Vad's Best Ideas

"If you do not know where you are going, all the roads will take you there"

Now, more than ever, I believe that Ben Bernanke is making a serious mistake that will come back to haunt all of us in the months to come... I still can not believe that with headline inflation number that is so stubbornly high, Fed actually had the stomach to cut rates last week...Yes, it is true that when trying to decipher the message between the lines of the release that accompanied the cut announcement one can make the reasonable forecast that this rate cut could be the last one for a while, and that Fed pretty much acknowledges (finally) that inflation threat is now real. But it is just simply too scary to realize that Fed's decision was clearly so heavily influenced (manipulated) by a widespread cry of Wall Street Babies...

But on the other hand unraveling of the sub prime fiasco might be causing more damage than everyone anticipated. And it doesn't really matter that the losses reported by major banks are predominately paper write downs and that cash flows have not yet been affected much. The truth is that in my view the main issue with financial sector right now is not a liquidity problem/event per se (which Fed is wrongly trying to fix with rate cuts) but rather a fundamental inability to correctly perform a basic function that bank must perform every day to survive- calculating the creditworthiness of the their potential client.

Technically bank can lend money to any client even without determining what the value of the collateral using the projected income stream as a basis. But here lies another issue- you can only use the income stream as a basis only if you are reasonably sure that the net worth of the borrower is can not go below the value of the income stream (intangible net worth) minus all the liabilities. Example could be MGI - it is clear that the income stream itself would allow for a higher valuation if only one could determine how low their tangible net worth could decline?

And that's were Buffet's "financial weapons of mass destruction" term comes handy- not only there seems to be no easy way to value many of the CDOs in question, but in addition to that methods that used most widely- the one based on agency ratings and the one based on ABX index-are starting to make thing look worth right at the time where they theoretically should be getting easier.

Every day seems to bring news of new securities downgraded. But is it all bad? Looking at the language behind some of these announcements does not give us a clear cut answer. For example in yesterday's WSJ's article about the newest round of SIV downgrades Moody's said it "wasn't taking the ratings actions because of the quality of the assets in the SIV. Instead, Moody's said the SIVs problems stemmed from the drop in the market value of the assets the SIVs own as investors shun those investments amid the credit crunch."

And that could be really bad news for the whole world economy because events driven by fear always unravel faster than the ones driven by greed. It is a common knowledge that correlation of assets and markets increases dramatically during the period of declines. And with so much volume across the world driven by computers this correlation has increased even more. This creates a feedback loop-because of the reduced paper value of the collateral banks are making margin calls which in turn reduce value of the collateral even more. This in turn triggers more paper losses which lead to new margin calls.

Many of the better capitalized players have resisted selling assets at fire sale prices so far which means most of the losses to date are purely paper write downs. But here comes the prisoner's dilemma that Paulson and Co are trying to solve with a Giant Super Fund- how long could one continue to hold on to paper losses knowing that if they are the last ones to sell they will end up with nothing? We all know that rational choice leads the two prisoners to both defect even though each player's individual reward would be greater if they both cooperated and resisted selling. In equilibrium, each prisoner chooses to defect even though both would be better off by cooperating, hence the dilemma.

Could the SIV fund provide a solution? I am not sure but I want to give Hank Paulson a credit for tryin. For now the capital cushion is sufficient to avoid the meltdown - but the real danger is that this cushion is getting thinner every day and if/when the landslide is triggered it will get really ugly in a heart beat...

One might argue that Fed's rate cuts designed to cure this problem and thus Fed is doing the right thing but my argument is very simple- does any one really believes that we can potentially inflate this problem away? Doesn't inflation destroy productive economic activity at the expense of the unproductive one? Can you really slow the inflation down once you let it get out of control without jacking rates even higher? And the really big one is -isn't financial sector very sensitive to inflation, because of the potential mismatch between assets at fixed low rates and liabilities at variable higher rates triggered by inflation fighting measures?

Anyway, enough rumbling - back to stock picking- what does all of the above mean for our portfolios? I think one thing is clear- as I mentioned one of my posts before http://www.investorplaceblogs.com/users/dishwasher/2007/10/the_wordly_bubble_part_2.php
Emerging markets and high flier speculative stocks might have passed the glamour stage and now are subject to correction. I've been a China bear for almost a month now and even though recent 20% declines might seem excessive to some, I think that we still have a long way to go there.

I am also not very satisfied with the performance of my portfolio recently. Most of my anti decline hedges put in place last week have not worked as I planned. So while I have my view of what's right and wrong, I am also not going to fight the Fed and the Market either. So early this week I have diversified into a more conservative portfolio: sold ETFC for MO and CG (tobacco is a staple so shouldn't decline as fast the market), sold airlines and trimmed my larger positions for small positions in PTNR, NOK, APFC, SRS, SDS and BQI.

To sum it up- I am in capital preservation mode now with most high volatility picks out and lower volatility plays in. I am probably a bit light on commodities after my sale of NXG, but you have to take a profits when your picks ran faster and higher than you expected, plus commodities have been running for a while now and thus could be subject to violent pull backs if Fed switches to inflation fighting mode...

Anyway trade safe and cheers,
Vad

Comments: View Comments |  Thursday November 8, 2007