Investment Process
The Investment process relies on in-depth macro-economic analysis, asset allocation, sector allocation and market psychology. Predicting the evolution of economic cycles, inflation, monetary and budgetray policies is paramount to determining wher interest rates are likely to go, yield curves likely to shift, currency rates likely to move and corporate earnings by sector likely to evolve.
Our macro-economic analysis is based on data and models, not on market consensus or intellectual shortcuts, and our ability to predict economic cycles has been excellent in the past and key to delivering performance on a constant basis.
Valuation analysis is performed on a tri-dimensonal basis, Intrinsic, Historical and Peer. The natural tendance of Asset classes to evolve from extremes of overvaluation to extremes of undervaluation was ilustrated again in 2007 and 2008. But in 25 years of Investing in the gobal financial Markets, the manager have never seen such extremes of over and under-valuation in some markets and asset classes
Market Psychology is what explains the extremes seen above as Financial markets are the only industry where decisin making remians entirely human and where human emotions and imperfection have not been eliminated by the inhumane perfection of technology. Succesfull investing requires a close monitoring of market psychology and being contrarians, too early, or too fundamentalists can be extremely dangerous as we experienced in 2008.
Finally, Risk management and the ability to Hedge, go back to Cash or even go outright Short on a tactical basis is an intrinsic part of the value added of the process.
Macro Economic Environment
Macro analysis is about detetermining, for every country, where GROWTH, INFLATION, INTEREST RATES, MONETARY POLICY, BUDGETARY POLICY, YIELD CURVES, EQUITY MARKETS AND SECTORS are going within a 12 to 18 months time horizon.
Macro trends are amongst the most predictable if proper models are being used and analysis is performed on the basis of real data and not intellectaul shortcuts.
The world today is divided into three totally distinct zones :
. the USA are in a STRUCTURAL RECESSION-DEFLATION that will take years to solve because of the massive accumulation of debt at the Consumer and the Banking balance sheet levels. Such debt was recklessly built to insustainable levels against Assest such as Stocks and Real Estate that were, once again, mistakenly thought never to fall in value. The prevalent GREED and the extremes of the Free Market philosophy with no boundaries that charcterized the Bush years led to the excesses and value destruction that the USA is going through. As was the case for Japan in the 1990's, the USA will experience value destruction for YEARS, generalized DEFLATION and VALUATION COMPRESSION that will ultimately take its stock market to 450 -500 on the S&P500, on the basis on 10 x 45 to 50 USD of earnings. The Banking system is facing SEVERAL years of having to reconstitute its capital base, as increasing bad loans and default rates in every segment of their huge loan books destroy capital year after year. Nationalization and Regroupement will be inevitable.
. EUROPE is in the middle of a severe and vicious CYCLICAL DOWNTURN. but apart form the UK, Eastern Europe, Spain and Ireland, it does not have any of the structural excesses that are apparent in the USA. Massive monetayr stimulus, a lower EUR and decisive policy action to guarantee the banking system will enable EUROPE to pull out of its recession by the first half of 2010. In the mean time, Social unrest, dangers to the Eastern European economies, the sharp slowdown of German exports and a continuously dogmatic European Central Bank will create huge tensions within the EURO Zone. Europe is charaterized by very different economic realities and budgetary policies. In normal crises, adjustments can take place through aggressive monetary policies wher needed and by exchange rate adjustments. Countries with great difficulties can avoid major contractions by devaluing themsleves out of the problem. In the current rigid European policy, the Moneatry Policy pursued by the Central bank is too strict for some and too lose for others and the fixed currency carcan forces the economic adjustment through major economic contraction. The prospevcts of such an outcome are already visible in the huge increasse in yield spreads between Government bondsof the various countries of the European Union.
JAPAN is experiencing its worst and most brutal recession since WWI, mianly because of the worst economic management of all times that is the consequence of an extremely weak political system. The Japanese economy was just bailing itself out of 15 years of deflation in 2006 when the Government decided abruptly and far too early to end quantitative easing. In 2008, at the time where Japan's biggest export markets were heading into recession, the Administration allowed the Japanese Yen to appreciate by more than 25 % against both the US Dollar and the Euro, devastating the all-important export sector. In the mean time, the Japanese stock market reached a 26 years low at valuation levels unheard of. It is our strong convictioon that 2008 is the undervaluation extreme opposite of the overvaluation extremes of 1989 when the Nikkei was trading at 39800, and that THE CURRENT LEVELS OF THE NIKKEI 225 ARE A UNIQUE LONG TERM BUYING OPPORTUNITY. The economic contraction of Japan will not be lasting, for three reasons, one, the government, after having been extremely passive has resorted to massive stimulus packages and to stop the Japanese Yen acsent, two, it has decided to revive monetary growth by re-initating quantitative easing, three, The Bank of Japan will start to buy stocks directly form the bankng system at the current levels.
CHINA is going through STRUCTURAL LONG TERM GROWTH. The size and night of its consumer will quickly replace the export sector as a drvier of growth and the massive stimulus package worth 15 % of GDP is taking place in a na economy that is already growing at 6 % plus, hence fully benefitting form the Keynesian multiplier. Monetray policy has benne extremely accomodative and loan growth has exploded in the 1st quarter of 2009. It is our view that China will achive and surpass the 8 % growth target of the Government in 2009 and grow much faster in 2010, leading the world ou of its global recession.
Market Analysis
The investment process relies on in-depth macro-economic analysis to determine where to invest and at what time. Macro-analysis is performed on the basis of data and predictive models and not on the market consensus or hearsay. The ability of the manager to predict macro-economic trends in the future has been superb, including predicting the current crisis and market deleveraging at a time where top bankers were still "dancing to the tune of liquidity"...
Up till 2006, the time lag between the macro predictions and their acceptance by the market consensus, and therefore the behaviour of asset classes remained within normal 6 to 9 months time lags.
Between 2006 and 2008, because of the prevalence of young and momentum based "prop traders" at hedge funds and hedge fund like banks created an extension of the time lag and extremes in over and under valuations of asset classes as momentum traders were pushing the trends way beyond the points wher fundamentals would have justified them. Cf. Oil prices for example
It is to be hoped that the market dislocation of 2008, the carnage in the Hedge fund spehere and the establishement of transparency rules and regulation in this industry will make the importance of these rogue traders diminish and that markets will come back to their real function : an optimized allocation of capital process based on real fundamantals.
The days of momentum driven "prop traders" betting with huge sums of money on whether the elevator is going up or down are hopefully over... and financial power houses that bet on the markets like hedge funds, even bringing down their own competitors for the sole purpose of making a few more Dollars on their books should be prosecuted...
This being said, the global macro environamnet leads to the following investment conclusions :
. BUY Long Dated US Treasury bonds. Deflation will prevail in the US for qaurters if not years to come and negative core deflator with 3.70 % nominal yields on the 30 year Bonds give 4.70 % real interest rates. We expect US long bond yields to fall towards 2 % nominal before the deflationary cycle is over.
. BUY the US DOLLAR and short the JPY, the CHF, and the EUR. For the above reasons, the real interest rate differentila in favour of the US Dollar combinedf with pro-active policies to devalue themselves ourt of the crisis and scares about the EUR will drive the value of the US Currency higher. Short term thinkers who belive that the current money creation and bond issuance by the FED will lead to a US Dollar collapse forgot to studythe Japanese crisis of the 1990's and have not compared the debt/GDP ratio of the USA when compared to Europe and Japan.
. Avoid Commodities. Oil is going to USD 20 and Copper as all other commodities will be falling for quarters to come. Demand is collapsng, overproduction is everywhere and the financial traders who created thespeculative bbubble of 2004 - 2008 in commodities are still trying to liquidate their long positions.
. BUY Japanese Stocks. Quantitative easing + 25 year low valuations + Huge amounts of cash in the hands of domestic institutional investors will propel the Nikkei to much higher levels. This is a decade low opportunity to accumulate top quality stoks in the second, soon to be third largest economy of the world.
. BUY Massively Chinese Stocks. The Chinese story is not over, it is just starting. Global investors will soon dicover that the world' engine of growth is China and will suudenly realize the might of the Chinese Consumer when his forces will be unleashed. Massively stimulative policies, lost of cash at hand, extremely low valuations, particularly in the H segment of the market will deliver massive performance in stocks, as strong earnings growth will be accompanied by strong valuation expansion. Moreover, global investors are just about to shift a significant portion of their equity holdings from the US market to the Chinese equity markets.
Risk Management
Up till 2008, the funds downside was tightly controlled with an objective to contain the maximum cumulative draw down to - 15 % at all times, but the markets dislocation of 2008 blew these boundaries away and the manager decided to stay invested in extremely cheap markets until the funds recovered. This imposed a huge volatility on the funds but will prove to be the right strategy in the future.
Now that the markets that we are active on have finished their bear phase and building the base for their new bull phase, our risk management techniques are back in force and the manager will benefit from his increased tolerance to volatility to avoid having to cut positions at a loss in intrinsically highly volatile markets.