Wednesday, September 06, 2006

Mail Time!

Reader Steve Feiss wrote a long and thoughtful comment the other day, which I thought deserved its own post. I can tell Steve is a bond guy by his proclivity for colloquialisms. Anyway, I'm not going to go through his point piece by piece, but rather try to explain myself a little better in hopes that answer his question.

Investing is a game of probabilities. If there is one thing I've learned in the investing business, its that. Most people, even some professionals, don't realize that. When I'm making trades and putting positions on, I know a certain percentage of my ideas won't work. Not because I didn't do enough research or I made some mistake in execution, but because the dice just didn't tumble my way.

If someone offered you 7/6 odds that a roll of a single die would come up anything but 5, you'd take that bet every time. Granted, you may well lose, but he's not paying you the correct odds. If you can keep playing over and over, eventually you will win lots of money. But even if you can only play once, you should take the bet. Even if the die comes up 5, it was still the right bet.

Economics and investing isn't random like dice, but there are so many variables that interact with each other, every forecast has a gigantic error term to it. You may look at economic conditions and predict that inflation will rise. So you short bonds. But then Fed acts in a way that counter-acts the forces you had observed. The long end rallies and your short gets killed. That was the story for many bond managers in 2004-2005, myself included. Good analysis, events just didn't fall our way.

But you can't let the time the die falls on 5 to discourage you. Let's take my view on interest rates, for example. I have argued that the curve has priced in multiple Fed cuts, and I didn't think that was justified. Is it because I think there is absolutely no chance the Fed will cut multiple times in 2007? No. Is it because I'm 100% sure the Fed will hike again some time in the next 6 months? Wrong again. Its because I look out at the pantheon of possibilities and I see several that result in the Fed hiking again, several more where the Fed goes on hold, and others where the Fed cuts. I just think that the most probable is the Fed stays on hold for a long while, followed by a hike or two, followed by a cut or two late in 2007. The curve seems to have multiple cuts priced in early in 2007. I just don't see that as particularly probable. Possible, but not probable.

I'm basing this on the persistence of trimmed-mean CPI. I'm basing it on the growth in jobs and personal income, which I think can offset a decline in MEW at least somewhat. I'm basing it on the fact that capacity utilization is the highest its been since 2000. I'm basing it on the idea that the Fed will fight inflation no matter the costs.

I've taken a duration neutral stance, however, because I think the chances of a large bond market rally are greater than a large sell off. By this I mean, if we are headed into a recession, the Fed may have to cut very aggressively to have an impact. We may see the 10-year fall into the 3's again if it gets bad enough. On the other hand, I can't see the 10-year rising to 6% any time soon. There would be no reasonable justification for it. So put the forecast together, I see little upside in Treasury prices, but only so much downside. Not much money to be made betting on rates.

On the other hand, almost every scenario I imagine winds up with a steeper yield curve. So that's the bet I'm making. To me, that's the 7/6 odds in the market today.

Steve mentions in his comments a host of reasons why the Treasury market may catch a bid. Any of those are possible. Again, its the reason why I'm not short duration here. There are plenty of scenarios where rates are lower next year. I think its the minority of scenarios, but still, that possibility exists.

All this is what makes investing so hard. Sometimes there is negative feedback from good decisions and positive feedback from bad decisions. You have to stay cold and logical, and always side with the best probabilities.

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4 comments:

Jay Walker said...

Good blog Tom,

hat tip to Abnormal Returns for directing me your way ...

Jay Walker
The Confused Capitalist

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