Thursday, May 19, 2011

Regarding Japan... more comments.

I got a few questions about the presentation on Japan... and I'd like to present here my answers to one of the emails.

Did my view change after the quake? No. Same direction. Only greater odds.
Many people bet on a Japanese Armageddon before and lost. Is this time different? That I don't know. Making money is different than 'being right'.


As I mentioned on my blog, the tragic incidents just make the case more compelling.

Pillars to growth: (A) productivity gains + (B) population growth + (C) capital invest in (A)+(B).

What are the key problems the country currently has:
(A) An already very high level of productivity: where will more productivity come from?

(B) Decreasing population and bad outlook for immigration: a possible solution to this problem, unlikely to happen due to cultural issues. Who wants to move to Japan? Tough society there.
(B) Worsening demographic distribution: reduced labor force
(C) Worsening demographic distribution: increased social security spending
(C) Decreasing tax-base (due to the above items)
(C) Bad outstanding gross and net public debt
(C) Private savings don't look too good: this is where I have difficulties in tracking data. I assume that a lot of their savings is abroad.

Their survival in the past years: An economy that gets a lot of its juice from net exports

With the earthquake and the following tsunami, which adds an apparently short/medium term energy problem, what changes from the above?

- Postponing hopes-of-growth to an ‘era’ of even worse demographics.
- Confidence worsens among citizens and business men. Slowing in consumption and private investment
- Even smaller tax-base and tax revenues, at least temporarily, likely for a good period.
- More public spending necessary to rebuilding basic infrastructure / lending to energy generation, bailing companies out: more debt
- Reconstruction costs are not to increase capacity, but to get back to existing capacity. 
**One plus: capacity might be more efficient.
- Likely more businesses which will not be willing to invest in Japan considering its long-term geographic / seismic risks, demographic outlook (less labor supply, more expensive labor, relative to world)
- Revaluation of the 'just-in-time' mentality
- If the corporate tax rate decrease that was being discussed happens, will business really come? Or will tax revenues just plunge?
- Lost momentum in economic growth
- Worsened momentum for the global economy (check out Mexican and American Auto production)

So... regarding the "people died on this trade" comment, many people have bet against Japan, hopefully aware that they could be wrong.
Investing is a risky business and without taking on risks there are no possible returns.
Now we see the early guys were wrong (if they shorted equities they made money!).
But people who bought Greek 5y CDS @ 5bps 4 years ago spent 5bps for 4 years (20bps total) and now are gaining +1200. 1200 – 20 = 1180 / 20 = 59x its LIMITED possible loss (max was actually 25bp).
It works the same for even US/Germany/UK/Japan CDS. Traded below 10bps/year and now are over 50bps. That’s quite a risk-reward bet.

I am sure that all the Central Banks and Governments are against me on this trade, but these are the same guys who said the US was healthy in 2007. And in many other occasions. I read this in many books/reports.. "If it can't go on forever it won't". Not sure who wrote this, but hey.. "It won't" might be within 3 years. It was 2007 for the Housing Bubble. It was 2000-2001 for TMT.

For Japan, the net-trade motor is worse (terms of trade keep getting worse), there is a larger debt-pile, worse demographics, all other developed economies are screwed too. The world is awash with debt... and inflation. If there's tightening... the interest expense becomes birds... it flies all over the place.

How likely is this trade to be successful? I'm not sure, but odds have certainly improved. The bet is relatively cheap compared to its possible returns.

Another very important fact is that this bet is part of a portfolio. It is not an all-in poker play. It is a piece of the puzzle within an investment portfolio. There are bets on currencies, rates, credit, worldwide. This is one of them. Most of them have a similar expected returns, but if the probability of this one goes to 10%-20% its realized return will be multiples of the other more likely bets'. We're trying to get more good trades, than bad trades. We're trying to have larger winners and smaller losses. People who never lose are likely cheating or about to go bust. It's very, very simple.

Good luck to us all!
The Intrigued Trader

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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