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Mark Wallace
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I'm an American (EEUU) by birth, but certainly a mutt by ethnicity. I prefer the Southern Hemisphere nowadays, and I try to spend time on at least 3 continents per year, in more than a few different countries. While there I explore intriguing social, investment, business and lifestyle... More
My company:
Capex Ltd.
My blog:
Capitalist Exploits
My book:
Mongolia Investment Report
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  • Changes At The Margin – How To Prepare For A Disorderly Move

    In a past life, while still in the clutches of the investment banking world, I'd made a few friends in the "trading fraternity" and visited them on a regular basis for work and social reasons. When it came to markets, opinions varied little within the group. Traders were unanimously bullish or bearish on any given market on any given day. Differences were about particular strategies, pricing, volatility and so forth, but rarely on market direction.

    Nights spent socializing with the white shoe'd investment bankers themselves were no different. Conversations were typically more heated about whether Chelsea or Aston Villa were superior…not unusual for human psychology. Safety in numbers.

    That being said, status quo and all…I recall one instance where the consensus had changed. Just like that, news was coming in and opinions were scattered and undecided! Only a few traders had changed their views, but the unanimous consensus was no longer there. The particular market in question flip-flopped for a few weeks before heading decisively lower. Thinking about it later and discussing it with my mentor (refer to my post, 3 Life-Changing Lessons) he mentioned something so obvious that most of us, myself included, tend to forget it, "A market needs only change at the margin." This is never truer than when a market is levered.

    The Yen has been strong for decades, and the Japanese government bond market has defied gravity while simultaneously destroying any who dared to short it. They called it the "widow-maker" trade.

    But… On Monday the USD/JPY pair punched through 94 after spending the last two months blowing through numerous technical levels. Meanwhile the Nikkei is following closely on its heels making new highs. Which is to be expected.

    Are there changes at the margin?

    USD/JPY reaction to new head of BOJ!

    USD/JPY reaction to new head of BOJ!

    Akira Amari, Japan's economic and fiscal policy minister recently went on record stating that he wants the Nikkei at 13,000 by end of March. Gone from the collective vocabulary are any novel concepts such as markets determining prices. Nooo, we can't have that. Capitalism and free market economics are still amusingly paid lip service by the collective podium doughnuts, while government and their incestuous bed fellows, the central banks, blatantly fleece the sheeple. It's the new normal!

    Setting a 13,000 target on the Nikkei is certainly achievable. Hey, if Zimbabwe could have a rip roaring stock market, why not the Japanese? Rising nominal values in stocks achieved by devaluing the currency ensures that those who own stocks lose less than those who don't but, history indicates that "real" wealth disappears.

    The wealthy who own productive assets see TSHF (the shit hitting the fan) before the faceless masses, and they get out of dodge in advance. As such, they get wealthier while the rest simply bask in rising energy, housing, and food prices…inflation. So basically, most get screwed.

    In the old days people used to keep warm with wool sweaters, blankets and firewood. For those Japanese citizens that long for nostalgia, fear not. The good 'ole days are coming to a prosperous, Tokyo suburb near you.

    A rookie economist will accurately determine the consequences to a certain action, while a good economist will be able to determine the consequences to the consequences of a certain action. Shinzo Abe doesn't even make it to rookie status here. Either that or he's been vacationing in Fukushima province for too long. I hear it's getting glowing reviews but, has clearly damaged Abe's ability to comprehend actions and consequences.

    His playbook hasn't worked yet. Devaluing the Yen is meant to strengthen exports. January saw exports climb 6.4% from a year earlier. Whoo hoo mission accomplished oh gilded one.

    Now lets look at the trade deficit.

    It should have shrunk right? Wrong. The trade deficit ballooned to a record 1.63 Trillion Yen. Oops.

    Japan Trade balance

    Of course we non-economist plebeians can even figure out that a weak yen means Mrs. Watanabe pays a lot more for any and all imports. This includes of course the one critical element that manages to touch every sector - ENERGY.

    Abe won't be liking that to much, nor will his constituents.

    There are two distinct takeaways from this:

    1. Abe is most likely going to (have to) re-start those nuclear reactors. This is another reason to be bullish Uranium, which has been crushed along with other resources.
    2. Central banks in South Korea especially, but throughout the world generally, won't take kindly to a rapidly weakening Yen. Expect competitive devaluing, trade wars and other "policy tools" to hit the newswires. Bullish government stupidity!

    What I must commend Japanese policy makers for is their honesty. They've announced to the world their real intentions. I contrast this to the US, where I routinely stumble across what seems to be sock puppets standing behind rostrums promising a strong dollar. Really?

    My personal favourite play as I've mentioned numerous times is that of trading gold for Yen in the spot FX market. It certainly makes sense to play the strongest currency against the weakest. Call me simplistic if you must.

    Unfortunately for US citizens this trade is a little bit more difficult to place since your kind, loving, generous government decided to forbid you from selling currency for precious metals in an FX trading account. For the rest of us we'll happily trade away.

    Sorry to our American readers…but your government is in the process of shutting down your every escape plan. Like Abe you too may as well get used to disliking gravity, because we're only getting started in this, the raping and pillaging of "Boobus Americanus" as Doug Casey is fond of saying.

    Aside from the simplicity of the trade long XAU/JPY consider that Japanese pension funds have $3.4 trillion in assets and less than 0.03% in gold. This seems about as intelligent an allocation as stuffing your retirement portfolio with garbage pail kids cards, marbles, and Franklin Mint trinkets. With saber rattling from China, competitive devaluations and a bond market on the brink of catastrophe, this is an insanely small percentage of gold to hold.

    Abe and his suspected new padawan, Haruhiko Kuroda, will continue their relentless knifing of the Yen. The change at the margin is in the process of taking place right here and now. With a government balance sheet that resembles something out of a far-fetched fiction novel I think the odds of a seriously disorderly move in the Yen, and ultimately the Japanese bond market, are in the offing. In this scenario I find it difficult to imagine the yellow stuff (no, not yellow cake) failing to scream ahead.

    For US citizens who are "protected" from profiting in this fashion I think it makes sense to buy some long term puts on the Yen itself. As I have mentioned previously I think the Yen will be taken out to the woodshed before the JGB market is left to crack. The BOJ will do everything in their power to keep funding the JGB's and this will mean running printing presses red hot.

    Till next week. I'm going to go have some sushi and a sake!

    - Chris

    "We will always take appropriate steps against an excessively strong Yen" - Haruhiko Kuroda

    Mar 01 12:55 AM | Link | Comment!
  • The Virtues Of Capitalism

    What can be said of Doug Casey? His life and career are the stuff of legend among investors and speculators, especially in the junior resource space.

    Born an American, which he will tell you was simply and "accident of birth", Doug could be described as espousing anarcho-capitalist viewpoints. He's a strong free market thinker, a best-selling author, avid traveler (over 175 countries), entrepreneur and the founder of Casey Research.

    Doug's first book, The International Man was published in 1978. It was focused on personal freedom and global financial opportunities. The following year he published the classic Crisis Investing, which became the best-selling financial book in history, holding the #1 spot on the New York Times Best Seller list for a total of 12 weeks. He followed that up with Crisis Investing for the Rest of the 90s in 1993. His newest book, Totally Incorrect: Conversations with Doug Casey was just published this year.

    Doug started writing his now famous resource-focused newsletter, The International Speculator (IS) in 1979, which is now edited by his friend Louis (Lobo) James. I was an early subscriber and I credit IS with shaping many of my investment and lifestyle ideas. Doug is still a contributor at Casey Research, contributing regularly to the flagship, The Casey Report.

    Doug is a friend and mentor. For over 25 years I've read his monthly missives, devoured his books and attended his Casey Research workshops. I blame him for my first big score, and also for imparting enough wisdom to make me see the sense of holding onto that winner as long as possible. The value of that lesson was something that can never be repaid.

    Doug was one of the key people with whom I credit for arming me with the confidence to leave my comfortable life in the States, family, friends and business partners to experience the broader world and invest and speculate in the frontier markets.

    Although he isn't always right, and has been early on many of his calls, his sage-like insights are relied upon by hundreds of thousands of loyal investors and speculators the world over.

    I rang Doug up the other day and asked if we could chat about my favorite subject, capitalism. I proposed that we discuss the virtues of capitalism, since these days capitalism is almost universally scorned and misunderstood. It is perceived as an evil system that creates greedy, uncaring and corrupt monsters. As part of the crowd that understands the folly in those perceptions, it's our moral obligation to right this wrong!

    Thankfully, Doug graciously agreed to a back and forth on the matter. I just hope I did it justice!

    Read on…


    Mark: Doug, thanks so much for speaking with me!

    Doug: Mark, I like people in general, and you in particular. Regrettably, most conversations are limited to subjects like the weather, sports, and the state of the roads. I can do ten minutes on those things, but that about exhausts my threshold of boredom. Trivial conversation doesn't give you much idea about the character of the person you're talking to-although, paradoxically, sometimes it tells you more than you care to know about them. They aren't interested in philosophical issues in general, and absolutely don't like to discuss practical and applied philosophy. Because that amounts to politics and religion-the two things that are anathema to polite company. I don't expect we'll do any riffs on religion here, but we can certainly do politics. And economics, which is, most regrettably, intimately related to politics in today's world.

    So it's a pleasure talking to you.

    Mark: Capitalism is oft-misunderstood. I've heard you say that most people tend to mis-use words because they don't truly know what they mean. I agree, and per the subject matter I want to discuss today, I'm convinced the majority have NO idea how to define capitalism. As evidence to this I refer readers to Peter Schiff's YouTube videos ( wherein he went to the Occupy Wall Street protests in NYC to defend the 1% and see if those protesting really understood what capitalism was.

    I don't know if he just happened to pick the dumbest of the lot, but in general the lack of any coherent understanding of what capitalism TRULY is was shocking. So that everyone reading this is clear, can you define "capitalism" for us?

    Doug: If someone can't define a word precisely, then they actually don't know what they're talking about. Imprecise language leads to sloppy thinking. Which inevitably leads to pointless and unresolvable arguments.

    But, yes, Peter here is somewhat reminiscent of Jay Leno in one of his "Jay Walking" skits, where he approaches normal looking people and asks them questions like "Who did we fight in the Revolutionary War?", and gets answers like "The Germans?". But what do you expect from people who have nothing better to do than hang out in parks and whine?

    Of course capitalism got a bad rap from the very start partly because-most people don't know this-the word was actually coined by Karl Marx. However, the fact is we don't have capitalism, and never have. Capitalism might be defined as an unrestricted free market, one where-to use Marx's quite correct distinction-both consumer goods and capital goods are both privately owned and privately controlled.

    What almost everybody calls capitalism is actually fascism, a system where both consumer and capital goods are privately owned, but they are strictly regulated and controlled. This is a huge distinction. In socialism-which is now quite rare-capital goods, the means of production, are state owned. In communism, absolutely everything is state-owned. In any event, all the evils attributed to capitalism today are do to state intervention in the economy-regulations, monopolies, subsidies, preferences, taxes, licensing, currency inflation. In a genuine capitalist society you'd have none of these things.

    Mark: I think it goes without saying that for the most part, sans inheritance (lucky), coercion (taxation) and theft (mafia), those that control any significant amount of capital are intelligent, hard-working value creators. One cannot legitimately amass wealth without producing something that other people are willing to pay for. Although many people argue that materialism is evil, including religious zealots, the desire for "stuff" is almost baked into our DNA. You've suggested this yourself.

    Despite an almost rabid hatred these days of capitalists and big business, I see a lot of people walking around, Tweeting and texting on their beloved iPhones, wearing their Nike tennis shoes and Levi's, while simultaneously trying to undermine and lobby for the destruction of the very system - capitalism - that allowed them to buy those things! The hypocrisy is mind-numbing! How can we make sense of the disconnect between reality and perception here?

    Doug: Well, a century ago Schumpeter predicted that capitalism's own success at producing would lead to its overthrow. I think he was right. Maybe it's genetic in humans. We've apparently always been tribal creatures, where the group held many or most things in common; perhaps that's just the way the human brain is wired. The fact that capitalism has changed almost everything in the material world over the last 200 years doesn't mean it's changed the way people think.

    I believe in Pareto's Law, the 80-20 rule. In this application I'm of the opinion that although perhaps 80% of people are basically decent types, 20% are potential trouble sources, and 20% of that 20%, or 4%, are really bad actors. 20% of that minority are hard core criminals. Criminals believe in coercion, violence, and theft. Unfortunately, they are naturally drawn to the state-which is institutionalized coercion. They concentrate there, and after a while they dominate it. They undermine and corrupt society by promising f"re"e goodies to society, which are stolen from the capitalists-which is to say the innovators and producers. It's hard for libertarians to counter that with esoteric and seemingly hard-hearted economic theories, however correct.

    At this point every country in the world is headed in the wrong direction, philosophically. Most importantly the US, where more than half the people are living at the expense of the other half. And as the economy grinds down in the years to come, things will get worse. Why should the trend change?

    I don't know if that's a good answer to your question. Maybe it's because libertarians are a tiny mutant minority. Maybe it's a spiritual flaw in the nature of man. Or maybe it's because most people are stupid-stupid defined as not necessarily of low intelligence, but having an unwitting tendency towards self-destruction.

    Mark: Almost every other political, religious or economic model besides capitalism supports the premise that a man's efforts and earnings are only virtuous when given to others. It's clear that the leader of the free world, Mr. Obama believes that. He has infamously said, "I just want to spread the wealth around". Doug, is capitalism itself virtuous, or is it what one does with it that is virtuous.

    Doug: Capitalism, defined as an unrestricted free market, is innately virtuous. I suppose it's possible to succeed in a free market without virtue, but it's unlikely. People-absolutely everybody-prefer to associate with and do business with virtuous people. People who are trustworthy, loyal, helpful, friendly, courteous, kind, cheerful, thrifty, brave, and clean. That's the official list of Boy Scout virtues, although I left out obedience on the grounds it's not a virtue, and reverence, which is questionable. Irreverence is much more worthy… Add in classical virtues like courage, fortitude, generousity, honor, foresight, prudence, hospitality, thoughtfulness, and patience. Disregard the faux virtues of faith, hope and charity-they're really moral flaws.

    In a totally free market, the most productive people, the people who create the most value for others, are rewarded. The ones with bad habits live under bridges and die young. Justice is another virtue I believe in, and it means that people should get what they deserve. Fascism, which rules the world today, is unjust because the people who are politically connected-not necessarily economically productive-do best.

    Capitalism brings out the best in people. Socialism encourages every possible vice. But people have been trained to believe exactly the opposite.

    Mark: One of the most well-known proponents of capitalism was Ayn Rand, whom I know is one of your favorites. In her book "The Virtue of Selfishness", she says, "The moral justification of capitalism does not lie in the altruist claim that it represents the best way to achieve 'the common good.' It is true that capitalism does-if that catch-phrase has any meaning-but this is merely a secondary consequence. The moral justification of capitalism lies in the fact that it is the only system consonant with man's rational nature, that it protects man's survival qua man, and that its ruling principle is: justice."

    Socialists and communists often cite the "common good" as the reason for their tyranny. That term is undefinable, as what is good for you, might not be good for me or others. Force and coercion - the things that the socialists and communists rely on - are what's really immoral, correct?

    Doug: It's absolutely perverse how the apologists for statism and collectivism have stolen the moral high ground. It's one reason I despise Republicans and conservatives, that they accept the moral premises of the enemy, only saying that we should be more moderate in pursuing these supposedly noble goals. Conservatives think they're being pragmatic, but are perceived-correctly-as just being confused and inconsistent hypocrites.

    And, yes, I'm a huge fan of Rand, primarily because she offered a moral defense of capitalism. I'm only sorry she didn't go far enough; unfortunately, she wound up defending the necessity of a state. It's also unfortunate that a religious cult has formed around some of her ideas, full of dogmatic acolytes who look on her every opinion as holy scripture. But, then again, another law I believe in is the Second Law of Thermodynamics, which holds that everything degenerates over time. That would appear to apply to intellectual movements as well the material world. As further proof of that I offer the fact the pundit Glen Beck now describes himself as a libertarian. That word is now clearly on its way to perdition, like the word "liberal" before it.

    Mark: Recently British MP Daniel Hannan argued at the "Occupy Wall Street Oxford Debates" that the bailouts were an "ethical crime" and a generational offense. As we've said herein, bad businesses should be allowed to fail to make way for better-run organizations to take their place. Yet, the politicians on both sides of the pond voted to bail out their campaign contributors at the expense of the taxpayer in 2008, and they continue to do it to this day.

    Capitalism has been ravaged by politicians and an empowered elite that need to limit and/or eliminate competition to survive. It's only cronyism that keeps them afloat at all. So, if bailing out failing businesses is unethical, then allowing them to fail would be THE ethical thing to do. I know the answers to this, but humour our freshman readers a bit and explain why allowing bad businesses to fail is more ethical, and ultimately pro-growth for the economy, than bailing them out.

    Doug: Well said, Mark. The important thing to remember is that if a business-whether it be a bank, a manufacturer, a food producer, or what-have-you-is allowed to collapse, it's largely a financial phenomenon. The real wealth-the buildings, the factories, the technologies, the skills of the workers-still exist. They're simply redeployed. In a capitalist society the owners of the business are punished for running it badly, which is correct and proper.

    In today's fascist societies, however, uneconomic businesses are propped up by the taxpayers. And managers and shareholders are rewarded, instead of bankrupted. So, perversely, the rich get richer and the poor get poorer.

    Mark: Doug, I've heard you and others I respect argue that amassing as much capital as one can is morally the "right thing to do". In fact, in your book, Totally Incorrect, Louis James paraphrases you, saying "…money is a positive moral good in society because the pursuit of it motivates the creation of value…" Can you explain this further?

    Doug: Yes, this speaks to my thoughts on charity. I'm opposed to conventional charity, not because it doesn't do some good, but because its major unseen consequence is to disipate capital, while it often cements poor people in bad habits. Conventional charity's main purpose is to allow the rich to feel righteous.

    If you really want to be a philanthropist, and benefit humanity, then you should create more wealth, and increase the supply of capital. That's what separates us from our primitive ancestors living hand-to-mouth in caves. It's the accumulation of capital, through productive activity, that raises the general standard of living.

    Mark: Back to Rand for a moment. In her book "For the New Intellectual", she says, "Capitalism demands the best of every man-his rationality-and rewards him accordingly. It leaves every man free to choose the work he likes, to specialize in it, to trade his product for the products of others, and to go as far on the road of achievement as his ability and ambition will carry him. His success depends on the objective value of his work and on the rationality of those who recognize that value." This implies that lazy people will not, and should not succeed, and that ill-conceived and/or poorly-managed businesses will fail.

    However, in this world of too big to fail, and "everyone gets a ribbon", ineptitude and laziness are almost considered maladies or handicaps that should be subsidized! We wrote a post called "The Strawberry Generation". Therein we talked about the belief among today's youth that regardless of their ability or motivation they are "entitled" to anything and everything they desire, most-specifically a high-paying job right out of college. It's almost ingrained in the DNA nowadays. Given that reality, I'm not too optimistic; how about you?

    Doug: I'm of two minds on this subject. On the one hand, the longest trend in existence is the Ascent of Man, and it's still in motion; that's cause for optimism.

    There are essentially two reasons for our upward progress. One reason is that even the average man-although especially the independent thinker-intuitively realizes that he has to produce more than he consumes, and save the difference. That;s not just how you become rich, it's how you ensure your survival. Saving builds capital. The other reason is science and technology, which both compound because of capital, and add to it. And there are more scientists and engineers alive today than have lived in all previous history put t ogether.

    On the other hand, it appears that half the people in the US, and even more in some other places, chronically consume more than they produce. They're essentially parasites that vote for a living. Their numbers are growing, they seem to feel more entitled than ever, they control the political systems of the world, and they're becoming bolder and more strident. Furthermore, the type of sociopaths that are attracted to government appear to have reached a critical mass. They've long controlled the school systems, which serve to indoctrinate kids with destructive ideas. In addition, governments seem to have co-opted many or most of the advances in technology-drones, military robots, surveillance cameras everywhere, massive communications monitoring-and this impresses me as quite destructive.

    So there's no guarantee that progress will continue.

    Mark: I know how you feel about charities, and both Chris and I agree; most of them aren't worth a damn. But, it's a fact that there are those that cannot care for themselves. Those born with major disabilities, mental retardation, or those who are injured physically and can no longer work in any capacity. In a true capitalist society, how would those individuals be cared for? Who is responsible for them.

    Doug: Despite the fact that no good deed seems to go unpunished I, personally, like to help people. But I'm rather discriminating. My policy is to only aid people of good moral character; the best allocation of my time, and the best thing for society, is to try to make the able more able, not fight an uphill battle for minimal returns. Further, when I help someone it's usually through a loan, albeit one that I never expect to be repaid. That has several advantages. It allows me to assess the character of the recipient, by seeing whether he repays it. It encourages him to use it wisely. And if it's paid back, it allows me to repeat the action, and "pay it forward", if you will. Only an idiot tries to be a cornucopia, giving money it to the benighted to fritter away till there's none left.

    But that's just my approach. If others want to help the halt, the lame and the retarded I'm all for it, and wish them well. I don't want to invalidate others choices. It's their money; they should use it as they think best. That's what makes a market, differing desires and approaches to problems. I simply urge them to act responsibly, which means to do it themselves, instead of guiltily giving money to some massive charity bureaucracy with executives hauling down a million dollars a year. Which is a fair description of most popular charities today.

    Mark: Doug, how about coming to Fiji with us to sit down with the Prime Minister and see if we can't get him to see things our way (laughs). All joking aside, I know you entertained something like that in Vanuatu…trying to turn it into a capitalist stronghold. You even told me you had a couple thousand acres picked out there for a "Galt's Gulch-like" community, years prior to Cafayate. What happened?

    Doug: Well, one of my hobbies for many years has been pitching heads of state on a radical plan that would radically transform their backwater hellholes into Hong Kong on steroids. I've had some really fun, and weird, adventures in the process. But while it's possible I could get lucky, it's an extreme longshot. So I view it as entertainment.

    But I also just wanted a neat place to live. So we bought 1300 acres on the edge of the wine-growing town of Cafayate in NW Argentina and have built a world-class resort there. Fantastic amenities of every type- you name it, we have it, or soon will (you can check out Doug's community here, it's truly spectacular). I did it because I wanted a place that had all the facilities and amenities a civilized person could want, but isolated. I want to watch the riots on my wide screen in the company of friends, not out my front window. I invite your readers to come down and check it out.

    Mark: Doug, this has been great! I know you get asked this question a lot, but in closing what countries seem to stand a chance? And, if you were in your 20′s again (ah, that would be nice for all of us…) where would you be planting your flags? Where is capitalism still understood and considered the virtuous path?

    Doug: I was a big promoter of Burma a few years ago, back when nobody went there, you could get a suite in the best hotel in Rangoon for $40 a night, and you could still cut deals with the generals. But that ship has sailed; the place is now overrun with Uhuru jumpers. Mongolia is still interesting for lots of reasons. In the Western Hemisphere I'd go to Guyana, or especially Surinam. But I think Africa is the place to be. If someone with some moxie were to camp out in Windhoek, Maputo, Luanda, Kinshasa, or the capitals of the smaller countries in West Africa for a month it's got to pay off. You have to go some place few people go, where you have a marginal advantage.

    But where is capitalism understood? Basically nowhere, although people in the Orient have the best intuitive understanding of it. I'd forget about Western Europe; it will be a petting zoo for the Chinese in a couple of generations.

    Mark: Chris and I agree wholeheartedly, as does our young upstart colleague, Scott. We plucked this young man from the jaws of Wall Street and are deploying him in the markets you speak of.

    Thanks Doug, let's do this again soon! Enjoy wherever you're at right now!

    Doug: You're welcome Mark!


    With no further comment…

    - Mark

    "Two things are infinite - the universe and human stupidity. And I'm not sure about the former." - Albert Einstein

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Feb 19 5:12 AM | Link | Comment!
  • Dancing The Contango

    The other day I received an investment note from a long-time reader of ours, Mark Schumacher. Mark is the portfolio manager at ThinkGrowth out in the great state of Massachussets.

    As we've said many times, Chris and I are primarily speculators. Mr. Schumacher on the other hand is more conservative, focusing on growth and income. However, his most recent note really piqued my interest, in part because our friend Harris Kupperman has put this type of trade on as well, with varying success.

    In general, Mark has looked at the relationship between ETF's that track the price of commodities, and the tracking error and contango that almost inevitably occurs. This also presents itself in the VIX (Kuppy's chosen target). We can make a lot of money by shorting these ETF's, but you have to make sure you understand the underlying relationships, it's not as easy as simply selling them and checking back in a few months.

    I thought that more than a few of our readers would appreciate Mark's take on this, so I rang him up and asked if I could reprint the article, with a few comments thrown in for good measure. He graciously agreed, so enjoy!


    It would be difficult to overstate the importance of innovation. Most everyone understands that new thinking, methods and products are vital at all levels of society especially in our globally competitive world. When an idea has scale potential there are plenty of incentives for risk-takers to pursue their long-shot ideas hoping to beat the odds. This we know.

    What's less understood and never celebrated is the critical role that failure plays in the innovation process. Thousands of relatively quick and modest-sized product and business failures are necessary for an inventive society to work because failure redirects inputs - labor and capital - in the most effective manner possible. Policies that hinder or delay the realization of failure misallocate resources, creating a less adaptable, productive, innovative society.

    In my field, a big recent innovation has been Exchange Traded Notes and Funds (I'll simply refer to them all as ETFs). They are low-cost products that attempt to track narrowly-defined assets including commodities, stocks, bonds and currencies. ETFs empower investors by broadening the pool of investment vehicles but there's a fly in the ointment, which will bring us back to the word failure because some of these products have serious flaws. They simply fail to track their target (especially when the target is a commodity) and that creates a low-risk investment opportunity for us.

    The primary reason some ETFs have high tracking errors is because they do not take physical possession of the underlying target asset, instead, they own futures contracts. They try to mirror price changes using these contracts which give them the right to buy a fixed quantity at a set price at a future date. The contracts' values fluctuate (and thus the ETFs value fluctuates) along with market price changes in the underlying asset. If you own an oil futures contract and oil prices rise the contract becomes more valuable so the ETF's share price will also rise. So far, no problem.

    But futures contracts have expiration dates and as those dates approach the contract owner (the ETF) needs to sell them and buy new contracts with expiration dates that are further out, otherwise, the owner will take delivery (via a warehouse receipt) which nobody wants due to storage and insurance costs, slippage, spoilage and lack of liquidity. Tracking error is primarily derived from rolling (selling and rebuying) these contracts because the new contracts purchased are usually more expensive than the old ones being sold. When this is the case (which it is more than 80% of the time for some assets) the asset's price is said to be in contango.

    Over time contango (upward sloping price curve) destroys the value of some ETFs, especially when a) contango is steep, b) the ETFs use leverage or are inverse and c) when the ETFs roll their contracts frequently, like every month as some do. I call the loss generated from rolling these contracts 'roll-decay.' The investment opportunity is to simply short the ETFs with lots of Roll Decay.

    Shorting is when you lose money when the price rises but make money when the price declines, which is exactly what you would expect to happen to ETFs undergoing a great deal of roll decay. Sometimes these shorts should be hedged to eliminate market risk, which I will cover in an upcoming article on Market Neutral Investing. (Note: We'll look at publishing Mark's follow-up articles as well for our readers)

    There are many ETFs that track their targets fairly well and therefore do NOT offer a compelling investment opportunity for us. My research has uncovered several high-profile ETFs with big roll decay over all time periods and conditions making them great short candidates. Let's take a look at my two favorites.

    Example #1: Natural Gas (/NG) is the target asset represented by the green line. UNG is the tracking ETF that is our short candidate represented by the purple line.

    Over 6 months natural gas is up +9.1% while UNG is down -10.4%. That's 19.5% decay versus the target in just six months. If there was no roll decay we would have lost 9.1% on our short, instead, we would have made just over 10%. So even if the price of the target asset moves against us we can still generate a profit if the cumulative roll decay is large enough. Thank you contango!

    Chart 1 - Contango

    Looking at the one year chart, natural gas is up +18.9% while UNG is down -22.5%. That's 41.5% decay in one year. That's a pretty strong 19% move against us in just one year, yet we would have still logged a 22% profit from our short! It's getting better...

    Chart 2 - Contango

    Over 2 years natural gas is down -30% while UNG is down -64%. That's only 34% decay over two years (less than the 41.5% decay over one year) but our total profit increased to 64%, because we would have benefited from both roll decay and the decline in natural gas prices. Notice that in all three examples the tracking was tight in the beginning but over time the gap expands significantly. This is compounding working in our favor.

    Chart 3 - Contango

    Example #2: S&P 500 Volatility Index (VIX) is the target asset represented by the green line. VXX is the tracking ETF that is our short candidate represented by the purple line.

    Over 6 months the volatility index is down -24.6% while VXX is down -51.8%. That's 27.2% decay in just six months. If there was no roll decay we would have made about 24% on our short, instead, we would have made nearly 52% because the profit we earn on the decay gets added to the profit from the target asset's declining price! (Note: This is the play Kuppy was talking about as well in his post Designed to Fail.

    Chart 4 - Contango

    Looking at the one year chart, the volatility index is down -24.4% (same percentage decline we had over six months) while VXX is down -76%. That's 51.6% decay in one year. Are you dancing with excitement yet?

    Chart 5 - Contango

    Over 2 years the target volatility index is down a modest -15.7% but VXX is down -79.3%. That's 63.6% decay in two years. You get the idea now, right?

    Chart 6 - Contango

    Why are these products still on the market?

    It would appear that these two ETFs are destined to lose all their investors money on their way to zero and termination. They are clearly 'designed to fail' and will wipe out every shareholder in short order, right? Well, not so fast. Today UNG and VXX each have over one billion in assets under management and shareholders have not been running for the exit. What gives?

    It turns out that these ETFs actually do a decent job over short time frames (days or a few weeks) in meeting their stated objectives to track an underlying asset "on a daily basis." We can see the tight tracking at the start of each period in all our charts. This "daily tracking" fills the demand in two niches - investors wanting a near-term hedge and investors wanting a near-term speculation. These niches offer fairly stable demand at a high enough level for the ETFs to be profitable for the issuers and have market staying power. They aren't going anywhere which is music we can dance to!

    Monitoring Contango

    Contango is dynamic. Each day the amount of roll decay changes and over a period of weeks or months it can steepen, flatten out or flip into backwardation (a downward sloping price curve) so I monitor it for the products I have shorted - currently the above two ETFs. There will be times when it makes sense to close a short and watch from the sidelines as well as times to increase a short position. These adjustments will affect our total returns but they are marginal in comparison to the profits available from roll decay.

    Bottom line is that a bit of maintenance is required to resize the positions as they grow or shrink as a percentage of your portfolio, as well as when the slope of the price curve changes.

    How is this low-risk investing?

    Shorting these decaying products is low-risk when the investment is sized properly (not too big) due to the wide margin of safety. When in contango the only way to lose money shorting is if there is a big spike in the target's price shortly after you put the position on such that you have not had time to benefit from the daily decay. Even then you can recoup your loss if either the target's price subsequently reseeds or the price stays elevated while the roll decay eats away at your loss as time passes.

    At times this margin of safety can be impressive. For example, the current roll decay for VXX is 12% (the long-term average is 7%) per month. VXX turns its entire portfolio over every month rolling the front month contract into the 2nd month. It's contango won't stay at 12% but even the historical average of 7% a month is impressive by any standard.

    What's the Catch?

    There is no catch but there are a few things to be aware of. Most importantly, select target assets not likely to experience rising prices and select tracking ETFs with a history of high decay and don't open your short position after a big move down unless it is quite small. Use ETFs with lots of liquidity; it can be difficult or impossible to short some ETFs especially the smaller and leveraged ones. Finally, you should have a plan for dealing with the inevitable price spikes and brief periods of backwardation.

    In my opinion, these innovative and fairly recently introduced ETFs have opened up a unique opportunity to make significant returns using low-risk investment tactics provided the targets are chosen carefully and positions are sized properly and monitored. This is something I am excited about - low-risk, high-return is the holy grail of investing.


    This is a strategy that almost anyone can employ, but as Mark points out, it's not risk-free, especially short-term. Mark asked me to make it clear that he doesn't believe NOW is the right time to put this trade on. UNG's contango is nil, and the VIX index is near its historical lows.

    The goal with this post is to explain a smart trading strategy that can be executed when the timing is right. If someone insists on putting on a trade like this now, Mark's suggestion is to short VXZ rather than VXX. VXZ is the mid-term VIX tracker owning months 4 through 7. The contango between the 4th and 7th month is 11.0% today, which is a 3.67% monthly roll-decay. This is because this ETF cycles four times a year, not 12 times like VXX does. The long-term average historical decay in VXZ is 2 - 4% (a little less than half VXX's historical monthly decay of 7%).

    Also, as Mark pointed out above, a rapidly rising underlying asset can cause this trade to backfire. For those that believe we may see hyperinflation, assets like natural gas and the stockmarket in general under that scenario will rise rapidly. Being short one of these ETFs would be unfortunate in that case. On the other hand, if you think we are headed for deflation, then you'll want to investigate this type of trade with vigor.

    - Mark

    "Often the difference between a successful person and a failure is not one has better abilities or ideas, but the courage that one has to bet on one's ideas, to take a calculated risk - and to act." - Andre Malraux

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

    Business relationship disclosure: This is an interview piece that was wrapped in an article format by myself and Mr. Schumacher. I have not been compensated.

    Jan 23 9:45 AM | Link | Comment!
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