Can You Survive A Random Walk Through The Minefield Of Sovereign Debt?

 |  Includes: AGG, BND, JGBL, JGBT
by: William Ramseyer

Random walk theory relates to the idea that no investor can predict stock movements from prior prices. If an investor could make such predictions then he would soon own the world. However, if no investor can make such predictions then why would anyone buy or sell in the markets, since buying and holding would achieve the same result with less transaction costs?

In a prefect world, stock markets could not exist. Where are the imperfections? Maybe one investor has more information than another - perhaps through hard work, or inside information not available to other investors. Maybe one investor thinks he has more information than another or is overly emotional and irrational, and an endless stream of these investors lose money to fund the markets. Maybe the markets are fueled by the buying and selling of stocks, allowing professional brokers and financial institutions to survive. Maybe it's a giant sales job. Or maybe it serves the core function of capitalism - which is to provide capital to the best enterprises.

So how do you beat the markets? I will skip the many ways people try and focus on just one - the collapse of bubbles and related financial crises, or what I will call "Warm Champagne" investing. Nobody wants Warm Champagne so go short before the bubbles burst.

The attempt to make money from Warm Champagne used to be the profession of sour-faced gremlins and fringe investors. Not any more. The incredible jackpots cashed in by Soros after his famous bet against the Bank of England, and Paulson after his bet against the US residential real estate bond market, make Warm Champagne a very lucrative product - provided you are short the right time and place.

The problems today for any investor who wants to take a doomsday approach to the markets include the fact that it's a crowded position. Another problem is the extreme volatility - one day the sky is falling down and the next it's nothing but blue skies from now on.

The biggest and most obvious bubbles today are the sovereign bond markets. The governments of the major economies: Europe, the US, and Japan, have borrowed more than they can pay back. Taxes and spending cuts will not work. I will skip the explanation but in a nutshell they CAN NOT AND WILL NOT PAY their debts. This means that those governments will default on their bonds, suffer currency collapse, or hyper-inflation-or some combination of all of those events. It is likely that China will join the club in the very near future after the extent of their own bad debts and investments finally become exposed.

If you are an investor who believes in these problems then how can you profit from your beliefs if you are right?

Here is the basic problem. Let's say that we have a town of houses that are all firetraps and it appears that they will all burn down sooner or later, but they are the only shelter for thousands of miles against the rain, cold and snow. You want to value the houses. You could bet that they will all go down in value because sooner or later they will each burn. But once one house burns down, the neighbors will all rush over to the remaining firetraps as the only remaining shelter from the storm, driving their value up.

So, for example, if Europe fails to pay its debts, then Japanese and US bonds and currencies may go up in value. This is true even though the US and Japan will also not pay the full amount of their debts (I include paying debts in hyper-inflated dollars as not paying the debts in full).

So, the problem we have is predicting which sovereigns will fail first. It can be expensive to bet short, and holding such positions, especially when the market moves against you can be even more expensive.

The bursting of a sovereign bond bubble depends both on politics and the markets. For example, will Republican/Democratic gridlock lead to a fiscal crisis in the US sooner than it would otherwise occur? There are equally unpredictable possible political events in Europe, Japan and China.

What to do? I don't know, but for the moment I am betting that government bond rates in the US and Japan will go up. That may be a good long-term bet, but in the short term, a crisis in one country will probably drive down the bond rates in the others. Further, it is possible that the massive flows of cheap debt into the economy by the major governments will continue to drive down bond rates as investors buy everything with such cheap money.

As to currencies, they can not all go down at once. A bust in some currencies by definition is a boom in others. Here, guessing which government will have a crisis first is crucial. I believe that China is the last major economy that will suffer a real estate and banking crisis, and that this will negatively impact its currency. I also believe that the Japanese currency is over-valued. However, the strength of the yen has never been adequately explained to me, so I can not say that it won't continue to remain strong. One might also invest in gold as a currency. However, rising bond rates (to the extent they outstrip inflation) may well crimp gold prices.

One investing procedure would be to buy very out-of-the-money options that would have value only in extreme movements of bond rates and currency rates. I believe that Nassim Nicholas Taleb uses a similar procedure. Most of these options will expire worthless, which means that the amount of money in your account will decline. However, if any of the extreme events happens during your option period you might make enough to pay for all the losers and have a profit left over.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long gold, and short the Yen, the Yuan and longer-term US and Japanese government bond rates.

Disclaimer: This article is provided for information and educational purposes only. There is no suggestion, advice or recommendation that you take or refrain from any action, or that you buy, sell, hold, short or borrow any security, or group of securities. No particular investment or group of investments is either recommended, or discouraged. Any given strategy might or might not work at any moment in time. Investing is extremely risky, and markets can move in any direction at any time. For these and other reasons, investors, even the most experienced, can suffer heavy losses at any time. Consult a professional advisor and/or do your own research. I believe that most investors do not beat the market, but I also believe that learning as much as possible about the investments that you make and about your own emotional make-up may improve your performance.