Blackthorn Quarterly Letter Q2 2013

The air goes out of the balloon much faster than it went in. 

-Howard Marks

Last quarter we talked about the madness of crowds and the fantastic gains put in for the market to start the year. If one were to extrapolate those gains to an annualized basis one could see that the pace of those gains was unsustainable. If your guess was that the full gallop that the stock market had broken out of the gate with in 2013 would slow in the second quarter you would have been right. The stock market slowed down its frenetic pace to start the year but still managed to keep its head above water. The bond market however took on water. The key moment from this past quarter was the selloff in the bond market following Ben Bernanke’s remarks that the pullback from QE would begin in late 2013.

That brings the big question for the second half of 2013. Has the 30 year bond bull market just ended? The bond market was a bit of a bust last quarter as investors began to adjust to the assumed QE tapering that is expected at the September FOMC meeting. It is almost as if the Fed has kept a beach ball (the bond market) under the water and just released it. Investors were left searching for a beach towel as they got all wet. In our April letter we also quoted Stanley Druckenmiller, one of the great investors of our time, and his opine on the Federal Reserve’s policy on interest rates and the effect of QE.

 “It’s one thing to control short-term interest rates,” he said. “It’s another thing when you’re taking 75 to 80 percent of the bond supply and holding that price down. … This is a big, big gamble to be manipulating the most important price in free markets, [interest rates].”

We quoted Ray Dalio in our quarterly letter in April and his words now seem quite prescient. We would remind you that Dalio, the founder of the largest hedge fund in the world, felt that second half of 2013 would be a rough one for the bond market. The last few weeks of the first half certainly were as the air came out of that balloon rather quickly. It remains to be seen if there is more air to come out in the second half of the year.

We practice a defensive philosophy when it comes to investing. We find it prudent to never invest and come to find that you have painted yourself into a corner. Investing is not about predicting the future but about assessing probabilities and the diversification of our investments allows us to take advantage of that. We diversify investments so as to have some component of your portfolio making money at all times no matter what the outcome. The question inevitably comes “why don’t we just sell all of our bonds if rates are going to rise”? In a game of probabilities we would never abandon an asset class as large as Fixed Income as we cannot predict with 100% accuracy that rates will rise. What we can do is manage duration and bond holdings so that our stance would keep us in the game in fixed income if rates flatten or go down but if rates rise then our losses will be muted. That stance would allow us to capture further gains should the bond bull continue and income without exposing us to undue risk. That underweighting of bonds has generated a “safe” income that stood up well in last quarter’s downturn. Has the time come to underweight bonds even more? We think that it may be.

From another source last month comes a further review of Fed policies and the further course of the policies of Quantitative Easing (QE). The Bank of International Settlements (BIS) is known as the Central Bankers bank. The BIS was established to facilitate the transfer of war reparations from Germany in 1930 as per the Treaty of Versailles. The BIS’s main role today is to facilitate the transparency of monetary policy amongst its members thereby making monetary policy more predictable among its 58 member nations. Its current Board of Directors is a virtual Who’s Who of the Central Banking world and includes Federal Reserve Chairman Ben Bernanke. This is what the BIS had to say on QE and central bank policy last month.


Alas, central banks cannot do more without compounding the risks they have already created. Instead, they must re-emphasize their traditional focus – albeit expanded to include financial stability – and thereby encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever larger quantities of government securities. And they must urge authorities to speed up reforms in labour and product markets, reforms that will enhance productivity and encourage employment growth rather than provide the false comfort that it will be easier later. – Bank of International Settlements (BIS) June 2013


Read that first line again. Central banks cannot do more without compounding the risks they have already created. The Bank of International Settlements (BIS) as much states that QE has had unintended consequences and that bubbles may have formed. You have blown up the balloon. You can’t just let it go. Markets would not react well if central banks were to let out all of the air from the balloon at once. As Dallas Federal Reserve Governor Richard Fisher has said “we cannot go from Wild Turkey to Cold Turkey” overnight. The market needs time to adjust to a new regime of tapering of QE and that will create spasms of volatility in the marketplace much as we saw in the last weeks of Q2. Also withstanding a resolute Federal Reserve which has succinctly said that it stands prepared to ramp QE back up if it so chooses in light of weaker data. That data would be a rapidly falling stock market or rapidly rising rates on the 10 Year.

The Fed seems to be implying through its latest statements that they will take Goldilocks approach to using continued QE. If the economy is running hot then less QE is in order. If the economy is running too cold then more QE is on the menu. Could that Goldilocks approach take the form of a rate peg? This would be a rate range at which the Federal Reserve would buy bonds if rates went above a certain level and sell them if rates fell below a prescribed level. A central bank biggest weapon may be its mouthpiece.  If the FOMC told markets the range at which it was essentially satisfied it would probably have to do less purchasing then talking.

The concept of pegging the 10 Year Us Treasury to a rate range is one that was noted by Federal Reserve Chairmen Ben Bernanke in his infamous Helicopter Speech in 2002. Pegging rates by the Fed is not unprecedented. The Federal Reserve implemented a rate peg in the post WW II period very successfully and without much balance sheet expansion. If that were the case then the next question is at what rate on the 10 Year will they peg? 2.5%? 3%? 4%? The answer to that question goes a long way in determining at what level we wish to be involved in bonds. If that change were to induce a volatile spasm where investors drove prices to bargain levels we would consider entering the buy side of the equation. Our job as investors is to sell when prices are high and investors are eager to take on risk. We also seek to buy when others are fear filled and reticent to take on that same risk as we seek to buy assets for less than they are worth. Our margin of safety.

It is not our role to predict the future but it is our role to extrapolate the probability of an investing outcome. Having said that let’s revisit the Recession of 1937. The classic schools of economics differ on the cause of the 1937 Recession that prolonged the depths of the Great Depression. Keynesian economists would have you believe that the recession was caused by a cut in Federal spending and the raising of taxes. We have higher taxes in 2013 and a sequester and still no recession. The Austrian School assigns blame to the large expansion of monetary supply from 1933-1937. Well, we have had a massive expansion of the Fed’s balance sheet and still no recession. There is only one school left so stay with me. I know your eyes are glazing over. Monetarists, such as Milton Friedman, blame the tightening of money supply in late 1936.  Given this knowledge how does the Federal Reserve normalize policy? Given the changes in the Federal Reserve’s policies and a de facto tightening in policy by the Fed and a reduction in QE how will the stock market respond? The stock market response in 1937 was to go down 50%.

We do not think that the stock market’s response will be the same in 2013-14 as it was in 1937 but we are not going to count on that outcome. The way to invest successfully is to try and plan for any outcome.

We feel with continued Fed easing the market may continue higher and perhaps even much higher although a tapering of QE could lessen the chance of a market melt up. We would however continue to have cash on the sidelines in order to be prepared for a selloff. No one wants home insurance until lightening strikes. Insurance costs money but that cost has to be weighed against the opportunity premium that will present itself given lower equity pricing. Cash has an implicit call option attached to it.  The true value of cash is its ability to buy assets during selloffs in the market. Where most investors go wrong is that they buy when they see others making money and sell when they lose their own. It takes steady nerves and great patience.

Given the highly indeterminate nature of outcomes and the unpredictability of worldwide economies and global markets it makes sense to practice defensive investing. It is far more important to ensure survival in light of the possibility of a highly negative outcome than it is important to maximize returns when times are good.Howard Marks

We try to be prepared and invested for all outcomes so that we are making money in at least a portion of our portfolio. We don’t know the future we can only make a probabilistic distribution and invest accordingly. We feel that for now our next move is to continue to back away from duration and fixed income while we take on incrementally more risk in high quality equities as opportunities present themselves at prices that we feel would give us a margin of safety.  Remember we need to look for 3 foot bars to step over and not 7 foot high bars to jump over. We will continue to monitor bond yields and our fixed income portfolio. The management of which may be a large part of what determines our returns going forward in 2013 and 2014. Remember, markets go down far faster than they go up.

A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference. – Robert Rubin


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