Saturday, January 10, 2009

If I Could Teach You One Thing

Ok folks - here it is - Kid Dynamite's 2009 Tip of the Year for investing:

Understand the reasoning and arguments of those who hold the other side of your position.

Prices are the result of buyers and sellers expressing their views in the markets. I don't want to get to sidetracked here, but this is why people screaming "the speculators are manipulating prices" - be it by buying oil (so unfair!) or by shorting financial stocks (so unfair!) - is ridiculous. Prices are the end result after everyone in the market has expressed (or had the opportunity to express) his opinion by buying or selling. If "speculators" pump up the price of oil to levels which are completely absurd, then others will come in and sell the oil right back down to a level they feel is fairly priced. If "short sellers" drive the price of a stock down to bargain basement levels, value investors will jump in and buy the stock back up to a price they feel no longer represents compelling value. It should be clear to the reader that any suggestion of banning sellers of financial stocks or buyers of oil is blatantly senseless, and results in falsely manipulated market prices.

In fact, oil prices were so high last summer because the reality of a harsh global recession hadn't yet hit - people were still clinging to arguments like "the average recession lasts x months" instead of waking up to the new paradigm of drastically decreased leverage and slower growth (or recession). Similarly, prices of financial stocks plummeted not because some evil mastermind was shorting the stocks down to zero, but because their balance sheets were unsound, and they were technically bankrupt.

But back to the lesson: I'll throw another simple example out there from the risk-arbitrage world, because I was a risk-arb trader for several years. Dow Chemical has a deal on the table to buy Rohm & Haas (ROH) for $78 in cash (I believe that's the price). This deal was struck back in July of 2007, before the credit markets blew up. Recently, Dow Chemical received notice from Kuwait that the nation was terminating a joint venture with DOW worth roughly $17B, which cast doubt on DOW's ability to finance their acquisition of ROH. Now, I'm not a lawyer, but I'm told that the merger agreement between the two companies is iron clad - it leaves DOW no "outs" to withdraw from the deal - even given the massive deterioration in the global financial markets.

ROH stock now trades around $62. The bull case is that Dow cannot get out of the deal, no matter how much they might want to - and will be legally required to complete the deal at $78 (they even have to pay interest starting next week, so that price goes up). The bear case is that everyone knows ROH would be worth about half that right now if they didn't have the Dow bid, and that Dow will be able to use some sort of other excuse, like insolvency of the combined company to renegotiate a lower bid. You have to understand the logic behind each argument. I don't have a position in ROH, but I made a small wager with a colleague who is a much better risk-arb trader than I am that the deal would NOT get done at the $78 price.

As for the broader markets, I'm intensely bearish. I'm not an economist, but it's clear to me that we're in a new paradigm of debt - one where the lavish spending and growth financed purely by debt for the last 7 years will be reigned in. I am constantly asking myself what the bull case is - how people can think that things will be ok. I think the bull case is based on ridiculous citing of PAST recessions, which are, to me, clearly irrelevant right now. It also hopes that massive government spending will re-ignite the economy and get us out of this mess. The key issue here is that we never allowed the economy to bottom - to stabilize at a natural level from which we could then provide stimulus. On the contrary, we're in a scenario where the economy is falling off a cliff (relatively speaking ) - and the policy makers are trying to "catch a falling knife." I don't think you can stop the inevitable - you can't prevent the pain, you can only delay it.

The bull case also assumes that things will be ok once house prices stabilize. Contrarily, I believe much of the growth of the last several years was a result of people SPENDING their home equity - the term is mortgage equity withdrawal - they treated their homes like an ATM and took their equity out. Now, some of these people have already spent their equity and find themselves with home prices worth less than their current mortgage value. We're supposed to feel sorry for them and bail them out by reducing their mortgage principal owed? They spent that money on a car, a flat screen TV and a vacation already! But lest I get diverted again - back to the point - we won't be able to use our mortgage equity on cars and tv's and vacations in the next 10 years because home values won't be on a 45 degree straight line up!

It seems obvious to me that after you have a drunken feast, you MUST have a hangover where you feel like crap. Well, the last 7 years have been an orgy of debt and spending - and we'll have to take the pain from that era. This pain will be much more than the foreclosures we've seen so far - those were people who never owned their homes in the first place. The next wave will be credit card defaults when revolving debt decreases, and the harsh realization that mortgage equity is not a one way straight line up.

I'd love to see how long the restaurant on my corner selling $8 plates of hummus lasts - or the trendy steak restaurants charging $65 for a fillet mignon. One of the things about NY is that the entire city seemed to be financed by corporate dollars - from restaurants to sports tickets. What will happen now that corporations are reigning in spending? Will they still tolerate $2k dinners for client entertainment? I doubt it... The new Yankee Stadium still had 6 unsold luxury boxes last time I checked - that doesn't bode well for NY corporate spending.

I'm not trying to convince anyone out there to go get short the market. I myself have a tiny short position now - I'm hoping to capitalize on the optimism and potential rally around the beginning of the Obama Administration and new stimulus plan - and establish a short position into the rally. I'm somewhat nervous because I do get the sense that many have this exact idea, and if the rally fails to materialize, the selloff will be swift and will not allow opportunity to establish short positions prior to the destruction.

My point was that regardless of your position, you need to understand what the argument on the other side is. By arguing the opposite, by playing Devil's Advocate with yourself, you can form a better thesis, gain more confidence in your position, or even reverse it all together.


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