Monthly Investment Letter – September 2010

There’s No Way You Can Bet Against America & Win.” Warren Buffett.

There is a Russian proverb: “трудно найти чёрную кошку в тёмной комнате, особенно, если её там нет” – “it’s difficult to find a black cat in a dark room, especially if it isn’t there.”

This pretty much characterises the current investment imbroglio. Everybody is looking for a reason to disbelieve, and has been doing so since the beginning of the great March 2009 rally. The myrmidon reign, but the black cat long ago left the room, and >115% later (Russian Stock Market MICEX), he probably isn’t coming back until at least 2018.

This is the “Wall of Worry” which has accompanied every great bull market in
history. There is a required level of doubt, scepticism, and even fear, to propel a
significant advance; e.g. climbing the wall.

Going into the reporting period, the put/call ratio had not been higher since the ashes of spring 2009, and we continued buying cyclicals, miners and industrials.

With a focus on America, an entire generation of investors might have given up on stocks, SPX being down 25% in 10 years. The yield on two-year bonds is <0.50%, but 25 of the S&P 500 companies have dividend yields >5% with y-o-y EPS growth of 38% and the lowest price to earnings multiples since 1998.

Some observers will remember the Wall of Worry in trying to short US tech stocks in 1994 … and 1995, 1996, and straight through to the dot-com bust in 2000 where the NDX advanced a meteoric 1,240% for the period.

At the time, it seemed that all the shorts had disappeared, or at least lied about their profession. Then the crash hit, and precious few were left on the field as the NASDAQ lost 75%.

On 1 September 2010, the percentage of bullish US investors was at a new low (21%), less than in February 2009 before New York rallied 80%. In what may have seemed like a long walk off a short plank, we promoted the idea in August 2010 that US stocks would trade higher. Corporations have significantly de-leveraged with high cash level, low inventories, excellent cost structures and low expenses on labour (high unemployment reduces company single largest expense and improves profitability).

Companies have never been so prepared for the prospect of recession and they have rarely been better positioned for profitability. While it does not always work out this well, the S&P 500 then staged the most powerful September rally in 60 years +8.76%, while the tech heavy NASDAQ market was up a turgid +13.05%.

So what cats did the unbelievers see in the dark rooms of 2010 that this veteran of the Russian market did not? Only fear.

The Four Horsemen of the False Apocalypse (2010):

Greek contagion

The Athens stock market rebounded +26.61% from 7 June to 4 August, making it one of the top performing equity markets in the developed world for the period.

Spreads on Greek bonds shrank, CDS dropped -38.29% from 24 June to 3 August, default is now a distant memory, and the country seems on path to resume its high spending, low working, strike happy, sunshine loving way. Where did the ardent default prognosticators go? To Skorpios for a holiday with Jim Chanos.

Were any of the central structural inefficiencies resolved? Did anything really
change? No. But Big Brother(s) stepped in as anticipated, and importantly, market perception has changed … and Greece was never a large enough economy to
fundamentally imperil “Europe” anyway. Big Brother(s) were never going to let Los
Galácticos and Futebol Portos default either. Pity the Irish – 13.2% unemployed, and every Irish baby is born owing $442,961.33 to external creditors vs. USA
($40,319.31) or Japan ($11,721.41) + weather + Danny Boy = emigration.

The death of the Euro

The Euro rallied 12% to month-end September.

The end of Chinese demand

Stock markets responded with the Hang Seng trading up +16.06% from trough to peak ending 29 September and the Shanghai composite +14.15% to peak on 7 September.

We moved from a net long 10% weight in February to a 7% short China weight in
March. Convinced that the Bank of China has successfully engineered a near-perfect deceleration and will be supportive of capital markets in the medium term, we started buying China again in the summer. Month-end China gross AUM stands at 10.31% and is anticipated to rise to 15% in Q4 2010. That includes the single top performing line item in our portfolio.

Double dip in the United States derails global recovery

In July, we took the politically incorrect position that the longest, protracted (while provisionally expanding) rate of job recovery in the US would be of maximum benefit to current portfolio construction, commodities, the weak dollar, risk assets and Russia-related investments.

We still maintain this position, and encouragingly, the consensus may be melting down in squeamish driblets.

Unemployment soared from 7.5% to 10.1% March 2009 to April 2010, as the market closed its eyes and advanced a generational +80% for stocks.

Conclusion: the current example backs the 90 year study in simply re-enforcing what most people already know. Unemployment is a lagging indicator and plays minimal role on share price performance. Stock markets are driven by (among other things) outlook related to earnings (direction not absolute) + outlook related to growth (direction not absolute) + current sentiment coupled with currency direction + rate direction and importantly, monetary policy. More difficult than it seems…

Editorial insert here: with apologies to Graham & Dodd, stock markets are not driven by absolute valuations either, but by anticipated future direction.
Fundamental analysis is surely one of the four pillars of successful investing, but
not to derive absolute levels of “value,” i.e. financial ratios which indicate a
“buy” or a “sell,” for any given security at a particular multiple. “It was
historically trading at 12x, so I buy it at 6x.” Q: why did it go from 12x to 6x
and what is going to take it back to 12x again?

Forgive the digression but to expand on the concept, markets are not wholly quantitative and cannot be anticipated over any period of statistical significance by formula or programming. None of the top 1,000,000 greatest investors in the history of the world made their money with robots or black boxes. Were there such a magic calculation, it would be digitised, pirated and mass marketed; filling the streets of Shenzhen with newly minted RMB millionaires.

Technical “analysis” is a brilliant way, for anyone with a PC to intelligently and graphically communicate to potential investors what has already happened; and provide visually supportive illustrations of the explanation. These studies will forever remain flawless as history can always be restated to perfection. But technical analysis has zero predictive ability. It cannot and will not be able to accurately anticipate what will happen next. There has never been a programme or statistical discovery to prove that chart readers are anything more then touts; and you read it here first, no one on the Forbes List ever made his fortune with Fibonacci. Were any singular science of technical analysis able to predict future stock price movements, the code would be stolen, copied, sold at Gorbushka; filling the streets of Moscow with newly minted Rouble billionaires.

Back to direction vs. absolute: stock markets are driven not by computers but rather by humans. There is a powerful, misunderstood, and understated psychological component which the academics and theorists are woe to accredit, because it simply cannot be quantified.

So have all the cat seekers recanted and allocated at least a 1/10th of the $2.8 tr in sideline money sitting in money market instruments? No. So what is the next fanciful feline?

Maelstrom de jour

“Currency Wars?” The term comes from the Chinese best seller of the same name by Song Hongbing and is apparently a must-read for top government officials and NPC loyalists. Labelled “an economic nationalist,” to his great credit, Mr. Song correctly predicted a banking crisis in the US in 2008. According to the Financial Timesand, his sequel “Currency Wars 2” is now one of the most purchased books in China.

The central thesis of both books is that the West and more specifically the US, is controlled by Jewish bankers who manipulate currency to make riches by first loaning money in US$ to emerging markets and then profiteering by shorting the corresponding EM currency. In the books, the Japanese “Lost Decade”, the 1997 Asian Financial Crisis, and the Latin American Financial Crisis are blamed on this syndicate. Mr. Song and proponents of the book warn the BoC guard the Yuan (and China) from these threats to national security and sovereignty.

Absurd fantasy? Perhaps, but according to the Wall Street Journal, (many/some?) Chinese buy into currency war plot and in essence, the politically incorrect storyline is consistent with the general concept being floated by the media these past three weeks.

Even so, we think there is a low probability of a currency war. This is just a tag line which will disappear from the current lexicon at some stage. What will likely happen? We think that China will successfully continue to pursue a glacial “China First” policy and the US will successfully continue to orchestrate a managed dollar depreciation.

Both the slow growth, high debt, low rate USD and the G7 as a basket, will decline against high growth, low debt, high rate EM markets, and commodity-centric currencies. More than any other macro driver of commodity related assets, the weak dollar is trump.

And that is a meaningful positive for risk and Russia-related assets. Our FX allocation remains long Australian Dollar, Korean Won, Thai Baht, Singapore Dollar, Norwegian Krone, Swedish Krona, Georgian Lari, Brazilian Real, Turkish Lira, and Russian Rouble through FX derivatives and securities. We are short the US Dollar, Swiss Franc, and GBP Sterling through FX derivatives.

So what is left to fear? Nothing but fear itself. John Paulson, who requires no introduction and is currently sitting on a $30 billion reflation bet, recently presented a lecture: “Bonds Are Wrong, Stocks Are Right.”

Our view is that “stocks are cheap and bonds are rich,” a not unfamiliar theme.

Equities. This is best place to be. The investment case is focused on the discrepancy between equity earnings yields of about 7-8% now compared to the 10-year yield at 2.6%. This is one of the highest dislocations since they started tracking these numbers.

Equities therefore offer superior returns compared to long-dated bonds and have a powerful earnings growth kicker lacking in fixed income instruments. Nor do they have the downside risk evident in long bonds when rates turn the corner.

Bonds. The purchase of long-dated bonds, either Treasuries or Corporates, should turn out to be a horrible trade. Rates are at record lows, and while the economy is turning they should continue to churn higher.

Paulson expects roughly 2% GDP growth for both 2011 and 2012. Quantitative easing should contribute to significant inflation over the next few years, possibly hitting low-double digits by 2012. This is bad for the 10- and 30-year bonds and the USD. Expect the USD to fall and yields on long-dated US Treasuries to rise.

We take JP + Soros + Mobius, with $89B at risk, 100x over Stiglitz, Roubini and Whitney, who collectively have absolutely nothing at stake.

Our perception remains unchanged since calling the bottom 19 months ago. We believe that we are in the midst of a broad-based global recovery, characterised by world-wide growth, inventory restocking, urbanisation, industrialisation and associated increased commodity consumption.

As such, we have zero exposure to defensive sectors of healthcare, consumer staples, telecommunications, food retail or electrical utilities.

Our top performing line items for the September reporting period were:

  1. Geely Auto 175 HK China +51.25%
  2. Kazakhmys KAZ LN Kazakhstan +28.44%
  3. Hyundai Mipo 001620 KS Korea +24.05%
  4. Noble Group NOBL SP Singapore +23.14%
  5. Swedbank SWEDA SS Sweden +23.03%

We remain long and leveraged to Russia-related assets, the risk trade, basic materials and emerging market equities. Our fund is selectively short long-dated bond futures, G7 and safe haven FX.

Our largest long holdings include November Brent ICE futures, January Comex Platinum, and December Comex Copper futures. Favoured stock sectors remain metals, industrials, shipping, coal, financials, and agriculture.

For the period, leverage remained constant at +/- 80%, while short exposure was decreased from 27% to 21%. Confident in our investment thesis, we take solace in powerful returns for investors.

Slava Rabinovich is CEO and CIO of Diamond Age Capital Advisors Ltd. and the Diamond Age Russia Fund, a hedge fund run from Moscow.

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