Ending 04/30/2012

+1.66%

Welcome to the first Monthly by ONYX.

Going forward I will make an effort to publish a short letter along with the return performances in the fund. The letter will not be technical. It will serve the purpose of summarizing of what happened in the past month without going into the overly specific details of the economy and the markets. It will solely reflect my opinion and my observations in the market, and should serve as a macroeconomic based opinion only. 

Before I continue, I want to talk a little bit of Ember fund’s principle of Relative Value. If I had to summarize it in one sentence, it’s that the market has no idea where anything is. Let me clarify with a real life example.

When I was a child, I was very much into playing with a cartoon card game called Pokemon Trading Cards. Each card depicts a specific cartoon monster, and each card is different. Like all trading card games, some cards are better than others and some are worse. I used to buy these cards from game shops in my neighborhood in downtown Los Angeles. I did not know how much these cards are worth, but I know I wanted the good cards and wanted to sell the bad ones. However, without knowing exactly the price where people are willing to sell these cards, I usually went in the store and looked to see what the vendor was advertising on similar cards I had in my collection. My price will be roughly based on what I observed. One day, my mother drove me to a shopping center outside the greater LA metropolitan area. In the shopping mall, I found the vendors were selling the cards for much cheaper. I immediately bought many cards that I normally would not have purchased back at my usual game shop. I found it interesting that my decision was heavily influenced by the prices of the cards, and the price of the cards can be easily defined by the relative locations to where they are sold. Looking back, knowing that things in the city centers are more expensive than the suburbs can easily justify why the game shopper sold the cards at higher prices. However, it does lend itself to show that I truly had no idea where the cards are actually traded. I was a mere price taker, and I was influenced by my environment.

“Looking back” is an interesting term because the world is all okay and can be neatly explained when we look back. Forward looking isn’t so easy, and when we forward look, we used the past to make decisions (relative value). When we don’t trust the past values, we look around to see where everyone else is buying/selling (relative value). The market, in a simple sense, is very much like my Pokémon trading card days. I am always looking to participate, but and I change my decisions constantly based on where some cards are selling relative to others, and I am always adjusting my perspectives on the chance encounters of new stores for new price information.

From that, Ember fund seeks to trade on relative value.

What Happened

           

            The same old story continues.

            Europe is not doing well. Greece is continuing having problems, but it seems like it has resolved itself because the media stopped blasting Greece default headlines every other minute. But the media doesn’t rest, or else the people working in the industry would be out of a job. So the media picks up Spain, and like a good writer who teases its audiences about an upcoming chapter in a thriller, the media also starts to expand its coverage on Italy. All in all, the world, especially Europe, doesn’t seem safe.

            From all these bad news, it’s not surprising the stock market (SP500 will be used as a representative sense for equity markets here) is dropping. What is surprising is that this bad news really fails to keep the equity markets down. Looking at the chart below, we see that from 04/01/12 to the end of the month SP500 dropped a merely 0.75%, reflecting nothing of the seemly catastrophic concern in global economy emanating from the imminent downfall of another series of Eurozone crisis.

            Just to be sure that the refuse-to-go down phenomenon exists not only in the equity markets, we take a look at the heart of the problem – the Euro. Given the European crisis, the Euro should have stepped lower (depreciating against the all mighty USD for example) to reflect the growing concerns of the lack of liquidity amongst the European nations. However, we do not see that in the euro. Like equities, the Euro did fall earlier this month, but has bounced back in a dramatic fashion around middle of April, and ended the month relatively unchanged (down -0.69%).

            From euro and equities, we see that may be the world is alright. It seems that investors did indeed panic at the beginning of the month, but collective brilliance finally kicked in and starting to taking on more risk and beginning to laugh at the notion of a failing Europe, or the high unemployment in the US, or the growing inflation concerns in China. If that’s the case, then can someone explain to me why do the US tsy, a long time synonym for risk aversion, is collecting a sizable rally of +2.89% over the month?

            From all 3 charts, we can probably compromise on this summary: risk aversion is still high in the market (hence tsy rally), but things are not yet bad enough where investors are unwilling to pick up cheap stocks/euro at a bargain price (euro/sp500 graph). It seems like a reasonable statement, until we look it from a economic perspective. If at the beginning of the month investors sold the risky investments like stocks to buy tsy, where did they have the money left to buy stocks from the lows when they have already exhausted their purchasing power on buying tsy? In my opinion, what we are currently seeing is asset allocation. At the end of last year, many investors readjusted their perspective on the markets. They believed one of two things, if not both: the world is not safe; the tsy market is too expensive. If the investors believed in any of the above statements, they tried their best to hold their assets in CASH. Flushed with cash, the investors are back into the market to play. No one really believes the world is okay, so tsy is still rallying. However, cash sitting around is cash collecting dust, so why not buy up some cheap stocks when the chance presents itself? From this, we see that at end of april, stocks, euro and tsy are all rising in prices. The fundamentals are broken; the technical and statistic relationships are gone. Everyone is buying everything. It’s a feeding frenzy.

What Will Happen

            The thing about asset allocation is that it does not forever. Cash can be used up pretty quickly, especially when everyone is buying everything in sight. When the cash is gone, so will the uprising prices.

            All good things must come to an end. It may not be now, and it may not happen before the next ONYX Monthly comes out, but it’s definitely sometimes in the near future when all the cash allocations are finished. In the very near short term, we should not be surprised that equities, tsy and even the euro continues to rally, because we all know there are enough people who believes in trend following out there to buy into this “bull market”. However, we will see that as the prices go up, the fundamental investors (the ones who looks for intrinsic values of where stocks are traded) will stop buying more stocks, or tsy, or anything that’s currently “relatively expensive” to where they were just traded a month or two ago. Therefore, if the rally continues, I believe the momentum will slow down, and that will be first tell-tale signs of the selling that are about to commence.

            Before I generalize an all-inclusive “mkt sell off”, I want to be specific that the sell offs will take either one or two forms. The first form is the most likely, and that is equities and Euro (and all risky assets) will begin to plunge in prices if the Eurozone crisis continues or additional negative information about the economy begins to resurfacing. In that sense, tsy market will continue to rally, or at least stabilize and not suffer the same price drop as other risky assets. The second scenario belongs to that of a risk on sell off. If no negative news surface in the next month, equity may very well continue to rally. The tsy investors who are currently investing in 10y tsy with a return of sub-2% will become very jealous of the equity investors very quickly (for equity can easily pick up 2% a day in returns if the timing is right). If this is the case, then the tsy sell off will commence, and we will see tsy across all curves moving back to its jan-feb levels.

Conclusion:

Stay safe and cautious. If possible, hold on to cash. If not, look to sell into the highs rather than buy at the lows.