Interview with Jesse at the Café Américain
"The easiest road to corruption is through self-delusion." - Jesse
By Ilene at Phil's Stock World
Ilene: Jesse, thank you for doing this interview with me. I’ve been visiting your Americain Cafe now for over a year and have greatly enjoyed the experience. Your site makes me feel like I’m in a real Cafe and have just picked up an interesting article to read with my coffee. However, as it is a virtual meeting spot, we haven’t been formally introduced yet. Will you tell me a little bit about yourself and how the Cafe got started?
Jesse: I am pleased that you are enjoying the Cafe as it has been intended. Too much information about the markets and the economy is hurriedly snatched and gulped down, like American ‘takeaway.’ Sometimes it is valuable to sample information from diverse sources, taste it from different methods of preparation that do not hide its true flavor, and digest it properly. Otherwise we tend to move from bite to bite, with a broadly shallow appreciation of current events, driven by those who shape the mainstream menu offerings.
In 2000 I had taken an early retirement from corporate work, where I had been a vice president at a Fortune 500 company. My intention was to take ten years off to study economics in greater depth, but primarily to spend more time with my family.
I had always been fascinated with economics from the time I had studied it at the university when I went back for an MBA. I am originally an engineer by trade with a background in mathematics and the natural sciences, and while finance was my favorite subject, economics was a fascination. It was clearly a nascent science, full of competing theories, and struggling to find a footing.
Even with my limited background, I could tell that we were approaching an historic period in economic history. The bubble in tech was obvious to anyone who was able to read a chart, and look at the rationale for the boom with a historically skeptical eye.
I had started to study bubbles and crashes in 1998. One of the benefits of traveling for business is that one can become a voracious reader, and so I read quite a few books on bubbles and crashes to supplement what I already had known.
In 2000 I discovered the world of financial chat boards. It was interesting to find a group of people who also did not believe in ‘the bubble.’ This was a chat board at a place online called ‘Fall Street.’ I had been studying technical charting for some time, and looked into most of the methods. I liked the classic charting method, and gained quite a bit of knowledge from Ken Shaleen. I found my own style of charting with what I called ‘the Babson method’ which had been used by the economist, Roger Babson.
There were requests to see these charts, which I was generating on a variety of timeframes. I started posting the charts, which included quite of bit of hand drawn features, for viewing at Yahoo Geocities at a site simply called Jesse’s Charts.
Early in 2001, I started taking things I wrote for the chat board and turned them into small essays, and placing them as text images along with the charts on this site, since the chat board was impermanent and not readily searchable. At that time, blogs were not so readily available. The name of the site was changed to Jesse’s Crossroad Cafe.
The site was intended to be entertaining and visually appealing, often funny, as well as informative. This made it more interesting to me to produce, and the idea was to educate people while providing an interesting diversion. Education does not have to be dry and painful to be effective. There is a wonderful experience to be had in the joy of learning, the ecstasy of understanding. It merely needs some encouragement to occur.
The format on Geocities was a single page, with a background wallpaper and music that changed every few days. The documents and charts were presented as links arranged around the page. It was visually appealing but difficult to maintain and with no search or long term archiving capability.
Yahoo Geocities decided to end their site hosting business in the autumn of 2007, and essentially shut down the Crossroads Cafe over a weekend. At first I was devastated as all the information I had stored there was lost.
I decided to find a new venue, and blogging seemed an even more effective method of providing information of various types in an attractive format with searchable qualities.
Le Café Américain as it is today opened in February 2008. And so here we are today.
Ilene: Are you planning on going back to the corporate world any time? Or will you continue with your studies, blogging and quest to educate people, or all of the above?
Jesse: I am not sure. My ten year hiatus is ending next year. What I do next will depend on where I am needed the most, and I imagine on who would have me. I will be ready for something new, but will always continue with my studies and reflection, meditation, as I have done all my life. It is always a matter of degree. The first six months in a new position are always intense with new learning. I have thoughts of writing a book or two, perhaps some essays, but one has to first think of something essential to say.
Ilene: I’d be willing to bet that you’ll find essential things to say…. As an avid reader of your blog, I sense some skepticism of the equity market’s recent ascent. Do you have any thoughts on where this market is headed?
Jesse: It is always difficult to forecast the short term direction of the US equity and bond markets, but it is especially so now because the Fed and Treasury have provided unprecedented amounts of liquidity to a relatively small number of Wall Street banks. The Fed is openly monetizing debt, and buying the long end of the curve! Because of the way in which rescue has been structured, the banks have little or no incentive to lend the money to commercial interests, but have plenty of incentive to chase beta by speculating in the markets.
The government and associated pundits and analysts also have an incentive to see the bond and equity markets rally because this is viewed as a ‘good sign,’ a way for the economy to rebound and carry the US past its financial crisis and the collapsing credit bubble. .
Without a reform of the financial system and a rebalancing of the economy there can be no sustained recovery. The Fed and Treasury are debasing the dollar in the hopes of masking their past policy errors. This is shaking the global currency regime which has been in place since World War II to its foundations.
So, will the stock market continue to rally? It can, as long as the world keeps accepting dollars, and the Fed pursues the quantitative easing, and the banks are free to trade for their own accounts with sophisticated programs that add no value, but transfer wealth from the many to the few.
Eventually the markets will reflect this economic reality, and the trend will revert to the fundamental mean. When this happens it may be quite painful for all of us. But predicting the time that it will occur is difficult, except to say that it will almost certainly be when the Fed must raise interest rates to save the bond and the dollar. Perhaps earlier than this, if people realize that the market has become a liquidity driven Ponzi scheme without fundamental underpinnings in the productive economy.
This may be triggered by some exogenous event, something that happens from outside the system, which causes the pyramid scheme to collapse. An oil shock would do it for example. It would even distract the public from the underlying causes and the need for reform.
Ilene: Your writing captures the frustration that many people may feel watching the stunning series of events leading to the financial meltdown/so-called recovery. I see our Constitution subverted, new powers created out of nothing, a system of justice turned upside down, and a free market that never really was (causing me to rethink many of my prior views). If you agree with my assessment, how would you explain how this could happen?
Jesse: From discussing this with much older friends, too many of whom have by now passed away, and from my own personal observation of large organizations, I would say that there is always some element, some minority percentage of people, who are amoral and possessed with a need to have many possessions for their own sake, and power over others.
They are often very verbally proficient and quick-witted, good on their feet. They tend to view other people as objects, and do not hesitate to act in a manner that most people would consider to be unthinkably dishonorable. To them the ends definitely justify the means, and the ends are all about the accumulation of more people and possessions to try and fill the great hole in their beings. Some of them are simply as they are because their father or mother did not like them, and they need to prove them wrong, that they are worthwhile. And so they have a neurotic need to gain power over the people and situations because they are afraid. It’s very sad really.
These people are mildly sociopathic, and generally miserable people to be around, but are normally restrained by the rule of law and social conventions.
But at some times the conventions of an organization or a society become weakened, through war or financial stress and crisis, and this relatively small group begins to assume more positions of power, often indirectly through other public personalities. Other people who are merely opportunistic and weak-willed, socially immature, fall in with them, acting as their enablers and supporters.
They see how things are going, and say to themselves, "Why be good? Why be honorable? If these others can gain power and position and possessions why should I not do the same? If I do not, someone else will do it."
This is where we are today. It has its roots in the ‘me generation’ of the 1980’s and the ‘greed is good’ culture that came with the counter-reaction to the altruism and idealism gone bad of the 1960’s in the economic shocks of the 1970’s and the recession of the 1980’s.
It was a remarkable achievement of American democracy that it resisted the allure of statism such as overtook Italy, Japan, and Germany in the 1930’s. Much of the criticism of FDR is from those who were disappointed at their failed coup to bring fascism or communism to the States. I thought FDR did a remarkable job of steering what was then a ‘middle course’ and was branded as a traitor to his class for it.
In retrospect many are harsh in their criticisms, but considering what other countries experienced, the US did quite well with his leadership, and like it or not the people loved him for it, and the elite monied interests hated him for it. Of course, there are always the masses of the ignorant that are only too eager to mouth slogans and selectively odd notions fed to them that they think make them sound wise in a contrarian sort of way.
Left or right, it is all about being successful by advancing over another, by taking what they have, by possessing them, objectifying them, setting yourself apart from ‘the crowd’ whom you secretly despise. For the most part these may be smart people, but in life they are mediocrities, banal in their tastes, unoriginal and unloved, unloving. But they are focused by their mania.
Could one find a more banal group of failed mediocrities than the National Socialist party leaders? And yet they almost succeeded in conquering much of the civilized world by corrupting a weakened nation.
After years of traveling, and seeking to meet people, I have come to the conclusion that people all over are essentially the same. But cultures can be different, because as an organization they reward and approve certain behaviours and discourage and admonish others.
Japan is very different culturally from the US. But I have met Japanese businessmen who were as egotistical and self-centered in private as an American scion of Wall Street might be publicly. But they tend to be restrained by their culture, and not held out as objects of admiration.
I do not believe in ‘conspiracy’ per se. But different types people tend to find each other, people with similar tastes and attitudes, and work together to achieve their similar ends when they are not fighting amongst themselves. It really is a sickness of the mind and the spirit, similar to any other sickness that needs to prey on others to satisfy its abnormal needs. It is because it involves financial and material goods, rather than physical abuse or physical theft, that a relativistic society can tolerate it, allow it to flourish.
It becomes a much more serious problem if amoral egoists begin to gain influence over the government and the media, and undermine the restraints on the will to power, their culture of emptiness. It only takes a minority of the people to give in to the darker impulses of fear and greed to support them, and for the majority to do nothing in response, and an entire nation can become slowly corrupted, allowing monstrous things to occur.
I would say that things in the US began to deteriorate in the middle 1990’s when Bill Clinton was in the White House. This was when we saw the overthrow of the last of the reforms put in place at the end of the Great Depression. Clinton was an egotistical verbalizer, a chronic abuser with a shocking set of personal habits that appear to be compulsive. And he was replaced by an amoral mediocrity that could view torture and the Constitution as impediments or enablers to his will.
Now the US has another high IQ verbalizer, who may be sincere and inexperienced, but unfortunately has surrounded himself with the same elitist group of corrupt statists that enabled the Clintons.
Ilene: What do you mean by “elitists?”
Jesse: Elitists are self-identifying, powerful people in business and politics. Those who consider themselves the elite, based on their wealth, their bloodlines, their university, their personal connections. They are certainly not egalitarian or humanists. They tend to worship power above all, and hold those who have less power in disdain. They have a decided lack of sympathy for their fellow humans, preferring to consider them as objects if at all.
By the way, it is a common characteristic that they cheat, they break the rules, they often flout the law as a matter of course. This type of person views the rules as something to be imposed on the common people, the others, those who need to be ruled by them. If you don’t believe me, start looking into their backgrounds. Everyone may cheat now and then, but for some people it is a way of life, an affirmation of their privileged status. It can almost become a game.
In the UK, it is hard to see daylight. Tony Blair was an egoist verbalizer, and it will be too bad if he gains power over the EU. Gordon Brown is truly frightening. The Tories are intellectually and morally bankrupt, but Labour is corrupted.
The answer of course is for society to begin again to restrain the minority who would serve the will to power, and discourage their demimonde of followers and enablers. The only way to do it is to put justice back into place, restraints on the risk-reward calculations of corruption. There really is little downside to white collar theft and graft, if you are ‘connected.’ Move on, all will be forgiven, we do not have time to enforce the rules in an emergency or a crisis. Besides, he is a ‘goodfella.’ One of our crowd. One of us.
The politics of the US today remind me of the competing crime families we saw in Chicago and New York at various periods in US history. Obviously they can gain enormous power, and the influence of their corruption can run deep. And just as obviously they can be taken down through a concerted effort by cutting them down at the roots.
Ilene: But doesn’t the trend seem to be one of ever-increasing power and wealth in the hands of the minority elite, who use their wealth and power to acquire more – how can that be stopped?
Jesse: The good news is that they are a minority, and they do not run the country and the world. There is always a minority of those who break the law, who subvert society, and there is the means to stop them from succeeding.
Their strength is their weakness. The focus which permits some people to succeed also gives them a ‘tin ear’ for the effects of their greed. In other words, they always go too far, and begin to blatantly start breaking the law, and acting in ways that are obvious wrong. And when there is a public revulsion to their deformity, they just do not get it.
One has to restore a rule of law, an atmosphere in which there are risks for wrongdoing. It is a classic case of the need for reform after a period in which rule breaking has flourished. It is a familiar story throughout history.
The Wall Street banks must be restrained from gaming with the public money. The markets must be a level playing field in which insiders and larger players do not engage in fraudulent trading practices. This requires honest regulators above all, who have not accepted jobs and favors from insiders. Self regulation does not work, because the easiest road to corruption is through self-delusion.
The flow of money from special interests to politicians via lobbyists and campaign contributions must be stopped through campaign financing reform and scrupulous disclosures. Those who accept money from special interests over which they have a public stewardship are a cancer to a society.
The media must once again be managed by diverse elements, and not a few corporations.
People must once again be willing to tell the truth, to stand for what is right, to speak for the ideals which govern the country under the Constitution, without fear of retribution or penalty.
Our treatment of ‘whistleblowers’ is often shameful.
Obama was obviously elected in the US as a reformer, and he is failing. Is he corrupt, or merely naïve? No matter. If he does not perform he will be replaced, by a third party if necessary.
I am a little less optimistic with regard to the UK, probably from a personal ignorance, but there is always hope.
America is a revolutionary country, and it still maintains a love of freedom and a dedication to its founding principles, even though at times it may seem to lose its way.
Reform is a response to a specific set of deteriorating conditions, some specific wrongs. It is when the majority of average people begin to restore a balance to their society by no longer being afraid to call certain behaviours ‘wrong’ and unacceptable to their society.
Who is to say what is wrong? There is a wonderful thing in America, its Constitution. It sets out the basic principles of freedom in a marvelous way. It is not perfect. It does not contain all the details, which are to be found in the body of laws that surround and support it, and those who swear to preserve, protect and defend it.
It starts by simply saying ‘no’ to those who would rule us by fear and discouragement. To say no to private prejudice and greed, which cause us to turn a blind eye to injustice. Daylight is a good disinfectant. Secrecy is not the normal condition in a free society.
Periods of time can be dangerous, because there are sometimes wolves in sheep’s clothing. Hitler was put forward as a strong reformer. He was elected by a minority, and suspended the rule of law. So a nation will be wise in whom it selects to lead it. If it holds on to its principles, in the case of America, the Constitution, then it can stay on the path to reform.
Fresh from the desk of Phil's Stock World
Interview With A Mad Hedge Fund Trader
Mad Hedge is quite a fascinating character who’s had a very exciting career in finances and more. He writes daily newsletter entries on market action, stocks and trends in the economy, and I highly recommend taking a moment to peruse his site, Diary of a Mad Hedge Fund Trader. - Ilene at Phil's Stock World.
Introduction
Mad Hedge Fund Trader began his career in finance by moving to Japan and working at Dai Nana Securities as a research analyst in 1974. In 1976 he was named the Tokyo correspondent for The Economist magazine and the Financial Times, which then shared an office. He traveled the world interviewing famous people, such as Ronald Reagan and Margaret Thatcher. In 1982, he was named the US editor of Euromoney magazine, and in 1983 he built a new division in international equities for Morgan Stanley. After moving to London in 1985, Mad Hedge supervised sales and trading in Japanese equity derivatives. In 1989, he became a director of the Swiss Bank Corp, responsible for Japanese equity derivatives. A year later, he set up an international hedge fund which he sold in 1999.
I haven’t even covered all of Mad Hedge’s adventures, such as his latent movie star career (as an extra in the 1979 epic war film, Apocalypse Now), and who knows what else. But now, missing the adrenaline-surging excitement of active trading, Mad Hedge has returned to the hedge fund business, set up an educational website, and is busy keeping up with the demands of newsletter writing.. So let’s begin our interview with Mad Hedge by exploring his current thoughts on the markets.
Interview
Ilene: Hi Mad Hedge. You’ve had a fascinating career having little to do with your major in biochemistry. A brief review of your newsletter shows that your recommendations early in 2009 have appreciated by an average of around 400%. You’ve been writing your daily market thoughts and investment strategies at your website - www.madhedgefundtrader.com - which it’s terrific, by the way. What are your goals with this site?
Mad Hedge: This whole thing started out as a letter to investors in my hedge fund, to tell them my thinking behind my positions. Then I thought, why not post this on the web and see what happens? Six months later it is now going out to 50,000 readers a day, mostly to portfolio managers, financial advisors, and traders. The growth has been explosive.
Ilene: Who are your readers?
I seemed to have stumbled on a market that I describe as “semi-professionals.” If you are a big hedge fund, with a staff of 600 and a huge in-house research department, I’m not going to tell you anything you don’t already know. But there appear to be a few million people out there who trade their own accounts, or invest their own IRA’s. They have never worked on Wall Street, but have taught themselves a lot about markets and investing. My letter gives them the 30,000 foot view on global stock, bond, currency, commodity, and real estate markets which they can’t find at their online broker. About half of them are from abroad. When I get up in the morning now, there are five e-mails waiting for me from China and India asking what to do about natural gas. I also try to make the letter funny and entertaining. Not all financial publications have to be dreary reading. It’s not always about the next stock to buy.
Ilene: In a recent letter you wrote that one of your favorite ETF’s is the Proshares Ultra Short Treasury Trust (TBT). Why is that?
Mad Hedge: TBT is a 200% leveraged bet that long Treasury bonds will go down. While the Fed keeps short rates low, it doesn’t directly control long rates. As the supply of government bonds increases exponentially, their eventual collapse is inevitable. All Ponzi schemes must come to an end, and the US government is no exception. We currently have the greatest liquidity driven market of all time, and the ten year is eking out a mere 3.30% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%. If the yield goes back to 5%, that will take the TBT from $45 to $70. The TBT could perform even better if Treasuries lose their triple “A” rating, which I think is a real possibility.
Historically, bonds are not a good buy in a low interest rate, deflationary environment. If long rates move from 3% back to the 12% we saw in the early eighties, bond holders will get slaughtered, and the TBT could exceed $200. Even if inflation stays low, the sheer weight of supply and credit concerns will crater government bond prices.
Ilene: What’s the worst case scenario for the bond market?
Mad Hedge: Debt service is currently 11% of the budget. If interest rates rise sharply, that could double to 22%. Then you get a downward spiral like you saw in Latin America in the eighties, when higher debt service creates more borrowing, and more borrowing creates a higher debt service, until the whole thing blows up. At some point China, Japan, the Middle Eastern countries may stop buying our debt. There are only so many “greater fools” out there.
The only way out of this is for the economy to return to a long term 3%-4% growth rate. That’s obviously what Obama is hoping for with his programs. He’s taking big risks, but he doesn’t have much choice. He really did inherit a bad hand. If he did nothing, we’d be in a depression by now, with 25% unemployment. He understands what he’s doing and understands the risks. He has great economic advisors.
Obama couldn’t have allowed the banking system to collapse. We need banks as the economy’s lynchpin. A year ago we could have lost the entire financial system over a weekend. Ships were being turned around at sea and going back home because their letters of credit were failing. The freeze up in credit could have gone on for years.
The stock market is up 50% since Obama took office, so it likes the uneasy stability that we have now. Credit markets have recovered tremendously, and IPOs are coming to the market again. Junk bond funds are up, confidence is returning. There’s greater willingness to lend, though only at high interest rates. But it’s a big improvement over last year.
Ilene: What do you expect for mortgage rates in the next few months? Years?
Mad Hedge: You shouldn’t touch real estate, as I think it will be dead money for another decade. Rent, don’t buy. If you have to buy, then get a 30 year fixed rate mortgage now at 5%, because rates are going up a lot in the future. When I bought my first home in New York in the early eighties, I got nailed with a 17% interest rate on my mortgage. We may revisit those levels.
Houses will continue to move lower, maybe another 10% or so. We have another wave of foreclosures hitting the system soon, triggered by the option arm readjustments. I see support for prices when the cost of owning and the cost of renting are more in line. Home ownership may have to become cheaper than renting, because of perceived risk to the principle, for the real estate market sell-off to finish. However, expecting houses to drop a lot from here is like shorting Citibank at $3. We’ve basically had the big move already. Due to poor demographic factors, the demand for houses is going to take a long time to come back. While 80 million baby boomers are trying to sell their houses to 65 million gen Xer’s, don’t expect a recovery in prices, especially when the gen Xer’s are still living in your basement.
Ilene: You mentioned you missed the rally in financials, but still have concerns about the financial sector.
Mad Hedge: With financials, I knew they would rebound, but didn’t imagine the extensive move we’ve seen. It was the greatest dead cat bounce and short covering rally of all time. But the financial sector will have troubles for years. If I had to buy U.S. stocks, I’d buy big tech stocks like Microsoft (MSFT), Oracle (ORCL), Intel, (INTC) and Cisco (CSCO), because for the most part they have tons of cash and little debt. Tech stocks didn’t have the problems that were plaguing the other sectors. For example, they have no troubled assets, and no regulatory clamp down on their business. The credit crisis didn’t affect them directly because they finance their operations through cash flow and tend not to borrow. Of course, they’re hurt indirectly when the customers have credit problems.
Credit markets are now seeing a huge differentiation in terms. Lenders are much more discriminating about who they lend to. American consumers are very constrained, but foreign consumers are not as constrained. They are not returning to frugality as we are because they didn’t share our excesses in the first place. You don’t see many black Cadillac Escalades with chrome wheels in China. If I had to buy stocks, I would buy equity in foreign companies where the growth will be in the coming years. In March, you could have bought anything and had a great trade, as the rising tide lifted all boats. But stocks in emerging markets outperformed US stocks by over a two to one margin.
Ilene: Would you be buying stocks now?
Mad Hedge: No, I sold most of my positions in June. The risk was low in March, but not so low in June, and it’s even greater now. The PE multiple on the S&P 500 has just jumped from 10 to 20 in six months. Historically, a 20 multiple is a terrible time to enter the market. Markets are discounting a “V”-shaped recovery, which we are not going to get. I think we’ll get more of a “square root” shaped recovery, a “V” followed by sideways to a gradually upward sloping grind. We’ve already had the “V”. Markets are overpriced. I don’t see how we can have huge economic growth with capital-constrained banks, catatonic consumers, and commercial real estate troubles up the wazoo. One of the only positives is the weak dollar, which makes everything we sell to the rest of the world cheaper. This is good for our multi-national companies, good for our exporters. So far, the dollar is on a grinding, controlled move down, which is good. But if the dollar’s fall accelerates, it would not be good. A real dollar panic would lead to the widespread dumping of dollar assets, and commodity prices would explode. Then we’ll get to $2,000 for gold and $40 for silver very quickly.
Ilene: You spent several years wildcatting for natural gas in Texas and Colorado, which has given you a unique insight into the energy space. What are your current thoughts on natural gas and oil?
Mad Hedge: Stay away from natural gas. The volatility will kill you. If you are a masochist, then buy it only when it’s cheap, on big dips, in the $3/MBTU range. In the last three years, thanks to the new “fracting” technology used in oil shales, we have discovered a 100 year supply of natural gas sitting under the US, and the producers have not been able to cut back fast enough. So now we have a supply glut, and we are almost out of storage. This is what took us down from $13 to $2.40 in 18 months. The lack of hurricanes has not helped demand either. Producers have been cutting back like crazy, trying to balance supply and demand, with a breakeven point of $2. They need a cold winter to help bring things back into balance. If the industry gets organized, then gas can become the 20 year bridge we need, until energy alternatives kick in. That makes me a big supporter of the “Pickens Plan.”
Oil is much more interesting. It overshot to downside in January to $32. Crude is now at $70 climbing out of the recession. Imagine how high it will get when all economies are functioning again. The financial crisis hurt the ability of big oil companies to get financing for large development projects in oil. These projects can take five to ten years to bring online. That means we will get higher oil prices sooner. We may get a pull back to the $50s, but the $30’s would be a stretch. The $32 low was an artificial one caused by a complete absence of liquidity in all markets. I don’t think we’ll see those lows again.
Ilene: Where do you see the price of oil going in the distant future?
Mad Hedge: I think it may dip into the 50s, then up, perhaps skyrocketing to $300 before dropping back down to $3 after alternatives take over and demand vanishes. But that’s at best 20 years out. If we can wean ourselves off oil in 20 years, it would be a huge accomplishment.
Ilene: I noticed you speak a little about politics in your essays; do you have a leaning one way or another?
Mad Hedge: I’m politically neutral. I’m getting bashed by the right these days because I’ve said that the Republicans have no ability to affect the legislative process now. But we need to adjust our portfolios to reflect the current political realities. No matter how much you love Obama, you can’t dispute the fact that the massive issuance of government bonds he is proposing is terrible for the bond market and the dollar, but great for precious metals and commodities. Obama won by a big margin, so the Democrats will be around for a while. Of course, if my “square root” scenario doesn’t pan out, and we get a serious “W” recession instead, all bets are off. People will only give him the benefit of the doubt for so long.
Ilene: Where do you think the stock market’s going to go over the next few years?
Mad Hedge: I think there’s a 1 in 3 chance for new lows. That’s the “W” scenario. But with Lehman, Bear Stearns, Merrill Lynch, and Washington Mutual gone, we have run out of companies that can suddenly go under and trigger a new financial crisis. The big survivors are partially government owned, and of course zero interest rates help a lot. More banks are going under, but they will be smaller, regional banks with excessive exposure to commercial real estate.
Ilene: How does this affect your actions in the markets?
Mad Hedge: The best and least risky trades were in the early part of the year. Now, there’s a lot more risk in all markets. I’m neutral right now. If stocks dropped from here, I might be a buyer, but only in energy, commodities, and technology, and of course in emerging markets like Brazil, India, China, Korea, and Vietnam. Gold, silver and commodities have all had huge runs. My inner wimp has me in cash, waiting for better opportunities. I haven’t been playing the short side, because it’s a nightmare trying to short a liquidity driven market with interest rates at zero. There is no return on low risk investments now. Capital always moves to risky assets when interest rates are zero. Just look at Japan in the 1980s. There PE multiples soared from 10 to 100 purely driven by liquidity. For the last three years of that run the fundamental analysts were left twisting slowly in the wind. Artificially low interest rates boost asset prices to artificially high prices. It always ends in tears, but can play out for a while. You want to have an asymmetric risk reward metric in your favor, as we did in March of this year. Now, we don’t have that.
The next downward move in the markets will more likely be due to disappointing economic data, earning misses, etc., not due to a total collapse of the system. We may sell off, but I don’t think it will be to new lows. It’s hard to see new lows with interest rates at zero. Instead, I see the “square root” recovery scenario mentioned earlier. The market may start drifting lower as people start seeing this possibility. That might set up a trading range for the S&P 500 which could last for years, something like 800-1,200. During the nineties, Japan peaked at ¥39,000, then traded in a ¥20,000-¥25,000 range for five years, before the final collapse to ¥7,000. That’s one scenario for the US.
Ilene: You’ve had an amazing career. Let me ask you about some of the people you’ve interviewed. What was Ronald Reagan like?
Mad Hedge: Although I never agreed with him politically, you couldn’t help but like the guy. He always had a joke ready. He was a lot smarter than he let on.
Ilene: And Margaret Thatcher, the prime minister of Britain?
Mad Hedge: Her nickname as “The Iron Lady” was well deserved. She could stare holes right through you. She treated journalists like a disapproving school teacher, which of course, she was.
Ilene: How about the terrorist leader, Yassir Arafat, of the PLO?
Mad Hedge: His body guards almost shot me when I reached to turn over a cassette in my tape recorder. I always thought he was a terrible leader. That is why the Palestinians never got anywhere, and why the Israelis left him alone.
Ilene: Meeting China’s Deng Xiaoping must have been amazing.
Mad Hedge: I am 6’4” and he was only 4’9”, so of course there were plenty of opportunities for humor. I could never envision this guy going on the Long March. He had a tremendous wit. Someone asked him why China kept its borders closed, and wasn’t this an imposition on human rights. He said if he opened the borders, the surrounding countries would get flooded with people. He asked “How many Chinese do you want? 20 million? 30 million?” I also met Zhou Enlai during the Cultural Revolution. He was a brilliant man, the last man on a bell shaped curve of 500 million.
Ilene: I read somewhere that you interviewed four US Secretaries of the Treasury.
Yes, Miller Reagan, Schultz, and Brady. And I visited the French chateau of a fifth, C. Douglas Dillon. I keep a collection of dollar bills they signed.
My goal in life was always to get in the way of history, and let it run me over. It’s been an amazing life. I wouldn’t trade it for anything.
Ilene: What about Apocalypse Now?
Mad Hedge: I happened to be in town to interview Ferdinand Marcos, the president of the Philippines. If you look hard, I’m in the USO scene. Most of the other “GI’s” in that scene were European and Australian hippies rounded up from the Youth Hostels of Manila by Francis Ford Coppola’s agents. Good luck, though. I was a lot younger and thinner then.
Ilene: Thanks a lot. It’s been great talking to you.
****
We hope you are enjoying our new interview series at Phil's Stock World. Sample a FREE 90-day trial to our PSW Report by clicking here.
Mad Hedge is quite a fascinating character who’s had a very exciting career in finances and more. He writes daily newsletter entries on market action, stocks and trends in the economy, and I highly recommend taking a moment to peruse his site, Diary of a Mad Hedge Fund Trader. - Ilene at Phil's Stock World.
Introduction
Mad Hedge Fund Trader began his career in finance by moving to Japan and working at Dai Nana Securities as a research analyst in 1974. In 1976 he was named the Tokyo correspondent for The Economist magazine and the Financial Times, which then shared an office. He traveled the world interviewing famous people, such as Ronald Reagan and Margaret Thatcher. In 1982, he was named the US editor of Euromoney magazine, and in 1983 he built a new division in international equities for Morgan Stanley. After moving to London in 1985, Mad Hedge supervised sales and trading in Japanese equity derivatives. In 1989, he became a director of the Swiss Bank Corp, responsible for Japanese equity derivatives. A year later, he set up an international hedge fund which he sold in 1999.
I haven’t even covered all of Mad Hedge’s adventures, such as his latent movie star career (as an extra in the 1979 epic war film, Apocalypse Now), and who knows what else. But now, missing the adrenaline-surging excitement of active trading, Mad Hedge has returned to the hedge fund business, set up an educational website, and is busy keeping up with the demands of newsletter writing.. So let’s begin our interview with Mad Hedge by exploring his current thoughts on the markets.
Interview
Ilene: Hi Mad Hedge. You’ve had a fascinating career having little to do with your major in biochemistry. A brief review of your newsletter shows that your recommendations early in 2009 have appreciated by an average of around 400%. You’ve been writing your daily market thoughts and investment strategies at your website - www.madhedgefundtrader.com - which it’s terrific, by the way. What are your goals with this site?
Mad Hedge: This whole thing started out as a letter to investors in my hedge fund, to tell them my thinking behind my positions. Then I thought, why not post this on the web and see what happens? Six months later it is now going out to 50,000 readers a day, mostly to portfolio managers, financial advisors, and traders. The growth has been explosive.
Ilene: Who are your readers?
I seemed to have stumbled on a market that I describe as “semi-professionals.” If you are a big hedge fund, with a staff of 600 and a huge in-house research department, I’m not going to tell you anything you don’t already know. But there appear to be a few million people out there who trade their own accounts, or invest their own IRA’s. They have never worked on Wall Street, but have taught themselves a lot about markets and investing. My letter gives them the 30,000 foot view on global stock, bond, currency, commodity, and real estate markets which they can’t find at their online broker. About half of them are from abroad. When I get up in the morning now, there are five e-mails waiting for me from China and India asking what to do about natural gas. I also try to make the letter funny and entertaining. Not all financial publications have to be dreary reading. It’s not always about the next stock to buy.
Ilene: In a recent letter you wrote that one of your favorite ETF’s is the Proshares Ultra Short Treasury Trust (TBT). Why is that?
Mad Hedge: TBT is a 200% leveraged bet that long Treasury bonds will go down. While the Fed keeps short rates low, it doesn’t directly control long rates. As the supply of government bonds increases exponentially, their eventual collapse is inevitable. All Ponzi schemes must come to an end, and the US government is no exception. We currently have the greatest liquidity driven market of all time, and the ten year is eking out a mere 3.30% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%. If the yield goes back to 5%, that will take the TBT from $45 to $70. The TBT could perform even better if Treasuries lose their triple “A” rating, which I think is a real possibility.
Historically, bonds are not a good buy in a low interest rate, deflationary environment. If long rates move from 3% back to the 12% we saw in the early eighties, bond holders will get slaughtered, and the TBT could exceed $200. Even if inflation stays low, the sheer weight of supply and credit concerns will crater government bond prices.
Ilene: What’s the worst case scenario for the bond market?
Mad Hedge: Debt service is currently 11% of the budget. If interest rates rise sharply, that could double to 22%. Then you get a downward spiral like you saw in Latin America in the eighties, when higher debt service creates more borrowing, and more borrowing creates a higher debt service, until the whole thing blows up. At some point China, Japan, the Middle Eastern countries may stop buying our debt. There are only so many “greater fools” out there.
The only way out of this is for the economy to return to a long term 3%-4% growth rate. That’s obviously what Obama is hoping for with his programs. He’s taking big risks, but he doesn’t have much choice. He really did inherit a bad hand. If he did nothing, we’d be in a depression by now, with 25% unemployment. He understands what he’s doing and understands the risks. He has great economic advisors.
Obama couldn’t have allowed the banking system to collapse. We need banks as the economy’s lynchpin. A year ago we could have lost the entire financial system over a weekend. Ships were being turned around at sea and going back home because their letters of credit were failing. The freeze up in credit could have gone on for years.
The stock market is up 50% since Obama took office, so it likes the uneasy stability that we have now. Credit markets have recovered tremendously, and IPOs are coming to the market again. Junk bond funds are up, confidence is returning. There’s greater willingness to lend, though only at high interest rates. But it’s a big improvement over last year.
Ilene: What do you expect for mortgage rates in the next few months? Years?
Mad Hedge: You shouldn’t touch real estate, as I think it will be dead money for another decade. Rent, don’t buy. If you have to buy, then get a 30 year fixed rate mortgage now at 5%, because rates are going up a lot in the future. When I bought my first home in New York in the early eighties, I got nailed with a 17% interest rate on my mortgage. We may revisit those levels.
Houses will continue to move lower, maybe another 10% or so. We have another wave of foreclosures hitting the system soon, triggered by the option arm readjustments. I see support for prices when the cost of owning and the cost of renting are more in line. Home ownership may have to become cheaper than renting, because of perceived risk to the principle, for the real estate market sell-off to finish. However, expecting houses to drop a lot from here is like shorting Citibank at $3. We’ve basically had the big move already. Due to poor demographic factors, the demand for houses is going to take a long time to come back. While 80 million baby boomers are trying to sell their houses to 65 million gen Xer’s, don’t expect a recovery in prices, especially when the gen Xer’s are still living in your basement.
Ilene: You mentioned you missed the rally in financials, but still have concerns about the financial sector.
Mad Hedge: With financials, I knew they would rebound, but didn’t imagine the extensive move we’ve seen. It was the greatest dead cat bounce and short covering rally of all time. But the financial sector will have troubles for years. If I had to buy U.S. stocks, I’d buy big tech stocks like Microsoft (MSFT), Oracle (ORCL), Intel, (INTC) and Cisco (CSCO), because for the most part they have tons of cash and little debt. Tech stocks didn’t have the problems that were plaguing the other sectors. For example, they have no troubled assets, and no regulatory clamp down on their business. The credit crisis didn’t affect them directly because they finance their operations through cash flow and tend not to borrow. Of course, they’re hurt indirectly when the customers have credit problems.
Credit markets are now seeing a huge differentiation in terms. Lenders are much more discriminating about who they lend to. American consumers are very constrained, but foreign consumers are not as constrained. They are not returning to frugality as we are because they didn’t share our excesses in the first place. You don’t see many black Cadillac Escalades with chrome wheels in China. If I had to buy stocks, I would buy equity in foreign companies where the growth will be in the coming years. In March, you could have bought anything and had a great trade, as the rising tide lifted all boats. But stocks in emerging markets outperformed US stocks by over a two to one margin.
Ilene: Would you be buying stocks now?
Mad Hedge: No, I sold most of my positions in June. The risk was low in March, but not so low in June, and it’s even greater now. The PE multiple on the S&P 500 has just jumped from 10 to 20 in six months. Historically, a 20 multiple is a terrible time to enter the market. Markets are discounting a “V”-shaped recovery, which we are not going to get. I think we’ll get more of a “square root” shaped recovery, a “V” followed by sideways to a gradually upward sloping grind. We’ve already had the “V”. Markets are overpriced. I don’t see how we can have huge economic growth with capital-constrained banks, catatonic consumers, and commercial real estate troubles up the wazoo. One of the only positives is the weak dollar, which makes everything we sell to the rest of the world cheaper. This is good for our multi-national companies, good for our exporters. So far, the dollar is on a grinding, controlled move down, which is good. But if the dollar’s fall accelerates, it would not be good. A real dollar panic would lead to the widespread dumping of dollar assets, and commodity prices would explode. Then we’ll get to $2,000 for gold and $40 for silver very quickly.
Ilene: You spent several years wildcatting for natural gas in Texas and Colorado, which has given you a unique insight into the energy space. What are your current thoughts on natural gas and oil?
Mad Hedge: Stay away from natural gas. The volatility will kill you. If you are a masochist, then buy it only when it’s cheap, on big dips, in the $3/MBTU range. In the last three years, thanks to the new “fracting” technology used in oil shales, we have discovered a 100 year supply of natural gas sitting under the US, and the producers have not been able to cut back fast enough. So now we have a supply glut, and we are almost out of storage. This is what took us down from $13 to $2.40 in 18 months. The lack of hurricanes has not helped demand either. Producers have been cutting back like crazy, trying to balance supply and demand, with a breakeven point of $2. They need a cold winter to help bring things back into balance. If the industry gets organized, then gas can become the 20 year bridge we need, until energy alternatives kick in. That makes me a big supporter of the “Pickens Plan.”
Oil is much more interesting. It overshot to downside in January to $32. Crude is now at $70 climbing out of the recession. Imagine how high it will get when all economies are functioning again. The financial crisis hurt the ability of big oil companies to get financing for large development projects in oil. These projects can take five to ten years to bring online. That means we will get higher oil prices sooner. We may get a pull back to the $50s, but the $30’s would be a stretch. The $32 low was an artificial one caused by a complete absence of liquidity in all markets. I don’t think we’ll see those lows again.
Ilene: Where do you see the price of oil going in the distant future?
Mad Hedge: I think it may dip into the 50s, then up, perhaps skyrocketing to $300 before dropping back down to $3 after alternatives take over and demand vanishes. But that’s at best 20 years out. If we can wean ourselves off oil in 20 years, it would be a huge accomplishment.
Ilene: I noticed you speak a little about politics in your essays; do you have a leaning one way or another?
Mad Hedge: I’m politically neutral. I’m getting bashed by the right these days because I’ve said that the Republicans have no ability to affect the legislative process now. But we need to adjust our portfolios to reflect the current political realities. No matter how much you love Obama, you can’t dispute the fact that the massive issuance of government bonds he is proposing is terrible for the bond market and the dollar, but great for precious metals and commodities. Obama won by a big margin, so the Democrats will be around for a while. Of course, if my “square root” scenario doesn’t pan out, and we get a serious “W” recession instead, all bets are off. People will only give him the benefit of the doubt for so long.
Ilene: Where do you think the stock market’s going to go over the next few years?
Mad Hedge: I think there’s a 1 in 3 chance for new lows. That’s the “W” scenario. But with Lehman, Bear Stearns, Merrill Lynch, and Washington Mutual gone, we have run out of companies that can suddenly go under and trigger a new financial crisis. The big survivors are partially government owned, and of course zero interest rates help a lot. More banks are going under, but they will be smaller, regional banks with excessive exposure to commercial real estate.
Ilene: How does this affect your actions in the markets?
Mad Hedge: The best and least risky trades were in the early part of the year. Now, there’s a lot more risk in all markets. I’m neutral right now. If stocks dropped from here, I might be a buyer, but only in energy, commodities, and technology, and of course in emerging markets like Brazil, India, China, Korea, and Vietnam. Gold, silver and commodities have all had huge runs. My inner wimp has me in cash, waiting for better opportunities. I haven’t been playing the short side, because it’s a nightmare trying to short a liquidity driven market with interest rates at zero. There is no return on low risk investments now. Capital always moves to risky assets when interest rates are zero. Just look at Japan in the 1980s. There PE multiples soared from 10 to 100 purely driven by liquidity. For the last three years of that run the fundamental analysts were left twisting slowly in the wind. Artificially low interest rates boost asset prices to artificially high prices. It always ends in tears, but can play out for a while. You want to have an asymmetric risk reward metric in your favor, as we did in March of this year. Now, we don’t have that.
The next downward move in the markets will more likely be due to disappointing economic data, earning misses, etc., not due to a total collapse of the system. We may sell off, but I don’t think it will be to new lows. It’s hard to see new lows with interest rates at zero. Instead, I see the “square root” recovery scenario mentioned earlier. The market may start drifting lower as people start seeing this possibility. That might set up a trading range for the S&P 500 which could last for years, something like 800-1,200. During the nineties, Japan peaked at ¥39,000, then traded in a ¥20,000-¥25,000 range for five years, before the final collapse to ¥7,000. That’s one scenario for the US.
Ilene: You’ve had an amazing career. Let me ask you about some of the people you’ve interviewed. What was Ronald Reagan like?
Mad Hedge: Although I never agreed with him politically, you couldn’t help but like the guy. He always had a joke ready. He was a lot smarter than he let on.
Ilene: And Margaret Thatcher, the prime minister of Britain?
Mad Hedge: Her nickname as “The Iron Lady” was well deserved. She could stare holes right through you. She treated journalists like a disapproving school teacher, which of course, she was.
Ilene: How about the terrorist leader, Yassir Arafat, of the PLO?
Mad Hedge: His body guards almost shot me when I reached to turn over a cassette in my tape recorder. I always thought he was a terrible leader. That is why the Palestinians never got anywhere, and why the Israelis left him alone.
Ilene: Meeting China’s Deng Xiaoping must have been amazing.
Mad Hedge: I am 6’4” and he was only 4’9”, so of course there were plenty of opportunities for humor. I could never envision this guy going on the Long March. He had a tremendous wit. Someone asked him why China kept its borders closed, and wasn’t this an imposition on human rights. He said if he opened the borders, the surrounding countries would get flooded with people. He asked “How many Chinese do you want? 20 million? 30 million?” I also met Zhou Enlai during the Cultural Revolution. He was a brilliant man, the last man on a bell shaped curve of 500 million.
Ilene: I read somewhere that you interviewed four US Secretaries of the Treasury.
Yes, Miller Reagan, Schultz, and Brady. And I visited the French chateau of a fifth, C. Douglas Dillon. I keep a collection of dollar bills they signed.
My goal in life was always to get in the way of history, and let it run me over. It’s been an amazing life. I wouldn’t trade it for anything.
Ilene: What about Apocalypse Now?
Mad Hedge: I happened to be in town to interview Ferdinand Marcos, the president of the Philippines. If you look hard, I’m in the USO scene. Most of the other “GI’s” in that scene were European and Australian hippies rounded up from the Youth Hostels of Manila by Francis Ford Coppola’s agents. Good luck, though. I was a lot younger and thinner then.
Ilene: Thanks a lot. It’s been great talking to you.
****
We hope you are enjoying our new interview series at Phil's Stock World. Sample a FREE 90-day trial to our PSW Report by clicking here.
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