment Management, LLC
Opportunities Funds Commentary
October 31, 2013
Performance Discussion
September and October have traditionally been down-months for equity markets, but they were anything but
weak in 2013. Over this period, the S&P 500 was up 7.6% while the MSCI Europe Index was up 8.24%. The
Nikkei and the emerging markets were up 7.01% and 11.66% respectively. Fixed-income was mixed. The
U.S. bond market rallied with yields on the 10-year Treasury falling 0.23% to end at 2.56%. However, many
overseas bond markets, particularly Australia, were largely unchanged. Commodities were weaker with gold
down 5.2% to end at $1,323/oz and oil down 10.5% to $96.4/barrel of WTI crude. Credit markets performed
well in the U.S. and Europe where spreads tightened over 0.23% on average to hit new multi-year lows. This
performance was not mirrored in the developing world where spreads tightened less while remaining well
above the tightest levels of the last several months. The U.S. dollar weakened against most currencies with
the U.S. Dollar Index depreciating 1.5% over the September-October period.
Our funds suffered again in September and October with most of our bets going against us. Our equity
positions in Japan performed but these gains were muted because our hedges in the U.S. also went against
us. Our credit book suffered considerably. Investors still shunned the credits of the developing and associated
countries, such as Singapore, even as they stampeded to buy U.S. and European corporate paper, typically
at much lower spreads. Our gold positions, although smaller than in previous quarters, also suffered. Our
fixed-income positions also hurt despite a limited fixed-income rally over the period; the gains from the rally
in the spot bond markets were more than offset by losses arising on our options from declines in volatility.
We have made only marginal changes to our funds’ exposures over the last two months. Our fixed-income
exposure has declined simply because the amount of premium invested in our options has gone down, and
virtually all of our exposure is through options. We have also fractionally trimmed our Japanese long equity
exposure, as well as our short U.S. equity positions. We have also cut back marginally on our short credit bets
as well. Our portfolio adjustments have been largely tactical, intended to bring down our risk in the nearterm in the face of market euphoria.
Market Outlook
In looking at the markets today, it is hard not to experience a sense of déjà vu. Investors are euphoric even
though global economic and earnings data suggest a much bleaker environment, even compared to the last
few years. Analysts and policymakers tout the sustainable recovery that is just around the corner, though
they have been wrong about this every year since 2010. They believe in the continued robust performance
of equities, particularly in the U.S., even though both profit margins and earnings multiples are close to alltime highs. Once again, the credit markets are at super-tight levels in the developed world despite the fact
that most of the industrial economies seem to be growing, at best, at stall speed.
2013
OCT
UPDATE
Markets are willing to believe in these hopeful assessments because most global policymakers are using
precisely the same arguments to rationalize their money-printing and deficit expanding measures. The last
time we were in this situation was in 2005. The data on U.S. housing had turned down decisively, but analysts
and policymakers continued to play it up anyway. Investors were badly fooled – more risky lending occurred
in 2006 than in the two previous years making the 2007-08 collapse that much worse. Unfortunately, we
believe that things will turn out no differently this time.
The major difference today, unlike previous bubble eras over the last two decades, is that policymakers
are actively involved in fostering the divergence between markets and reality. In fact, the cornerstone of
their policy framework is that rising asset prices, despite a contrary reality, will somehow engender
“confidence” which in turn will generate a sustainable recovery. We believe that these policies are
fundamentally misguided.
The world today faces significant structural problems. In the developed world, consumers have seen their
incomes eroded over the last several years. Many of the relatively high paying jobs available to them have been
outsourced to the increasingly competitive developing world. The crisis of 2007-08 exacerbated this problem
because it caused a collapse in many non-tradable industrial sectors such as housing where outsourced
workers could hope to find jobs. The governments, in the developed world facing weak economies and
unemployed citizens since 2008, have seen their social insurance payments skyrocket, even as tax revenues
have fallen. Additionally, fiscal deficits are at nosebleed levels.
The developing countries are perhaps in better health. Their consumers as a group are not as levered.
They have, however, experienced significant erosion in their purchasing power because their incomes and
investment returns have simply not kept pace with high domestic inflation. While many governments of
emerging countries appear to have more budget flexibility, their fiscal positions are by no means robust relative
to their own history. Usually, these governments are unable to run fiscal deficits of the same magnitude as the
developed world, even in the best of times.
Given these conditions, it is highly unlikely that either consumers or governments can become the locomotives
for global growth. In fact, consumption in both U.S. and Europe has been anemic. Governments globally,
with some exceptions such as China, are trying to limit spending growth because of increasing concerns
about debt sustainability. Net exports cannot prove a driver for growth because by definition they have to
sum to zero – one country’s gain is another’s loss. As such, the only reasonable locomotive for global growth
should be investment.
We consider below the prospects for a substantial global increase in real investment. We then take up just
why current policies have not worked, especially in the investment arena to the extent expected. And finally
we consider the investment implications of the current environment and our portfolio positioning.
2013
OCT
1. Investment – The big question mark
UPDATE
Investment is logically the only potential driver for sustainable growth. The global banking system has
plenty of ability to create credit, except perhaps in Europe. Large companies are cash rich and borrowing
rates are at record low levels. Wages are falling in much of the developed world even as countries engage
in structural reforms to permit even more labour flexibility.
While conditions seem ripe for an investment boom of epic proportions, global investment growth (except for
China) has been anemic. Far from seeing double-digit growth rates in investment, as is common after recession,
we have seen outright contractions in investment in many European countries and tepid improvements in
the U.S. The commodity sectors of the global economy which saw a huge boom in investment over the last
few years are also experiencing a bust, with countries such as Australia and Brazil bearing the brunt of this
pullback, notwithstanding the relatively high prices for commodities today.
Understanding the dynamics of investment today is critical to assessing the prospects for sustainable growth
given the absence of other policy levers especially in the developed world.
We take up the problems with investment today in greater detail below. We will discuss in particular the
financial market implications and why the markets today, thanks to government policies, have become highly
speculative, if not totally Ponzi-like in their behaviour.
1.1 The Problem of Over-Investment
In previous letters, we have discussed at length the fact that the policies pursued by the authorities, especially
in regard to financial institutions, have resulted in over-investment on a truly gargantuan scale.
In the U.S. the Fed responded to every deflationary shock, emanating from the U.S.’ trading partners, by
lowering rates and cheapening the cost of credit. This had the effect of boosting investment in marginal
projects and, not surprisingly, these were precisely the investments that suffered when rates had to be increased.
Yet, every time such pain was felt by lenders, the Fed cut rates permitting these questionable investments to
pay off. The bailout culture created by the Fed instilled in lenders the belief that investing was no longer
risky – they could rely on the central bank to provide a backstop in the event of losses. Not surprisingly, this
led to more investment to the point where even negative nominal return investments (subprime loans against
overvalued housing) were funded, requiring ultimately the colossal financial system bailout of 2008-09.
The authorities in China, unlike most of the world, have not even tried to create the illusion of market-pricedriven lending. Instead, they have forced investment by fiat with the primary investing vehicles being the state
owned enterprises in the country. Many of these investments were loss-making almost from day one, but the
Chinese banks were directed to provide additional credit for the same by continuously rolling over loans and
keeping up the pretence that these loans were performing. The hit to bank profitability from these impaired
assets was subsidized by consumer financial repression in the form of deposit rates kept low by regulation.
With such measures, investment in China is about 50% of GDP and it is virtually certain that much of this
investment is inefficient.
There has also been excess investment in Europe, especially in some of the problem countries like Spain. The
design of the Euro-system itself was perhaps more to blame than the authorities here. Post the creation of the
Eurozone, the private sector assumed that the credits of Spain and other less solvent countries were broadly
2013
OCT
UPDATE
comparable to that of Germany. The financial system lent to these countries at rates that were only marginally
higher than those prevailing in Germany. These rates were among the lowest borrowers in these nations
had ever seen and induced a private-sector-led investment boom that the authorities were only too happy to
encourage. We saw Spain, for example, building houses and infrastructure at a frenetic pace at this time, even
though the country’s income level and prospects did not warrant such expenditure. When these investments
soured after 2008, the authorities resorted to backstopping private sector losses – an unfortunate move that is
only going to prolong the ultimate adjustment.
The pattern of over-investment appears to have been repeated in most of the world’s major economies,
with very few exceptions. The world is awash in excess capacity in many industries, a situation that virtually
guarantees poor returns on new investment. Even worse, the highest returns to investment are likely to come
in select countries in the developing world such as India, South Africa, Russia, Argentina and the like. An
investment boom in these nations to mirror the activity in China will do little however, to boost developed
country growth. In fact, by depressing traded goods prices, it might actually increase structural unemployment
in these countries and increase the risks of deflation.
1.2 Significant Political Risks to Investment
Even with the problem of global over-investment, one could argue that select sectors such as alternative
energy, clean water technologies and the like might prove fertile pastures for new investment, especially in the
developed world. However, such investment inherently takes time as new technologies need to be devised and
refined and policymakers simply cannot dictate a strong pace of growth because of macro exigencies. More
importantly, countries need to have governments that can provide conditions conducive to new investment in
these sectors. Significant structural impediments to investment such as complex labor laws and uncertain tax
regimes only make such investment riskier.
Unfortunately, the high levels of unemployment in the developed world and rising inflation in the developing
world have made the general populations rather restive. Most governments have resisted structural reforms
that might bring about near-term pain and unpopularity, while attempting to pander to their electoral base
with misguided, though popular palliatives. The constant flip-flopping by the French president on tax policy
and the inability of Italy to eject the disgraced ex-Prime Minister Berlusconi from the Senate are all examples
of such political ineffectiveness. The crowning example, of course, is in the U.S. where the country flirted with
a debt default in October because lawmakers could not agree on basic budgetary matters including financing
an already-passed healthcare law. Unfortunately, while governments resist needed reforms, they continue to
pile up debt at rapid rates. This creates considerable uncertainty regarding ultimate debt repayment and future
tax policy. As such, this increases the risk to longer-term investment because it changes the net after-tax payoff
stream to investors.
In sum, the world is awash in excess capacity in numerous areas thanks to over-subsidized investment in the
past, which depresses the returns to new investment. Also, the risks of changes in the fiscal drivers such as
tax rates and royalty payments are high since governments are short of tax revenues. Therefore, we have to
conclude that real investment in actual productive projects is unlikely to pick up dramatically from current
levels, even with record low rates.
2013
OCT
2. Speculation as Investment
UPDATE
With the relatively bleak medium-term growth backdrop, policymakers have continued and, in fact, intensified
their policies of quantitative easing. Such policies create ideal conditions for speculation and the unfortunate
part of such speculation is that it is inevitably viewed as “investment” even though it is fundamentally different.
When the true, risk-adjusted operational returns to investment are poor in relation to the cost of capital, there
may not be much real investment. However, investors might make financial investments where the returns
are inherently poor, but where the potential appreciation of the investment’s value might compensate for the
lack of adequate returns over the holding period. The best example might be the purchase of an expensive
artwork. The work in question might represent a negative cash flow stream to the investor in the form of
paying for the funding costs, storage, security and display of the piece. Yet, this investment will be justified if
the artwork can be sold at the end of our investor’s desired holding period to another buyer at a price that will
more than cover the interim losses in addition to the initial cost of the work. Of course, the next purchaser will
likely face the same stream of negative returns from the artwork with his problem being even worse because
his purchase price was that much higher. The important point to note here is that the initial purchaser of the
artwork cannot possibly cover his total costs without capital appreciation – its ownership does not generate
any intrinsic positive cash flow. As such, he is not investing in the classic sense but speculating on the future
price of the art.
If the artifact purchased by our investor was one that is or will be in plentiful supply, it would be ridiculous for
him to expect it to appreciate in value. Yet, such considerations do not often enter into investor thinking once
speculative fever takes hold. For example, consider the thrifty Dutch who speculated on tulips as early as 1637
without any regard for their ultimate supply. The U.S. public was convinced to part with untold amounts of
money in the early 1990s to purchase readily available stuffed toys called Beanie Babies, with some of the less
available ones selling for inflated prices. The NASDAQ bubble in 1999 and the housing bubble of 2003-07
seem relatively tame by comparison even though the havoc wreaked by them was no less consequential.
When investors purchase assets at prices that are considerably higher than their underlying earnings power
would suggest, we have a so-called investment bubble. When the bubble investor has to rely on new, more
foolish investors to purchase his assets at even higher prices to break even or turn a profit, we have the makings
of a Ponzi scheme. Thus, all Ponzi schemes involve bubbles at some level, but not all bubbles are Ponzi
schemes. It is also important to note that with a bubble, the positive impact on the actual economy during the
bubble period is rather limited in comparison to the negative impacts that can be expected once it bursts. Put
differently, real investment is an afterthought when bubble dynamics are at play because the focus is often on
exchanging already existing assets. If the bubble is allowed to continue, there can also be unproductive real
investment to produce more such assets, only worsening the ultimate impact when it bursts.
3. Ponzi Markets and Investing
We could have reasonably characterized the environment that existed in 1999 in technology stocks, or from
2005-07 in housing as a bubble. By printing money without limit in the aftermath of the bursting of the
housing bubble, the Fed and the other central banks are promising to remain the patsy at the investment
table, always ready to be the losing, final purchaser. While such a role might have been justified early in 2009
given depressed financial asset valuations, such action today is tantamount to actively promoting a Ponzi
scheme. Benjamin Bernanke as the first governmental Ponzi abettor has surely earned his place in history!
2013
OCT
UPDATE
Several important characteristics can be identified when Ponzi dynamics are at play in markets. First, since
such markets depend on a continued influx of investment lemmings, the bullish narrative has to be constantly
reinforced. As such, all fundamental news, good or bad, will be twisted to reinforce the bullish consensus. The
focus of investors in such markets will be on assets where reality can be easily explained away. If the assets in
question are simple enough that even the untutored understand their valuations, it will become impossible
to generate a Ponzi dynamic. Finally, as the number of participants increases, the amount of new entrants (or
new money) has to keep increasing at an even more rapid rate to permit the early entrants to even partially
exit from their winning positions.
Markets today share most of the Ponzi characteristics we have identified above. In particular:
1) U.S. stocks, where the Ponzi scheme is at its more mature form, have become the global darlings. All news
in the U.S. is good news. A debt default avoided by the country is cause for celebration. A potential new
budget showdown in early January is another reason to celebrate today. Poor earnings are certainly positive.
2) The European stock markets have all started to perform because of the cyclical recovery that seems to
have started everywhere in Europe except, of course, in the data. Greece is bankrupt. Spain is struggling
with 25%+ unemployment and a potential vote on secession by its wealthiest state, Catalonia in 2014. Yet,
investors have started to tout Greek banks and Spanish real estate as historically cheap investments!
3) The stock market rallies are being led by companies which are expected to have bright futures rather than
those which are the profitable ones of the present. So, no price is too high to pay for Amazon which has
negative operating margins and losses almost two decades after its formation. After all, this firm may even
turn a huge profit as an Internet monopoly in the 22nd century. However, Exxon, which has a volatile yet
relatively predictable profit stream, is just not exciting.
4) The dash for trash in the credit world is in full swing. Covenant-lite bonds and other fatuous investment
vehicles are once again being done in record numbers. Investors love getting paid little for huge potential
future losses, but simply do not care about the more staid corporate credits which lack the sizzle.
5) Sovereign bonds of the highest quality countries rank among the worst assets to own simply because their
payments are so predictable.
The Ponzi hierarchy of investments is entirely predictable. Market participants avoid investments that they
can understand and believe to be fairly valued. They prefer to own something with potentially significant,
and typically incomprehensible, upside even if it is grossly overvalued given the risks.
We draw the following conclusions from our analysis:
- Global growth cannot be sustained. Since policies are being directed to keeping markets buoyant, rather
than healing the real economy directly, we do not expect any sustainable growth. In fact, we believe that
growth globally has already started to falter. The data both in the U.S. and Europe, outside of surveys,
suggest that these regions may be flat-lining on the growth front if not actually starting to decline.
- Risks of deflation and a sovereign bond crisis are high and rising especially in Europe. The weak
growth in Europe, the strong Euro, and the continued rise in debt levels make for a nasty combination.
The problem countries in the Eurozone will ultimately need a huge debt restructuring. The situation in
Europe is much worse than that in Japan in 1991.
2013
OCT
- Ending of quantitative easing is unlikely in the near term, no matter what the data suggests. Anything
other than cosmetic adjustments to Fed asset purchases could precipitate an end to the Ponzi scheme and
create serious knock-on effects on confidence.
UPDATE
- A substantial increase in volatility is imminent. If markets begin to believe that the current central bank
policies are unsustainable, there will be a profoundly destabilizing adjustment. This should induce much
more volatility than we have seen in recent years. Insurance is cheap until disaster strikes.
4. Portfolio Positioning
We have positioned our portfolio to reflect our views above and not surprisingly we have had a difficult few
months. Unfortunately for us, the data continue to support our fundamental viewpoint, even as markets
levitate with a thesis that we feel is simply not borne out by the facts. However, we believe that we are now
reaching the limits of the current euphoria with a number of catalysts that might prompt a major reversal in
sentiment in the short- to medium-term.
The data in the U.S. in the near term is likely to be mixed given the government shutdown in October and we
will enter 2014 ready to resume the budget theatrics in the U.S. Congress. We expect deficits in Europe (ex
Germany) to continue to climb and “surprise” policymakers once again. Given the fact that a new German
government coalition should be in office by then, what might prove a huge shock to market participants is
that the new coalition is not appreciably different from the old one. That is, the Germans are not willing to
open up their wallets without limit no matter what the politics there. The Italian government saga continues
and early elections are likely by the first quarter of next year. China is all set to restructure its economy in its
November Party Congress, but the new China might want to export even more rather than help its global
trading partners. Unfortunately, when markets are so divorced from fundamentals, it is unclear what the actual
catalyst will be that will force reality to re-assert itself. All we are certain of is that it will re-emerge!
We believe that the Japanese equity market today is extremely undervalued. It is likely to outperform other
global markets if the current speculative environment continues. It is also likely to outperform even if there
is a reversal of the current euphoria. Japan is the one country today where tapering is nowhere in the cards.
In fact, the Bank of Japan has virtually assured investors that it is prepared to act more aggressively to boost its
quantitative easing if global circumstances require it to do so.
We also believe that the selloff in the fixed-income markets has run its course. Investors have shunned fixedincome because of the coming recovery and the removal of tapering. Neither of these is likely to occur in
our view. The Fed has already refused even a token tapering. The European authorities have repeatedly
downgraded growth forecasts for the region and urged investors to temper their optimism. As such, we believe
the bonds of Sweden and Norway today are compellingly priced.
Finally, the credit markets, particularly in Europe, are at levels that would be deemed to be rich even in
good times. Quasi-bankrupt entities in Europe are investor darlings while solvent companies elsewhere are
viewed as highly risky. This makes no sense to us even given the global Ponzi dynamics. We find numerous
opportunities in this arena.
2013
OCT
UPDATE
5. Conclusion
It is amazing to us that, a few short years after 2009, we are back in a situation where conditions may be
deteriorating even with monetary and fiscal policies on overdrive. If disaster strikes today, we are plumb out
of options unlike in 2008. However, markets are euphoric and totally unconcerned about what we believe is
a gathering storm, if not hurricane. Markets appear to have seriously taken the quip by Will Rogers who said
“if stupidity got us into this mess, then why can’t it get us out?”
Performance Summary at October 31, 2013
Trident Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
2 Yr.
3 Yr.
5 Yr.
10 Yr.
YTD
Since Inception
(Feb. ‘01)
-1.2%
-2.6%
-11.1%
-3.4%
-1.9%
-1.3%
-0.1%
10.3%
-2.5%
8.7%
CI Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
3 Yr.
5 Yr.
10 Yr.
15 Yr. YTD
Since Inception
(Mar. ‘95)
-1.5%
-2.8%
-11.2%
-3.7%
-1.5%
-0.2%
9.6%
10.6%
-2.8%
15.5%
Nothing herein should be read to constitute an offer or solicitation by Trident Investment Management, LLC or its principal to provide investment
advisory services to any person or entity. This is not to be construed as a public offering of securities in any jurisdiction of Canada. The offering of
units of the Trident Global Opportunities Fund are made pursuant to the Offering Memorandum only to those investors in jurisdictions of Canada
who meet certain eligibility or minimum purchase requirements. Important information about the Funds, including a statement of the Fund’s
fundamental investment objective, is contained in the Offering Memorandum. Obtain a copy of the Offering Memorandum and read it carefully
before making an investment decision. These Funds are for sophisticated investors only. ®CI Investments and the CI Investments design are
registered trademarks of CI Investments Inc. 1311_1972_E (11/13)
2013
OCT