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A Trader and an Investor



I normally don't actually talk to Mr. Practical; he communicates mostly by writing letters. If you knew him you would know why. He is very deliberate and never rushed. For the way he thinks, tomorrow is just as good as today ("Let me have one more day to think about that" he often says). His investment decisions are always well thought out and he is never that concerned about price (I am consumed with it). What counts in his mind is being right in the long run.

When we first met he took quite an interest in what I do and like everything else, set out on a methodical course to learn all about it. It took him about a week before he knew just about everything that I know about derivative trading, although he always listens carefully to me on the subject. Since then we exchange information. I clearly have the best of the deal, and now as you will see, so do you.

Here is what he wrote:

My friend John informs me that he has been writing for a website, one that has no agenda other than the truth. I don't really play with computers, but I am all for the truth, so I have agreed that he may pass on my thoughts from time to time.

First, let me tell you what I think of "trading" the market. It is in general a loser's game. Any black jack player will tell you that if the odds are against you, even by just a bit, and you bet the same amount of money each time, it is just a matter of time before you lose it all. So the best strategy in the case where the odds are against you is actually to bet all your money on one hand (this is why you do hear from time to time of someone who made a lot of money "trading": they were lucky).

If the odds are slightly in your favor, the best strategy instead is to bet so that you can sit at the table as long as possible. This entails betting less when losing and more when winning: this maximizes the preservation of capital. So to be a successful trader (black jack player), you must not only have some special advantage over everyone else, you must understand how to size your bets to minimize losses and maximize profits.

So you must ask yourself realistically what advantage you have over the market, which consists of millions of investors, some of which always have better information than you. Hedge funds, which I have come to understand much more clearly with John's help, seem to have those advantages if (a big if) they are run properly. That takes an intense understanding of the product (a product with some type of inefficiency), an efficient infrastructure in terms of costs and research, and above all, a good process of risk control and capital allocation.

So I don't concern myself with short term (under one year) movements in the markets. I believe they are influenced predominantly by psychology: investors' propensity to assume more risk or less risk. This is for the most part indeterminable and I don't bother with folly. I only care about positioning my assets in the long run to 1) avoid loss of value and 2) earn compound returns at the best after tax rate possible.

My views are long term in nature and are totally inappropriate to attempt to trade with short term. I listen to John's views, but also believe they are inappropriate to use for trading purposes. If you notice, John's views always have an indirect application. For example, if his macro analyst believes the dollar is going down and that will eventually be negative for equities, he does not short equities, but instead sets up volatility positions that have diminutive negative effects if he is wrong. So now you are forewarned. As long as you understand this, I am happy to share my views.

Most investors view the current environment as a normal, albeit drawn out, business cycle: one where increased liquidity and a lower dollar will spur the U.S. economy and cure the ills of the stock market. I do not share this view. I believe the current problems are more structural in nature, ones based on capital imbalances and over capacity.

The U.S. economy has accounted for almost 90% of the world's growth over the last five years. It is a consumption led economy with a very low savings rate (some would even say it is negative). It needs to borrow capital from the rest of the world to finance this consumption. The cumulative external deficit, which is the difference between the value of assets the U.S. owns of the rest of the world and what they own of the assets of the U.S., is around 20% of GDP or $2 trillion. In other words, the U.S. owes $2 trillion to other economies. This far exceeds any previous levels and must be corrected. I do not think this will be an easy process.

In addition, the domestic debt that has been accumulated in almost all facets of the U.S. economy both public and private is also too high to be maintained and therefore I believe a debt liquidation cycle is approaching.

Again, this may go on for years because we do not know the propensity for debt: how much our debtors are willing to tolerate. The signal that it is the beginning of the end will be a significant decline in the dollar (even after what has occurred) in conjunction with a decline in U.S. bonds. Until then you have exporting countries kowtowing to the U.S., trying to keep their currencies weak and afraid of the ramifications of refusing to lend anymore. You see, the rest of the world is in a worse position than the U.S., after all, they are the creditors. If the U.S. sinks into recession from here, it may be more painful for the creditor than the debtor.

The U.S. knows this and is using this to their advantage. The strategy is to delay the debt liquidation cycle and continue to inflate. If they can manage this process long enough without anyone blinking, they can pay back this debt with cheaper and cheaper dollars at the expense of their creditors.

As long as our creditors don't blink and everyone cooperates, this process may actually seem the least of all evils to them. The process is derailed if one of the major exporting countries is no longer willing to hold dollars.

The problem again is that a lower dollar makes the U.S.'s exports more competitive, but who is the U.S. going to export to when the rest of the world's economies are depending on their exports to the U.S. to keep their economies afloat?

If you want a great description of this situation, Stephen Roach of Morgan Stanley has written extensively about these imbalances and the possible scenarios that lie ahead. The bottom line is that these imbalances need correcting and the process is not likely to be easy.

For now I am willing to have my assets in Euros and wait. I like to wait.

No positions in stocks mentioned.

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