Mad Hedge is quite a fascinating character who’s had a very exciting career in finances and more. He writes daily newsletter entries on market action, stocks and trends in the economy, and I highly recommend taking a moment to peruse his site, Diary of a Mad Hedge Fund Trader. - Ilene
Interview With A Mad Hedge Fund Trader
Mad Hedge Fund Trader began his career in finance by moving to Japan and working at Dai Nana Securities as a research analyst in 1974. In 1976 he was named the Tokyo correspondent for The Economist magazine and the Financial Times, which then shared an office. He traveled the world interviewing famous people, such as Ronald Reagan and Margaret Thatcher. In 1982, he was named the US editor of Euromoney magazine, and in 1983 he built a new division in international equities for Morgan Stanley. After moving to London in 1985, Mad Hedge supervised sales and trading in Japanese equity derivatives. In 1989, he became a director of the Swiss Bank Corp, responsible for Japanese equity derivatives. A year later, he set up an international hedge fund which he sold in 1999.
I haven’t even covered all of Mad Hedge’s adventures, such as his latent movie star career (as an extra in the 1979 epic war film, Apocalypse Now), and who knows what else. But now, missing the adrenaline-surging excitement of active trading, Mad Hedge has returned to the hedge fund business, set up an educational website, and is busy keeping up with the demands of newsletter writing.. So let’s begin our interview with Mad Hedge by exploring his current thoughts on the markets.
Ilene: Hi Mad Hedge. You’ve had a fascinating career having little to do with your major in biochemistry. A brief review of your newsletter shows that your recommendations early in 2009 have appreciated by an average of around 400%. You’ve been writing your daily market thoughts and investment strategies at your website – www.madhedgefundtrader.com – which it’s terrific, by the way. What are your goals with this site?
Mad Hedge: This whole thing started out as a letter to investors in my hedge fund, to tell them my thinking behind my positions. Then I thought, why not post this on the web and see what happens? Six months later it is now going out to 50,000 readers a day, mostly to portfolio managers, financial advisors, and traders. The growth has been explosive.
Ilene: Who are your readers?
I seemed to have stumbled on a market that I describe as “semi-professionals.” If you are a big hedge fund, with a staff of 600 and a huge in-house research department, I’m not going to tell you anything you don’t already know. But there appear to be a few million people out there who trade their own accounts, or invest their own IRA’s. They have never worked on Wall Street, but have taught themselves a lot about markets and investing. My letter gives them the 30,000 foot view on global stock, bond, currency, commodity, and real estate markets which they can’t find at their online broker. About half of them are from abroad. When I get up in the morning now, there are five e-mails waiting for me from China and India asking what to do about natural gas. I also try to make the letter funny and entertaining. Not all financial publications have to be dreary reading. It’s not always about the next stock to buy.
Ilene: In a recent letter you wrote that one of your favorite ETF’s is the Proshares Ultra Short Treasury Trust (TBT). Why is that?
Mad Hedge: TBT is a 200% leveraged bet that long Treasury bonds will go down. While the Fed keeps short rates low, it doesn’t directly control long rates. As the supply of government bonds increases exponentially, their eventual collapse is inevitable. All Ponzi schemes must come to an end, and the US government is no exception. We currently have the greatest liquidity driven market of all time, and the ten year is eking out a mere 3.30% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%. If the yield goes back to 5%, that will take the TBT from $45 to $70. The TBT could perform even better if Treasuries lose their triple “A” rating, which I think is a real possibility.
Historically, bonds are not a good buy in a low interest rate, deflationary environment. If long rates move from 3% back to the 12% we saw in the early eighties, bond holders will get slaughtered, and the TBT could exceed $200. Even if inflation stays low, the sheer weight of supply and credit concerns will crater government bond prices.
Ilene: What’s the worst case scenario for the bond market?
Mad Hedge: Debt service is currently 11% of the budget. If interest rates rise sharply, that could double to 22%. Then you get a downward spiral like you saw in Latin America in the eighties, when higher debt service creates more borrowing, and more borrowing creates a higher debt service, until the whole thing blows up. At some point China, Japan, the Middle Eastern countries may stop buying our debt. There are only so many “greater fools” out there.
The only way out of this is for the economy to return to a long term 3%-4% growth rate. That’s obviously what Obama is hoping for with his programs. He’s taking big risks, but he doesn’t have much choice. He really did inherit a bad hand. If he did nothing, we’d be in a depression by now, with 25% unemployment. He understands what he’s doing and understands the risks. He has great economic advisors.
Obama couldn’t have allowed the banking system to collapse. We need banks as the economy’s lynchpin. A year ago we could have lost the entire financial system over a weekend. Ships were being turned around at sea and going back home because their letters of credit were failing. The freeze up in credit could have gone on for years.
The stock market is up 50% since Obama took office, so it likes the uneasy stability that we have now. Credit markets have recovered tremendously, and IPOs are coming to the market again. Junk bond funds are up, confidence is returning. There’s greater willingness to lend, though only at high interest rates. But it’s a big improvement over last year.
Ilene: What do you expect for mortgage rates in the next few months? Years?
Mad Hedge: You shouldn’t touch real estate, as I think it will be dead money for another decade. Rent, don’t buy. If you have to buy, then get a 30 year fixed rate mortgage now at 5%, because rates are going up a lot in the future. When I bought my first home in New York in the early eighties, I got nailed with a 17% interest rate on my mortgage. We may revisit those levels.
Houses will continue to move lower, maybe another 10% or so. We have another wave of foreclosures hitting the system soon, triggered by the option arm readjustments. I see support for prices when the cost of owning and the cost of renting are more in line. Home ownership may have to become cheaper than renting, because of perceived risk to the principle, for the real estate market sell-off to finish. However, expecting houses to drop a lot from here is like shorting Citibank at $3. We’ve basically had the big move already. Due to poor demographic factors, the demand for houses is going to take a long time to come back. While 80 million baby boomers are trying to sell their houses to 65 million gen Xer’s, don’t expect a recovery in prices, especially when the gen Xer’s are still living in your basement.
Ilene: You mentioned you missed the rally in financials, but still have concerns about the financial sector.
Mad Hedge: With financials, I knew they would rebound, but didn’t imagine the extensive move we’ve seen. It was the greatest dead cat bounce and short covering rally of all time. But the financial sector will have troubles for years. If I had to buy U.S. stocks, I’d buy big tech stocks like Microsoft (MSFT), Oracle (ORCL), Intel, (INTC) and Cisco (CSCO), because for the most part they have tons of cash and little debt. Tech stocks didn’t have the problems that were plaguing the other sectors. For example, they have no troubled assets, and no regulatory clamp down on their business. The credit crisis didn’t affect them directly because they finance their operations through cash flow and tend not to borrow. Of course, they’re hurt indirectly when the customers have credit problems.
Credit markets are now seeing a huge differentiation in terms. Lenders are much more discriminating about who they lend to. American consumers are very constrained, but foreign consumers are not as constrained. They are not returning to frugality as we are because they didn’t share our excesses in the first place. You don’t see many black Cadillac Escalades with chrome wheels in China. If I had to buy stocks, I would buy equity in foreign companies where the growth will be in the coming years. In March, you could have bought anything and had a great trade, as the rising tide lifted all boats. But stocks in emerging markets outperformed US stocks by over a two to one margin.
Ilene: Would you be buying stocks now?
Mad Hedge: No, I sold most of my positions in June. The risk was low in March, but not so low in June, and it’s even greater now. The PE multiple on the S&P 500 has just jumped from 10 to 20 in six months. Historically, a 20 multiple is a terrible time to enter the market. Markets are discounting a “V”-shaped recovery, which we are not going to get. I think we’ll get more of a “square root” shaped recovery, a “V” followed by sideways to a gradually upward sloping grind. We’ve already had the “V”. Markets are overpriced. I don’t see how we can have huge economic growth with capital-constrained banks, catatonic consumers, and commercial real estate troubles up the wazoo. One of the only positives is the weak dollar, which makes everything we sell to the rest of the world cheaper. This is good for our multi-national companies, good for our exporters. So far, the dollar is on a grinding, controlled move down, which is good. But if the dollar’s fall accelerates, it would not be good. A real dollar panic would lead to the widespread dumping of dollar assets, and commodity prices would explode. Then we’ll get to $2,000 for gold and $40 for silver very quickly.
Ilene: You spent several years wildcatting for natural gas in Texas and Colorado, which has given you a unique insight into the energy space. What are your current thoughts on natural gas and oil?
Mad Hedge: Stay away from natural gas. The volatility will kill you. If you are a masochist, then buy it only when it’s cheap, on big dips, in the $3/MBTU range. In the last three years, thanks to the new “fracting” technology used in oil shales, we have discovered a 100 year supply of natural gas sitting under the US, and the producers have not been able to cut back fast enough. So now we have a supply glut, and we are almost out of storage. This is what took us down from $13 to $2.40 in 18 months. The lack of hurricanes has not helped demand either. Producers have been cutting back like crazy, trying to balance supply and demand, with a breakeven point of $2. They need a cold winter to help bring things back into balance. If the industry gets organized, then gas can become the 20 year bridge we need, until energy alternatives kick in. That makes me a big supporter of the “Pickens Plan.”
Oil is much more interesting. It overshot to downside in January to $32. Crude is now at $70 climbing out of the recession. Imagine how high it will get when all economies are functioning again. The financial crisis hurt the ability of big oil companies to get financing for large development projects in oil. These projects can take five to ten years to bring online. That means we will get higher oil prices sooner. We may get a pull back to the $50s, but the $30’s would be a stretch. The $32 low was an artificial one caused by a complete absence of liquidity in all markets. I don’t think we’ll see those lows again.
Ilene: Where do you see the price of oil going in the distant future?
Mad Hedge: I think it may dip into the 50s, then up, perhaps skyrocketing to $300 before dropping back down to $3 after alternatives take over and demand vanishes. But that’s at best 20 years out. If we can wean ourselves off oil in 20 years, it would be a huge accomplishment.
Ilene: I noticed you speak a little about politics in your essays; do you have a leaning one way or another?
Mad Hedge: I’m politically neutral. I’m getting bashed by the right these days because I’ve said that the Republicans have no ability to affect the legislative process now. But we need to adjust our portfolios to reflect the current political realities. No matter how much you love Obama, you can’t dispute the fact that the massive issuance of government bonds he is proposing is terrible for the bond market and the dollar, but great for precious metals and commodities. Obama won by a big margin, so the Democrats will be around for a while. Of course, if my “square root” scenario doesn’t pan out, and we get a serious “W” recession instead, all bets are off. People will only give him the benefit of the doubt for so long.
Ilene: Where do you think the stock market’s going to go over the next few years?
Mad Hedge: I think there’s a 1 in 3 chance for new lows. That’s the “W” scenario. But with Lehman, Bear Stearns, Merrill Lynch, and Washington Mutual gone, we have run out of companies that can suddenly go under and trigger a new financial crisis. The big survivors are partially government owned, and of course zero interest rates help a lot. More banks are going under, but they will be smaller, regional banks with excessive exposure to commercial real estate.
Ilene: How does this affect your actions in the markets?
Mad Hedge: The best and least risky trades were in the early part of the year. Now, there’s a lot more risk in all markets. I’m neutral right now. If stocks dropped from here, I might be a buyer, but only in energy, commodities, and technology, and of course in emerging markets like Brazil, India, China, Korea, and Vietnam. Gold, silver and commodities have all had huge runs. My inner wimp has me in cash, waiting for better opportunities. I haven’t been playing the short side, because it’s a nightmare trying to short a liquidity driven market with interest rates at zero. There is no return on low risk investments now. Capital always moves to risky assets when interest rates are zero. Just look at Japan in the 1980s. There PE multiples soared from 10 to 100 purely driven by liquidity. For the last three years of that run the fundamental analysts were left twisting slowly in the wind. Artificially low interest rates boost asset prices to artificially high prices. It always ends in tears, but can play out for a while. You want to have an asymmetric risk reward metric in your favor, as we did in March of this year. Now, we don’t have that.
The next downward move in the markets will more likely be due to disappointing economic data, earning misses, etc., not due to a total collapse of the system. We may sell off, but I don’t think it will be to new lows. It’s hard to see new lows with interest rates at zero. Instead, I see the “square root” recovery scenario mentioned earlier. The market may start drifting lower as people start seeing this possibility. That might set up a trading range for the S&P 500 which could last for years, something like 800-1,200. During the nineties, Japan peaked at ¥39,000, then traded in a ¥20,000-¥25,000 range for five years, before the final collapse to ¥7,000. That’s one scenario for the US.
Ilene: You’ve had an amazing career. Let me ask you about some of the people you’ve interviewed. What was Ronald Reagan like?
Mad Hedge: Although I never agreed with him politically, you couldn’t help but like the guy. He always had a joke ready. He was a lot smarter than he let on.
Ilene: And Margaret Thatcher, the prime minister of Britain?
Mad Hedge: Her nickname as “The Iron Lady” was well deserved. She could stare holes right through you. She treated journalists like a disapproving school teacher, which of course, she was.
Ilene: How about the terrorist leader, Yassir Arafat, of the PLO?
Mad Hedge: His body guards almost shot me when I reached to turn over a cassette in my tape recorder. I always thought he was a terrible leader. That is why the Palestinians never got anywhere, and why the Israelis left him alone.
Ilene: Meeting China’s Deng Xiaoping must have been amazing.
Mad Hedge: I am 6’4” and he was only 4’9”, so of course there were plenty of opportunities for humor. I could never envision this guy going on the Long March. He had a tremendous wit. Someone asked him why China kept its borders closed, and wasn’t this an imposition on human rights. He said if he opened the borders, the surrounding countries would get flooded with people. He asked “How many Chinese do you want? 20 million? 30 million?” I also met Zhou Enlai during the Cultural Revolution. He was a brilliant man, the last man on a bell shaped curve of 500 million.
Ilene: I read somewhere that you interviewed four US Secretaries of the Treasury.
Yes, Miller Reagan, Schultz, and Brady. And I visited the French chateau of a fifth, C. Douglas Dillon. I keep a collection of dollar bills they signed.
My goal in life was always to get in the way of history, and let it run me over. It’s been an amazing life. I wouldn’t trade it for anything.
Ilene: What about Apocalypse Now?
Mad Hedge: I happened to be in town to interview Ferdinand Marcos, the president of the Philippines. If you look hard, I’m in the USO scene. Most of the other “GI’s” in that scene were European and Australian hippies rounded up from the Youth Hostels of Manila by Francis Ford Coppola’s agents. Good luck, though. I was a lot younger and thinner then.
Ilene: Thanks a lot. It’s been great talking to you.