Tuesday, February 15, 2011


Goatmug often writes solely about economic and trading things in an attempt to warn readers of the disparity between feelings and reality.  In fact for the last eighteen months (since August 2009), the disconnect between feelings and reality have led us to actually invest heavily in commodities and emerging markets despite our longer term fears although we've maintained a careful eye on the "fundamental picture" of reality.  We've essentially had to hold our nose and deploy dollars, despite the fact that we know how it will actually all end sometime in the future and attempt to target areas that would provide enhanced returns.

As I look back, I recall feeling this way in 1999 as an investing novice witnessing worthless companies become overnight sensations.  I felt deep concern in October, November, and December of 2007 when I asked many of my friends to abandon the markets because I sensed that carnage would soon follow.  Now, I still have real hesitation about the state of reality and want all of us to be on alert for a change in the posture and perceived health of the market.  Over the last couple of weeks the stock markets have slowed a bit and have not pushed significantly higher.  Perhaps this is just the buyers taking a breather?  As I have laid out in the 2011 Outlook, I did anticipated a drawdown of 3%-5% early in the year that would allow the markets to reach higher levels inimid April or May.  Guess what?  We haven't really seen that pullback as of this writing.  Timing is everything so we simply need to watch for new cracks and signs of weakness.

I was sharing with a friend today that we must also be on the look out for the end of QEII.  My thoughts for a significant pullback in late April to May has been predicated on the idea that large institutional investors will anticipate the end of QEII in June of 2011 and therefore attempt to get out in front of a draining of the liquidity swamp.  At that time we may see all assets fall and the USD and treasuries actually gain.  I do not believe that these institutions will wait till June to make their moves to see if QE II will be extended or QEIII spawned.

On a longer term time frame (before 2015) there are other pot holes to be aware of.  In the past I have mentioned one of my favorite investors, Kyle Bass of Hayman Capital Management, L.P as one of the smartest guys in the room that was sounding the alarm to the impending MBS and real estate collapse years before it came to fruition.  Kyle made more than $1 Billion betting against the entire industry in 2007 and 2008.  Kyle was featured in CNBC's documentary House of Cards.  Please find my previous posts here - Kyle Bass Part I- Why the Fed is Trapped and also House of Cards .  Kyle is sounding his alarms again and going deeper into his thesis that Japan's massive debt will be one of the first sovereign collapses that well see.  In his article to clients called "The Cognitive Dissonance Of It All", Kyle lays out his firm's view that Japan will not be able to sustain their high debt levels and low interest rates.  So far the country has managed to survive because they have had a nation of savers, but because most of their population is now nearing retirement, they face the mathematical impossibility of keeping their pozni scheme going. 


You must read this article!  One of the awesome quotes from his letter is captured below -

"One last point about Japan that is more psychological than quantitative: there is an interesting psychological
parallel between JGBs and US housing. In the last 20 years, Japanese stocks have dropped 75%, Japanese real
estate has declined 70% (with high‐end real estate dropping 50% in the last two years), and nominal GDP is
exactly where it was 20 years ago. What one asset has never hurt the buyer? What one asset has earned a 20‐
year pro‐cyclical, ‘Pavlovian’ response associated with safety and even more safety? The buyers and owners of
JGBs have never lost money in the purchase of these instruments as their interest rates have done nothing but
fall for the better part of the last 2 decades. It is fascinating to see an instrument/asset be viewed as one of the
safest in the world (10‐yr JGB cash rates are currently 1.21%) at a period of time in which the credit
fundamentals have never been riskier. "

What Kyle is focusing on is exactly the type of thought that ripped the financial worlds to shreds during 2003-2007.  Kyle is pointing out that the Japanese Yen and the Japanese Bond is essentially priced to as a risk free asset, or said another way, always to be considered safe money.  Remember real estate?  Remember how all of the securitized deals and tranches of MBS were modeled on the assumption that housing values always would increase?  Remember how pervasive the notion that real estate was easy and riskless became?  Do you remember shows like Flip This House?  Remember your neighbor telling you he was going to start buying houses and telling you there was no way to lose money?  Essentially this is the mentality of investors in JGBs (Japanese government bonds - many of which have been Japanese nationals).  What happens when those Japanese nationals begin selling JGBs to fund their retirement?  What happens when those holders start to lose money on their bond holdings? 

What is beautiful about Kyle's strategy is that he doesn't need a total collapse of Japan to make huge sums of money for his fund or his firm.  Kyle simply needs the world to wake up and realize that there is a real risk that Japanese bond interest rates could go significantly higher, creating big losses for holders of Japanese debt.  I hate to say it, but it goes back to the theme I always talk about, this is about mis-pricing of the cost of credit.  Do you really think buying Japanese bonds at 1% or 1.5% for 10 years is a good deal?  Who is the world would do that?  This is the bet that Kyle is making.  Now a lot of things will go wrong when Kyle's investment bets (gains) are realized, as this will really lead to a systematic collapse of many other institutions and ponzi schemes. 

In closing, many of you may not know this, but Goatmug grew up a rabid heavy metal fan.  The Goat played a mean guitar and often dreamed of being on stage in front of thousands while shredding some hard core riffs on his 6-string axe.  Kyle's note reminded me of one of my favorite Megadeth tunes on the album Countdown to Extinction, the song's name was Symphony of Destruction.  Kyle has composed the symphony, the orchestra is assembling, it won't be long till the destruction is played out in real life on the financial stage.


Enjoy one of my favorites.