Diary Archives - Mad Hedge Fund Trader

SPECIAL CHINA ISSUE

I am writing this from the back of a taxi in Hong Kong?s Central district. My meetings with assorted bankers, hedge fund managers, Taipans, and the press stretched on longer than expected, with the result that I am now stuck in rush hour traffic on the way to the airport. So I might as well use the time productively and sum up my thoughts on my recent trip to China.

When I first cajoled my way into to the Middle Kingdom in the early seventies, it was in the back of a broken down truck carrying bags of wheat, no doubt destined to a thriving black market. We drove down a heavily potholed single lane road that had not seen serious maintenance since the thirties.

The Communist border guards couldn?t have been more hostile, and sneered at my US passport. Chairman Mao was then constantly railing against American imperialists and capitalist roaders to massive crowds of people wearing green, blue, or grey uniforms chanting with little red books in hand. The Korean War, where China lost 2 million men, had ended only 20 years earlier, and bitter memories were still fresh.

I arrived to find a country in utter chaos. Bands of Red Guards were rampaging through the countryside, lynching anyone with a connection to the West, such as university professors or those with a single foreign possession, like a violin. The lucky were simply made to wear dunce caps and paraded down the street where abuse was hurled upon them. Famine was rampant, and authorities were piling up the bodies of those who had starved, burning them with kerosene. Even getting just a single egg to eat was hard work, no matter how rich you were. My paper money was worthless.

Fast forward four decades, and conditions couldn?t be more different. As I waited patiently for an attractive young immigration official to clear me, I noticed a small voting machine asking if I was satisfied with my experience. It showed 4,734 ?yes? votes for that day. I counted 1,000 people a minute crossing the border, squeezing into packed trains that were leaving every 15 minutes. The sheer scale of this human tide was breathtaking. Welcome to the new China.

On this trip, I approached the country from the end of its long distribution chain and worked my way back towards the source, starting in New Zealand, and traveling on to Australia, Singapore, and Hong Kong. The message was the same all the way down the line: China is slowing. I heard countless stories of cancelled orders, reduced volumes, and thinning shipments.

So it was no surprise to me when, one my first day in Shenzhen, a local developer slashed the prices on new condominiums by 25%. This should come as no surprise, as the Chinese government has been determined to slow the economy for the past two years with no less than eight interest rate hikes and 12 bank reserve snuggings. Local residents were surprised when I explained to them that the 5% they were getting on overnight deposits seemed incredibly generous compared to the zero we get at home.

But slowing is not crashing, contrary to the view argued assertively by some prominent hedge fund managers, like Jim Chanos, who constantly refers to ghost cities of unsold real estate easily visible via Google Earth. Well, I checked out those ghost cities. It turns out that the cities in question change every six months. That?s how long it takes the Chinese to fill one city with people and bring another one somewhere else up for sale.

The Chinese essentially have an assembly line for cities which runs 24/7. They are really building a Rome a day. That?s what you would expect in a country that is attempting to bring another 400 million into the modern economy.

What I think is true is that China is in the midst of permanently downshifting from a blistering 11%-13% annualized growth rate to a more sustainable 8%. This is a good thing, and I saw the Japanese economy go through the same teething process over four decades, first growing at 10%, then 7%, 5%, 3%, and finally bottoming out at 1%. More stability in China will lead to less volatility in the global economy. This will be welcomed with open arms by oil and copper traders whose lives have been shortened by the extreme market moves this year.

The good news for the rest of us is that a China with a GDP today of $5.5 trillion today growing at 8% generates far more GDP growth than it did a decade ago with a $1 trillion economy growing at 10-13%. In fact, a China growing at 8% generates much more new GDP ($440 billion) that a US economy growing at 2% ($290 billion). This means that China is still a great investment for the long term.

What if it starts to grow less than an 8% rate? Senior government officials refer to this as the ?red line? below which the risk of political instability rises. No government fears its own people more than China, which refers to its ?bicycle economy?; it must keep moving forward or fall over. And in China they don?t send retiring political leaders off to putter around at country clubs, they put them in front of firing squads.

Fortunately for the health of the current leadership, they have a lot of resources to head off this worst case scenario. China currently has the largest accumulation of foreign exchange reserves in human history, some $3.2 trillion. During the 2008 crash, they implemented a $500 billion emergency stimulus package, which was three times larger than ours on a per capita GDP basis, and they had a second one on the shelf which they never had to use.

The country now has enough savings to execute six such packages to head off a hard landing, or even a substantial slow down. This is not idle speculation. The budgets have already been drawn up with triggers ready to pull. They involve spreading the country?s impressive modernization inland from the coast to enfranchise more of the population.

Of course, such action would be massively inflationary and require inconveniences like making the Yuan, or Renminbi (CYB), a freely floating and exchangeable currency. Development of a serious secondary renminbi (or people?s currency) bond market would also be a big help. But these liberalizations are eventually going to happen anyway (by 2015?). There is also the additional benefit in that this would help pacify the 2.3 million strong People?s Liberation Army, which is largely recruited from the countryside and is unhappy with the unequal distribution of the country?s wealth. Sound familiar?

This will fundamentally change the investment targets in the Middle Kingdom. Huge fortunes have been made investing in Chinese Internet and export companies. Go no further than my own call to buy Baidu (BIDU) at $12 three years ago, 10% of its current value, by clicking here. In the future the focus will shift to firms capitalizing on the growth of the domestic economy.

None of this makes the Middle Kingdom immune from the ?RISK ON?/?RISK OFF? paradigm that has the world?s financial markets marching up and down in lockstep. As long as the global economic and political scene is jittery, Chinese financial assets are going to trade just as poorly as everyone else?s. But when emerging markets catch a bid that lasts more than a day, China (FXI) will be a good place to be.

Will you Take a 2 Bed, 2 Bath With a Hot Tub?

My hedge fund friends in Shenzhen asked what I needed in a translator and guide to accompany me on my local forays. I said that I required someone who could walk at least ten miles on the city streets on the 90 degree heat, and be prepared to ask the price of everything and everything.

The next morning a diminutive young woman showed up at my hotel wearing an imitation pair of Nike?s and a cheap polyester suit. She told me that she migrated to the city from a small village eight hours away by train after learning English from the radio. I quickly discovered that she free lanced for local hedge funds as a research analyst. Not only did she know where all of my target companies were, she had cousins working at all of them. Talk about a total home run.

At the top of my list was a visit to a fake Apple (AAPL) store. She looked perplexed, and then told me she would not take me to a single store, but an entire city where every business sold the full range of Apple products, from IPhones, to iPods, tablets, and iMacs. Sure enough, I found a building downtown with at least 500 such businesses. They were even offering products that Apple itself hadn?t invented yet. Want a G5s iPhone for $75? No problem.

An iPhone G5? No problem

At one dinner the country?s second largest furniture maker told me of his hugely successful strategy of offshoring manufacturing from China to Vietnam, where labor is one third the cost. This means that the automation and globalization that has decimated America?s labor force was now turning full circle and coming back to haunt Chinese workers. If he can replace 1,000 men with a single high end machine imported from Germany, he will do it in a heartbeat. He then whisked me off to a karaoke bar in his brand new, yellow, Ferrari 360.

As modern as China is, you still stumble across pockets of the 19th century. Prostitution is absolutely rampant, with the hotels posting security guards at the front door to keep them at bay. I will not delve into this topic in any detail so as not to offend my female readers. Suffice it to say that the current market price for virgins is $150, but are probably as authentic as the $75 Apple G5 iPhones.

Not All of China is Modern

On my last evening in the Middle Kingdom, a state dinner was given in my honor thanking me for 40 years of service to the People?s Republic of China. As the evening drew to a drunken close, I thanked my hosts and outlined the broad sweep of my family?s connection with China over the past century.

I once listened with rapt attention as Alice Roosevelt Longworth, President Teddy?s oldest daughter, described the wreckage in the wake of the short-lived 1900 Boxer Rebellion. Senate majority leader, Mike Mansfield, told me of the sweating Chinese coolies who carried bags of coal onto his cruiser when it docked in Shanghai in 1920.

Veteran AP correspondent, Roy Essoyan, riveted younger correspondents at the Tokyo Press Club with a blow by blow account of the Japanese invasion of Shanghai?s foreign quarter in 1937. My dear friend, Al Pinder, head of the OSS in China during WWII, described how children working in sweatshops in China during the thirties dipped tiny, but deeply scarred hands into boiling water to fish out silk cocoons.

My Uncle, Mitchell Paige, recalled his adventures as a young Marine on gunboat duty on the Yangtze in 1935. He later fought off massed waves of Chinese attackers when his First Marine Division conducted its infamous frozen retreat from Chosen Reservoir in Korea in 1950.

The First McDonalds in China

When I came on the scene, the Chinese initially treated me as a capitalist tool and CIA spy, while the FBI viewed me as a communist sympathizer, opening my mail for years. For all I know they still do. When I asked Premier Zhou Enlai about the long term impact of the French Revolution, he responded that ?it was too early to say.? When

I queried Generalissimo Chiang Kai-Shek why he continued his stubborn 50 year battle to wipe out the communists, he responded simply that ?the sky cannot have two suns.? My impudence didn?t prevent him from introducing me to his wife, the lovely Madame Chiang Kai-Shek, one of the Soong sisters famed for being the most beautiful women in China.

I mentioned that the scar on my hip still itched whenever the weather changed. That?s the one left from a slug fired from a Chinese supplied AK-47 in the jungles of Cambodia.

In 1978, I questioned Deng Xiaoping, the father of modern China, when he would allow free emigration. He responded ?Feeding our people is our biggest problem. How many do you want? 20 million? 30 million? I?ll give them to you.?

In the late 1990?s I became an unofficial advisor to the Chinese government on their financial and economic modernization efforts, meeting regularly with friends at the Ministry of Finance and the People?s Bank of China. More than once I responded with ?You want to do what?? as they outlined grandiose plans for a nationwide network of bullet trains, 200 nuclear power plants, the damming of the Yangtze at Three Gorges, and building new cities to accommodate a half billion people. Needless to say, I told any of my hedge fund friends who would listen, this represented the investment opportunity of the century.

I finished by saying that over four decades, I had known the Chinese as both friends and enemies, and definitely preferred the former. It?s better to trade than to fight. I believe they felt the same way. The younger people sitting around the table sat there with their jaws dropped.

November 21, 2011 - Quote of the Day

Diary

?The asymmetric risk is more on the upside than on the downside because people are prepared for the downside,? said Lawrence Fink, CEO of Blackrock, a manager of $3.3 trillion in assets.

Trade Alert Update- (FXE) November 18, 2011

Diary, Trade Alert

As a potentially profitable opportunity presents itself, John will send you an alert with specific trade information as to what should be bought, when to buy it, and at what price. Read more

?RISK OFF? Strikes Again

Diary

You would think that this was going to be a good day. Weekly jobless claims fell to 388,000, a new six month low. New permits for home construction in October were up 10.2%. The October CPI even fell by 0.1%.

But the second that Spanish bond yields spiked, it was all over but the crying. The S&P 500 opened weak, and then proceeded to plunged 25 points, decisively breaking a triangle to the downside on the charts that has been narrowing for the past three weeks. Once again, improving fundamentals in the US were trumped by contagion fears in Europe. If you don?t bounce off the 50 day moving average on Friday, then we?ll be on the Lexington Avenue Downtown Express to 1,150 or worse.

The ?RISK OFF? nature of the move across all asset classes could not have been more clear. Oil skidded by $5, gold gave up $65, silver pared $2.20, copper gave back 15 cents. Ten year Treasuries, which never believed in this ?RISK ON? rally for two seconds, received a nice little boost, but not as much as you might expect. Perhaps we are near a top in this most bubblicious of asset classes? In the meantime, the (TBT) was beaten like a red headed stepchild.

One cannot underestimate the impact of the bankruptcy of MF Global, which has deprived the market of $600 million of trading capital. It is particularly serious in the metals and energies, where MF was particularly active. Hence the gut churning moves. The peripatetic CNBC commentator and Tea Party founder, Rick Santelli, is finding out that ?let the chips fall where they may? means that all his friends on the Chicago CME floor get fired.

Strangely, the Euro, the currency that everyone loves to hate, was one of the best performing assets of the day, down less than a penny. The headline risk here is huge. Will the European Central Bank continue buying enough bonds? Forex traders tell me this is because of a number of temporary, one off factors like European bank repatriation of funds back into Euros to shore up their balance sheets and Asian and Middle Eastern central bank purchases of high yield PIIGS bonds. The second shoe has yet to fall on this beleaguered means of exchange.

Who Says There Aren?t Any Jobs?

Diary

While recently winging my way across the South Pacific, I spotted an unusual job offer:

WANTED: Social worker, tax free salary of $60,000 with free accommodation and transportation, no experience necessary, must be flexible and self-sufficient.

With the unemployment rate stuck at 9.1%, and running as high as 45% for recent college grads, I was amazed that they were even advertising for such a job. Usually such plum positions get farmed out to a close relative of the hiring officials involved. Intrigued, I read on.

To apply you first had to fly to Auckland, then catch a flight to Tahiti. After that you must endure another long flight to the remote Gambler Island, then charter a boat for a 36 hour voyage. Once there, you had to row ashore to a hidden cove, as there was no dock, or even a beach.

It turns out that the job of a lifetime is on remote Pitcairn Island, some 2,700 miles ENE of New Zealand, home to the modern decedents of the mutineers of the HMS Bounty. History buffs will recall that in 1790 Fletcher Christian led a rebellion against the tyrannical Captain William Bligh, casting him adrift in a lifeboat.

He then kidnapped several Tahitian women and disappeared of the face of the earth. When he stumbled across Pitcairn, which was absent from contemporary charts, he burned the ship to avoid detection. An off course British ship didn?t find the island until some 40 years later, only to find that Christian had been killed for his involvement in a love triangle decades earlier.

The job is not without its challenges. There is one doctor, and electric power is switched on only 10 hours a day. Supply ships visit only every three months. The local language is a blend of 18th century English and Tahitian called Pitkern, for which there is no dictionary. Previous workers have a history of going native. Oh, and 10% of the island?s 54 residents are registered sex offenders, due to its long history of incest.

The next time someone you know complains about being unable to find a job, just tell them they are not looking hard enough, and to brush up on their Pitkern.

November 18, 2011 - Quote of the Day

Diary

?We know things are upside down when we have an Italian central banker and a German pope. That?s not the way it is supposed to be,? said Steve Cortez of Veracruz Research.

Why Residential Real Estate Will Not Recover

Diary

One of the most frequently asked questions at my recent round of strategy luncheons, seminars, and keynote speaking engagements has been ?Is it time to buy a home?? I responded with ?No, no, a thousand times no,? and proceeded to rail off the countless reasons. My answer always piques listeners? interest, as 67% of Americans are still homeowners, and probably more at these assemblies.

My expectation is that house prices have another 25% to go before we reach a final bottom. Of course, such comments invite truckloads of abuse from the real estate industry, which has been insisting that a recover is just around the corner for at least five years now. For those of you who were unable to attend these events, let me list off everything that will go wrong with real estate over the next two years:

*80 million baby boomers are attempting to sell their homes to 65 million Gen Xer?s who make a lot less money than their parents did. Don?t plan on selling your house to your kids, especially if they are still living rent free in the basement.

*Fannie Mae and Freddie Mac, which are currently refinancing 95% of US home mortgages, are in receivership. Having wiped out their capital in the housing crash, they are unlikely to get refunded by congress. A wholly privatized home loan market is likely to raise borrowing costs by 200 basis points, as it already does in the non-conforming jumbo market.

*Get ready to say goodbye to that home mortgage deduction as part of any budget balancing effort in Washington. This government subsidy, worth $13,000 per homeowner with a mortgage less than $1 million, is costing the government $250 billion in tax revenues annually. Any flat tax proposal does the same thing. How long should renters continue to subsidize homeowners?

*Ben Bernanke?s ?twist? program has dramatically flattened the positive yield curve, depriving banks of recapitalizing themselves with the shrunken positive carry. This is what bank share prices have been telling us with their horrific performance, with lead stock Bank of America (BAC) plunging from $14 to $5 in just six months. Translation: fewer bank loans for you and I mean lower house prices.

*Look at the chart of September Case-Shiller data below. Despite the greatest real estate stimulus in history, prices have flat lined in for two years. The 30 year mortgage is under 4%, a 60 year low, and affordability is at a 60 year high. Until this year, buyers in California were getting a combined state and federal tax breaks of $18,000 to buy a house. What happens when the stimulus ends?

* According to the Federal Reserve, 35% of US homes have less than 10% equity or negative equity. That means that 50 million homeowners will have nothing left after a sale, including closing costs. We now have negative equity states, like Nevada and Arizona.? People are trapped in their homes, and can?t move to accept new jobs elsewhere.

*To say there is an inventory overhang would be a huge understatement. There are 1 million new homes and 5 million existing homes now on the market. According to Zillow.com, another 10% of homeowners, or 15 million, would sell on any improvement in prices.

*Add up all the above, and of a total market in the US of 150 homes, there are 21 million homes for sale, and 50 million buyers shut out of the market.

*Has anyone heard there might be a recession next year? What little buying that is going on has to dry up. The expanded U-6 unemployment rate, including ?discouraged? workers and those with expired benefits, is likely to soar from the current 16% to 25% to match Great Depression highs.

*After the 1929 stock market crash, home prices took 25 years to recover pre-crash levels. I think that we are seeing a repeat of this phenomenon, with 2006 as the start date. Get ready to cash in on the new bull market in real estate in 2031, when newly enriched Millennials start to join the fray in large numbers.

With all that said, I am still looking for a home to buy. That will most likely occur on a courthouse?s steps, where cash is king. Why not, if I can get the 2020 price today, down 50% from today?s level? Until then, I will happily rent, not buy.

Is This a Sell Signal?

Bottom Feeding in Real Estate

Diary

I was driving through a prominent San Francisco neighborhood last Sunday, looking for a McMansion open house. When I came to one key intersection there were more than a dozen signs directing me to competing offerings. What a joke. And the agent told me that market conditions were gradually improving! It looks like current and former millionaires are in a rush to unload their properties before then next recession hits, noticeably adding to the already bloated inventory of unsold homes.

I heard this morning that the Federal Housing Authority, the government agency that insures residential real estate loans, has lost nearly all its cash reserves to cover losses. Since last year, these reserves have fallen from $4.7 billion to $2.6 billion.
Federal law requires it to maintain a reserve of 2% of the $1.2 trillion of loans it currently has outstanding. Reserves will fall from 0.5% to 0.24% by 2012. Independent analysts say that the agency is underestimating loan losses by at least $50 billion.

That means the FHA will need a bail out next year, and therein lies the problem. In its current gridlocked mode, it is highly unlikely that congress will approve the multibillion dollar refunding of a controversial federal agency. The ?let the chips fall where they may? crowd seem to have the upper hand. The FHA currently insures one third of US mortgages, up 560% since 2006, largely through the demise of its private competitors. No insurance means no loans. For you and I that means lower home prices.

The FHA specializes in loans with less than 5% down. With home prices in a six year nosedive, more than half of these are now underwater. With $30 billion in liquid capital and $1.2 trillion in outstanding guarantees, it now has a 43:1 leverage ratio. Sound familiar? The shorthand for this is that the FHA is basically a government version of Lehman Brothers begging to happen.

Even while congress is starving the FHA of new funds, it is asking the beleaguered agency to stick its neck out even more. Conforming loan limits went from $729,750 down to $625,000 on October 1. Congress wants to return to old limits. This would be a big deal for homeowners in the expensive states of California and New York. But again, action is needed.

In the end, I never made it to the open house I was looking for. Instead, I tripped across another house that was twice as nice for a third less money. With all of these cutthroat price reductions going on, continuing to rent sounds like a really good idea. The taxes, insurance, and maintenance on the last place added up to more than my current rent, and that is not even accounting for a mortgage interest expense, it I could get one.

I?ll tell you the title of the next book that I am going to read. Make Millions with Foreclosures and Short Sales: How to Profit From a Real Estate Crisis can be bought at Amazon by clicking here.

November 17, 2011 - Quote of the Day

Diary

?The problem is not the new ideas, it is escaping from the old ones,? said economist John Maynard Keynes

What?s Up With Gold?

Diary

Have you ever held a basketball underwater in a swimming pool and let go? It flies to the upside and pops you in the nose. That is exactly what gold is doing now. After the barbarous relic peaked at $1,922 on August 24, it traded like an absolute pig, giving up 20% in a matter of weeks. I managed to coin it with a couple of quick in and out trades in (GLD) puts, some doubling over a weekend. So much for the ?safe asset? theory.

You can thank hedge fund titan, John Paulsen, for the action. John gained international notoriety when he earned a $4 billion bonus after making huge bets against subprime loans going into the housing crash.

Since then, his touch has grown somewhat icy. He started out 2011 with a huge, bullish bet on US banks, a play, I confess, I never really understood. This was back when Bank of America (BAC) was trading at a lofty $14/share. As a hedge, he backed up these gargantuan positions with big holdings in gold, which quickly made him the largest owner of the ETF (GLD).

John?s P&L held up reasonably well during the first part of the year. As the banks faded, gold went from strength to strength, limiting his damage. That all changed on April 29 when global financial markets flipped into ?RISK OFF? mode and gold melted along with everything else. Its hedging capability proved to be nil. By August, John?s losses approached a near death 50%.

Needless to say, his investors failed to see the humor in the situation, and rumors of cataclysmic redemptions started sweeping the street. By implication, this could only mean large scale liquidation of the yellow metal. This was happening when the rest of the hedge fund industry was catching daily margin calls, forcing them to dump even more gold into a downward spiral, their best performing holding for the year. When the sushi hits the fan, you sell what you can, not what you want to. By the time the carnage ended, gold was down $392.

When the crying was over, Paulson had reduced his ownership in the ETF (GLD) from 31.5 million shares to 20.3 million. That?s a haircut of $1.76 billion of the shiny stuff. In the end, Paulson says he only suffered redemptions of 10% of his somewhat reduced funds, much lower than expected.

Gold actually anticipated the new ?RISK ON? trade by a week, bottoming on September 26. Since then it has behaved like a paper asset, tracking the S&P 500 almost tick for tick, adding a quick 19.6%. So, what?s up with gold?

As we approach yearend, the downward pressure of this redemption selling is waning, hence my basketball analogy. New bull arguments have also come to the fore. The contagion in Europe has prompted massive buying of all precious metals by panicky individuals, including silver (SLV), platinum (PPLT), palladium (PALL), and even neglected rhodium, with a collapse of the Euro imminent. And how will the ECB eventually end the crisis? With a continental TARP and quantitative easing, which we here in the US already know is hugely positive for gold prices.

How far will the gold get this time? The gold bugs say we?re going to break the old high and power on through to the inflation adjusted high at $2,300. I?m not so sure. I am not willing to bet the ranch here on an asset class that could plunge $1,000 going into the next recession, which could be just around the corner.

But there may be a trade here in precious metals space for the nimble. My pick has been to buy lagging silver, which offers much more bang per buck if the sector starts to build a head of steam. The white metal will not get hit with IMF gold sales, which are also a rumored part of any European bailout package.