iBankCoin
Joined Nov 1, 2015
27 Blog Posts

Flash Point $SPY $ES_F $TF $IWM $RUT $SPX

China’s Economic Distress

The sugar rush from China’s most recent economic stimulus has begun to wear off as second-quarter growth is expected to slow to 6.6%, a seven year low (Update: Official GDP numbers showed 6.7% – led by construction & retail consumption.) Meanwhile, calls are growing louder to recapitalize banks and State-Owned Enterprises struggling under massive debt loads.

China has effectively abandoned Premier Li Keqiang’s pledge of last January to maintain currency stability: “The yuan will remain basically stable in weighted terms. China has no intention of stimulating exports through competitive currency devaluation.”

From the Telegraph:

The country’s currency basket has been sliding at an annual pace of 12pc since the start of the year. This has picked up sharply since the Brexit vote, suggesting that the People’s Bank (PBOC) may be taking advantage of the distraction to push through a sharper devaluation.

“This makes a mockery of the PBOC’s suggestion that its policy is to keep the currency’s value stable,” said Mark Williams, chief China economist at Capital Economics. “Markets will not take PBOC policy statements at face value in the future.

China is carrying out a systematic devaluation of the yuan –accelerated during the Brexit excitement– sending a powerful deflationary impulse through the global economy. Its attempt to export its problems though devaluation is a key reason why inflation expectations are crashing to record lows across the developed world.

This in turn is driving global bond yields to historic lows almost daily. From Bloomberg:

10-year borrowing costs are down to -0.58pc in Switzerland, -0.28pc in Japan, -0.16pc in Germany, 0.14pc in France, 0.78pc in Britain, and 1.4pc in the US.

Although China’s most recent currency reserve numbers showed a surprise increase — suggesting that capital is not fleeing the country at as rapid a pace as the last six months of 2015–  overall reserves are in fact falling relative to M2. Speculation is rising as to whether China is actively intervening in markets, all of which, in the eyes of many China watchers, increases the probability of a disorderly RMB shock later this year.

The latest twist comes from the foreign reserves data, which suggest that China may have begun to intervene actively in the markets to drive down the yuan. This would have grave repercussions. Provisional figures imply that the PBOC purchased a net $34bn of foreign bonds in June, once valuation distortions are stripped out.

Mark Williams, chief China economist at Capital Economics, said it is too early to tell whether this was active buying. “If they are intervening it would set off a bomb in relation with the US, especially in the run-up to the US elections,” he said.

The White House has become neuralgic about the strength of the US dollar after a 20pc surge since mid-2014, one of the most dramatic spikes of the post-War era. US officials read the riot act at the G20 summit in Shanghai in February, warning Japan and Europe that use of negative interest rates as a stealth tool to drive down exchanges would not be tolerated.

Friction in the South China Sea

From the New York Times:

BEIJING — An international tribunal in The Hague delivered a sweeping rebuke on Tuesday of China’s behavior in the South China Sea, including its construction of artificial islands, and found that its expansive claim to sovereignty over the waters had no legal basis.

The landmark case, brought by the Philippines, was seen as an important crossroads in China’s rise as a global power and in its rivalry with the United States, and it could force Beijing to reconsider its assertive tactics in the region or risk being labeled an international outlaw. It was the first time the Chinese government had been summoned before the international justice system.

“It’s an overwhelming victory. We won on every significant point,” said the Philippines’ chief counsel in the case.

From The Interpreter:

The biggest test is that posed by the ruling for China. It is also the most difficult. Now, if China simply continues its present actions around features in the Philippine exclusive economic zone in the South China Sea and continues to insist on the validity of the 9-dash line, it will be unambiguously undertaking unlawful activities. This will deepen the already profound distrust and fear of China in the region and contribute to China’s self-isolation in maritime East Asia. As President Xi notes, big powers are different to smaller ones.

While the decision is legally binding, no enforcement mechanism exists. China flatly refused to participate in the legal proceedings and reiterated again today that it would not abide by the international court’s decision.

Speaking at a meeting with European leaders, President Xi Jinping was defiant, reasserting China’s claim to sovereignty over the South China Sea “since ancient times,” the state-run People’s Daily reported. His remarks echoed a statement from the Foreign Ministry. The tribunal’s decision “is invalid and has no binding force,” the ministry said. “China does not accept or recognize it.”

Although this outcome was expected, the five judges and legal experts on the tribunal ruled unanimously, and the decision was so heavily in favor of the Philippines that there are fears about how the Chinese leadership will react.

“Xi Jinping has lost face here, and it will be difficult for China to do nothing,” said Bonnie S. Glaser, a senior adviser for Asia at the Center for Strategic and International Studies in Washington. “I expect a very tough reaction from China, since it has lost on almost every point. There is virtually nothing that it has won.”

The issue could have ramifications for domestic politics in China. Mr. Xi has made defense of maritime claims a central part of the governing Communist Party’s narrative that it has restored the nation to global greatness after long periods of humiliation by bigger powers. Any challenge to that narrative is seen in Beijing as a challenge to the party’s rule.

This challenge could add pressure to a government already feeling the heat of a weakening –if not imploding (if one dares question official economic statistics)– domestic economy, structurally impaired from over $30 Trillion in total debt. The prime directive of the CPC is to remain in power, ergo, maintain domestic stability at all costs — which includes redirecting domestic attentions and channeling nationalistic furvor when necessary. Yet, ultimately these are destabilizing triggers, and the probability of a misstep is very high from a party still stinging from its incompetent handling of self-induced financial crises earlier this year and last.

“Asian Arms Race” & Growing Risk of Confrontation

China’s PR machine had been in high gear leading up to The Hague announcement. Last week state media said the country “must be prepared for any military confrontation” with the US, and “must not flinch from war if provoked.” 

From the Telegraph:

It (The Hague decision) is the latest in a series ominous developments in Asia and Europe that are rapidly subverting the Western international system and setting off a global rearmament race with strong echoes of the late-1930s.

Tensions are flaring up across so many spots in East Asia that global investment funds are actively betting on defence stocks and technology companies linked to military expansion. Nomura has launched an “Asian Arms Race Basket” as a hedge against potential conflicts in the East China Sea, the Straits of Taiwan, and the South China Sea. Among the companies listed are Mitsubishi Heavy Industry and Sumitomo Precision in Japan, China Shipbuilding and AVIC Aircraft in China, Korea Aerospace and the explosives group Hanwha, as well as Reliance Defence and Bharat Electronics in India.

The Stockholm International Peace Research Institute says China spent $215bn on defence last year, a fivefold increase since 2000, and more than the whole of the European Union combined. It is developing indigenous aircraft carriers. US experts say its “Two-Ocean Strategy” implies a fleet of five or six aircraft carrier battle groups to project global power.

Japan has upgraded its once invisible Self-Defence Force to a full-fledged fighting machine with a humming new headquarters and an air of determined alertness. The country has been increasing military spending for the last four years, especially under its nationalist leader Shinzo Abe, commissioning its largest warship since the Second World War, an 800-ft DDH-class helicopter carrier.

Flash points are now legion. China’s dispute with Japan over the control of the Diaoyu/Senkaku islands in the East China Sea continues to erupt in spasms, with alarmingly close brushes by air and sea. There is still no hotline mechanism in place to stop skirmishes spinning out of control.

But the South China Sea is where matters are coming to a head. The Pentagon has made it clear that any move by Beijing to weaponize the Scarborough Shoal off the Philippines would be a step too far, leading to military response.

Possibility of Contagion

From The Telegraph:

The great worry is that parallel dramas in East Asia and in Europe could feed on each other. Washington’s ‘Asian Pivot’ is diverting US focus and power from Nato to the Far East, creating an opening for Russia’s Vladimir Putin.

Mr Putin’s arms build-up has equipped him with a formidable military machine just at the moment when the EU has been slashing spending on modern weaponry. He has a window of opportunity to press his advantage, perhaps by testing Nato solidarity in the Baltics with his hallmark form of hybrid warfare.

“I am convinced that Europe stands on the edge of several strategic and political precipices and could well see more change in the next five years than in the preceding fifty,” says Julian Lindley-French, vice-president of the Atlantic Treaty Association.

This is, granted, a lot to unpack.

The main question is how will the CPC respond within the South China Sea, post-decision? Particularly given that if it proceeds as it has historically, it will “unambiguously be undertaking illegal and unlawful activities”, thereby theoretically ratcheting tensions within an already high-pressure, re-armed region. Will the CPC use this as an opportunity to redirect from economic issues at home?

What then would President Obama –or President-elect Clinton or Trump– do, should one or more conflicts break out within Asia-Pacific?

Will Putin then take advantage in Europe? It’s almost certain he will.  If so, would America still be able to fulfill its European obligations and come to the defense of its NATO partners? (Simultaneously conducting operations against two nuclear-armed adversaries, one of whom is the world’s second largest economy, representing nearly 60% of global growth?)

Nobody knows the answer.

The world has seldom, if ever, been in quite this situation.

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The Aramco Gambit $XLE /CL $USO

Often, the simplest explanation is the most likely to be correct.

With an economy geared to fossil fuel production, Saudi Arabia has been running a significant budget deficit in the two years since they intentionally depressed global oil markets. The listing of Aramco is one way to plug the gap in government finances.

This is probably why they’re listing, however, there may also be another motivation.

From Bernstein:

Perhaps Aramco’s growth will be focused on refining and natural gas, but it is possible that Saudi have also realized that demand is likely to run out before supply and it makes more sense to deplete their own reserves ahead of others.

While Bernstein admits this is pure conjecture at this point, “it could have (long term) bearish implications for oil markets” (among other things).

Bernstein’s conclusion:

In the near term however, Saudi will not want to list Aramco at a low oil price. In the run up to 2018, we expect that Saudi will do everything in its power* to ensure oil markets remain balanced and prices stable. This could be positive near term for oil equities.

image

*Although Saudi’s power is less than it was prior to the advent of hydraulic fracturing, this premise isn’t likely too far off. Oil markets should continue to stabilize and rise further…

At least, for a while.

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On Gilead $GILD

(A longer post for your weekend reading pleasure.)

For shareholders of the most wildly profitable biotech in history, it’s been a rough three months, but on any comparative basis, last week’s action was truly hideous.

GILD finished its week of horror closing -5.5% Friday at $82.7 on high volume, massively underperforming the +2.5% gain in the S&P 500 –this is just for the day– as it breached the important $87 technical level overnight. The week’s -11% fall was largely due non-stop, galactically negative, yet-not-really-new newsflow:

  1. The AIDS Healthcare Foundation files another federal antitrust complaint against GILD
  2. Using what appeared to be a national PR campaign, Massachusetts’ AG reveals her inquiry into GILD along with her written request that it “reconsider its pricing structure” as her office examins whether Gilead’s pricing is an “unfair trade practice,” in violation of Massachusetts law
  3. MRK receives regulatory approval for its HCV treatment, which has a similar label and TAM to ABBV’s HCV treatment, Viekira Pak
  4. ABBV reports sales for Viekira Pak that misses street estimates and lowers 2016 HCV growth outlook to $2B
  5. GILD reports leadership shift as +25 yr President & COO takes the role of CEO while +20 yr former CEO remains in role of GILD board executive chair

The week’s news combined with a.) 2016’s ytd market bleed (IBB and XBI ETF selling have been relentless, both down >-20%)  b.) continued USD fx strength that is hurting S&P500 international sales, c.) next Tuesday is a key GILD earnings report, updating the market on the HCV treatment outlook — apparently, it’s all been too much.

GILD shares have fallen like the violent snows of a nor’eastern blizzard: unwanted, non-stop and in far too great a quantity, to the tune of -25% in a straight line since its Oct 27 earnings report, and -20% since GILD’s pre-ER corporate buyback blackout period began nearly 5 weeks ago. (For those who are interested in such things, the buyback window reopens next Thursday, Feb 4.)

But is such a severe reaction warranted?

EXECUTIVE SHIFT

From Bloomberg:

Gilead was founded in 1987 by Michael Riordan, a physician with a Harvard MBA. He named the company for the “balm of Gilead,” an ancient healing resin mentioned in the Bible. Riordan sought to commercialize so-called antisense treatments for genetic disorders, but his plans fizzled in the lab. In 1996, Riordan was replaced as CEO by Martin, who’d joined Gilead from Bristol-Myers Squibb hoping to pursue antiviral therapies based on his research on nucleotides, organic molecules that serve as building blocks of DNA and RNA. The company’s chairman was Donald Rumsfeld, who stepped down in 2001 to become President George W. Bush’s secretary of defense. Martin later took on the chairman’s title as well.

The messaging around current chair and former CEO Martin’s most recent transition on Friday could have been handled more effectively.

This is a recurring GILD theme under Doc Martin’s (sorry) tenure, as outbound messaging and communications have been a weak spot.

(Are you listening new CEO Milligan? Please find a brilliant certain-someone who can *use their words*, specifically in ways that public markets, investors and various government officials will appreciate. And then, immediately loan that person to China’s PBOC! Hah! We kid the Chinese. Seriously though, please hire a talented PR professional ASAP & give your beleaguered shareholders a break.)

Mr. Martin is a 64 year old billionaire who has, well, a billion reasons to have someone else deal with this going forward.

Meanwhile, John Milligan, Gilead’s new 54 year old CEO joined in 1990 as a research scientist, with a Ph.D. in biochemistry. He became CFO in 2002, and President & COO in 2007. Milligan is polished, an excellent public speaker, deeply technical, highly financially literate and very much liked by the Street. The guy has been groomed for the CEO chair for nearly a decade.

Martin will still be involved on strategy and with Milligan, the franchise is in excellent hands.

POLITICAL TARGET

As the NYT writes: “GILD’s prices, and the demand for its treatment, have strained the budgets of state Medicaid programs and prison systems, forcing many of them to restrict treatment to those most seriously ill.”

This being the case, it’s unfortunate that politicos appear default-set to demonize GILD as a rabid profiteer.

Apparently, whether you’re a politically ambitious state AG, US Senator or Presidential hopeful, GILD is your godsend. Democrat or Republican, Conservative or Liberal, GILD is your pre-fabricated *bad thing to hiss at* campaign-hot-button; a witch dipped in oil, straight out of central casting, matches & stake included.

But understand why they take this approach. To properly fund state & federal medicare budgets, a public discussion about the complex issue of HCV would include raising taxes –full stop. That doesn’t win elections.

Sadly, this is a public conversation that does need to take place, because even a rudimentary cost benefit analysis shows massive reductions in lifetime total healthcare spend for all the $300k liver transplants and $1M cancer treatments that are no longer required by cured patients. In this light, Harvoni is the highest value healthcare bargain of the millennia.

This is perhaps THE major problem facing pharma/biotech and society, and we need a functioning government to intermediate and lead.

The current regulatory environment, including patent protection expiry, the nature of antibiotics efficacy and political witch hunting have created an industry where a company would be crazy to spend scarce resources inventing drugs that a.) cure b.) physicians want to limit prescriptions for (efficacy) c.) politicians jump to demonize if priced for (gasp!) profit.

Incentives matter, and as with politicians, we can also understand why pharma/biotech companies have taken their approach, yes? So enjoy your viagra, just pray you don’t catch Zika, ebola, MRSA, etc…

(And if you think GILD is 100% innocent angel in all this, well, probably not. If it really did delay on filing for TAF approval just to maximize patent exclusivity for its HIV lineup, while allowing patients on tenofovir to succumb to bone loss and kidney damage…ugh. I hope it’s not true. But we may find out eventually via the federal case filed by the AIDS Healthcare Foundation this week. Sometimes, our capitalist/democratic system deserves a little hating on. To borrow from Churchill, it truly is “the worst system, save all the rest.”)

Strangely, the AG’s letter does not go into detail on how GILD’s pricing might violate MA state law. As another lawsuit –previously filed by the Southeastern Pennsylvania Transportation Authority, which said Gilead’s high prices violated a California law against unfair competition– was already dismissed by a federal judge, the legal grounds of this case appear tenuous.

Conclusion?

Politicians –as well as pharma/biotechs– appear to be proving out a fundamental law of Smithsonian economics when they act in their own self-interest.

This is my shocked face.  😐

COMPETITION

Speaking of economic laws, here’s one: “The solution to high prices is high prices.”

Enter MRK into the fray.

Zepatier, MRK’s new once-daily pill was approved by regulators on Thursday night and will be priced (list) at $54,600 for a 12 week course of treatment, versus $94,500 for GILD’s Harvoni.

Using apples to apples numbers, it remains possible, even probable, that the MRK after-discount price won’t be too far away from GILD’s net. Although we won’t know if MRK will truly be cheaper until the extent of their discounts are known, historically, net prices paid by insurers, aka “payers” usually demand large discounts in return for access to their patients.

IMHO, it’s this uncertainty that explains why GILD gapped down so much today. *IF* MRK provides as steep a discount as GILD, then the market projects GILD to have to match price, ergo less margin, less cash flow, lower PE, less buybacks, etc…

However –and most importantly– MRK’s new Zepatier is seen as an inferior course of treatment compared to Harvoni. From Citi:

Merck has priced the newly approved HCV doublet Zepatier at a 35% discount to the list price of competitor drugs from AbbVie and Gilead Sciences. We believe the discounted list pricing strategy (before rebates) is necessary in this highly competitive segment, given narrower indication and the prior-treatment mandatory liver function testing highlighted in the drug label. Zepatier requires liver function testing prior to, and during treatment. This compares unfavourably to Technivie’s updated labels which recommends hepatic laboratory testing only during the first 4 weeks of treatment and the unencumbered label of Gilead’s Harvoni. While Merck’s US label for their HCV agent is clearly inferior to incumbent competitors, we expect the launch of Zepatier to further drive net price reductions for the all market participants. We note that Merck’s focus will now be tilted towards next-gen all-oral triplet therapy (eta 2018) to better challenge Gilead and AbbVie.

Given MRK’s label issues, including availability for two out of six genotypes (1, the most common, and 4, which is rare), the added costs of multiple tests (HCV liver tests appear to run $200-400 each), the requirement of patient liver function as well as possible negative side effects (it can cause liver damage in some percentage of users), it would seem possible that Merck may be more of a competitive threat to ABBV, given they share similar label issues, etc…

ABBV. The guys who have repeatedly underwhelmed the market with their HCV regimen sales and forward outlook.

Regardless, we’ll learn over the next year what MRK’s discounting and sales efforts mean in term’s of GILD’s HCV market share. At present, estimates suggest MRK HCV sales will eventually reach $2B. (But just to be on the safe side, the market went ahead and priced GILD for a dire case today.)

OTHER FUNDAMENTALS

It would appear a number of former shareholders believe HCV is a rapidly declining opportunity, perhaps due to impending threats including political pricing controls, increasing competition and the fact many of these drugs have a cure rate in the 90th percentile, or, as one well-known bio-journalist wrote, “it’s a race to patient zero.”

Maybe. But second derivative thinking suggests these conclusions may be premature. For example:

  • U.S. HCV patients are estimated to be 3.7 MM, with 300.000 cured to date
  • The EU 5 is estimated to have 2.5 MM patients and Japan 1MM, doubling the patient count
  • Merck says it hopes to eradicate HCV by 2030

2030, by my count, is 14 years from now. Most companies are horrible at projecting 3 months from now (surprising how often this is the case even when they’re midway through the quarter they’re trying to project.) 14 years is an exceptionally long outlook.

I’ll add two more items: the extended GILD pipeline appears promising (All-genotype HCV ETA in June, new HIV this year, early stage Hep B, NASH, Oncology, etc…) and they now get 30-50% more for their M&A effort AND buyback bucks given the recent biotech selloff.

Who knows what they buy. But when they do, they prefer to pay up for the sure thing. (So it’s largely de-risked.)

TECHNICALS

Granted, when things get extreme, things tend to overshoot. And (trend) buyers are higher, sellers lower, etc…

However, I’ll argue that margin of safety is a real thing, GILD is not a stock at risk of going to zero, and the further it goes down, the more de-risked it becomes over a long time horizon. #bagholderquotes

GILD held $83(ish) at the close. On a long term chart -given that in times like these, everyone becomes a technical analyst- GILD looks to have spent a bit of time in 2014 accumulating between $60-80 – call it $75 as a probable (worst case?) low.*

*Keep in mind, given its market cap and liquidity, GILD is a core position for hedge funds, SWFs and ETFs the world over. Much like AAPL, your GILD shares serve from time to time (recently, all the time) as a source of funds for forced redemptions, sort of an institutional ATM.

(So on behalf of institutions everywhere, please accept their thanks. They’re surviving to sell another day – by selling your favorite holdings into the hole. This, by the way, is likely why the phrase about markets staying irrational longer than you can stay solvent exists. We don’t know how long the dump must continue. Risk management remains key.)

CONCLUSION

While GILD probably deserves a low PE until such time that they change minds regarding a sustainable growth path, a 7 PE is venturing deep into crazy town:

From RBC:

(1) Valuation is historical low 7-8x and below lows of 2008-09 when Street thought there’d be an HIV cliff

(2) FCF yield on Gilead now at 10-12%+. Even if HCV revenues fell by 30%, FCF yield would still be 8% and PE still 10x and cheap to trough HCV levels. (That means they can buy the company outright in ~12 yrs under a worst case scenario.)

(3) Gilead last reported $11B of their share buybacks remaining (largest in biotech) and we expect this to get more aggressive.

(4) Drug pricing seems more rhetoric than reality as Merck’s price sounds low but net price is not known and may not be different or drastic than what is already modeled by consensus to get Merck to 10% share.

(5) Cutting price in Hep C can get some modest share but has not led to material market share for AbbVie (today’s EPS report shows 7% share and Gilead 93% share still) and thus Merck will get some share but probably not dramatically turn the business upside down.

(6) Also, much of the HCV contracts are already locked up (Express Scripts/AbbVie) and Gilead has suggested much of their deals have technology clauses that protect any material formulary change against Gilead.

(7) We already wrote this month that formularies might actually start opening up to treating healthier patients as UnitedHealth Group and Anthem and if Gilead HCV scripts start going up in time, we think this would change the view on Gilead; this is 50% of the scripts written and not getting booked for revenue in 2014-15.

Sounds about right. Hang in bulls, it can’t continue this way for too long.

Seriously. At this rate, GILD will be able to acquire themselves with their own cash on-hand before ski season ends.

Enjoy the rest of your weekend, talk soon.

g

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China, the Fed and Oil $CNY $CL_F #FED #Oil

China, the Fed and commodity prices –specifically oil and natural gas– will continue to be the ultimate macro-arbiters of global asset prices. To understand how the three are related, let’s go back some 50 years and pick up the story of modern global capital flows:

Before the 20th century, the value of money was tied to gold. Banks that lent money were constrained by the amount of their gold reserves. The Bretton Woods Agreement of 1944 established a system of exchange rates that allowed governments to sell their gold to the U.S. Treasury. But in 1971, U.S. President Richard Nixon took the country off the gold standard, which formally ended the linkage between the world’s major currencies and gold.

At the same time, the U.S. negotiated a deal with Saudi Arabia whereby in exchange for arms and protection, the Saudis would denominate all future sales of oil in U.S. dollars. Other OPEC members agreed to similar deals and the U.S. “petrodollar” was born.

This result has been the basis of the global monetary system, with petrodollars serving as the foundation of global liquidity and driving an enormous global distribution of wealth, or as Izzy Kaminska of the FT writes, “A form of underwriting by the richest state in the world, which has increased global interconnectedness, global trade and global growth in general.”

It’s been the definition of a virtuous cycle. Petrodollar rich countries –commodity exporters– invest in emerging market growth projects, which in turn, stimulate additional demand for commodities. The positive feedback loop of globalization has grown both foreign reserves in emerging markets and global sovereign wealth fund assets – now well over $7 Trillion, with +$1T having found its way into US securities.

And now, as the price of oil has collapsed, the cycle is slamming into reverse.

From Citi:

The most important consequence of the disappearance of the oil exporters’ surplus is that it would accelerate the withdrawal of Petrodollars and likely put further downward pressure on capital flows to EM.

From what we can see of Petrodollars in the official data, the withdrawal of this liquidity could get considerably worse. This is illustrated in… data from the US Treasury and from the BIS….showing that major oil exporters still – at least up until September last year – had US$1 trillion of exposure to US securities, and that number had remained remarkably stable in the previous 18 months, despite the collapse in oil prices. As oil prices stay low and these countries experience current account deficits, it seems fairly certain that there will be a withdrawal of liquidity from US securities markets, with negative consequences for global risk appetite.The IIF’s January 2016 analysis suggests that SWFs funded by commodity revenues (almost entirely oil and gas) may have reduced their direct exposure to EM assets from US$600 bn at the end of 2014 to some US$550bn last month. This is based on their estimate that some 15% of commodity-financed SWFs had been invested in EM. We assume that this direct exposure of Petrodollars to EM is also at risk.

So not only are SWFs likely to increase redemptions of their $1T in direct U.S. exposure, but declining petrodollars and corresponding net capital flow reversals are also reducing EM GDP growth rates, making it far more difficult for EM companies to service their $23.7T in corporate debt (up from $5T 10 years ago), of which $16.7T is China.

And finally we get to the bottom-line, debt. The world is awash in more than $200T in total debt, up as much as $60T from 2007 levels. (China itself has an estimated $28T in total debt, at least $10T of which is believed to be USD denominated.)

What’s China’s role in this? Ultimately it’s increasing the probability for global debt default — and anything that puts substantial quantities of debt at risk should immediately be the bull’s greatest fear.

Over the month of December, China spent an estimated $170B in net reserves (including monthly trade imbalance) –and again according to IIF, perhaps as much as $676B gross over the last 12 months– defending the yuan. Of its +$3T in remaining reserves, it’s estimated that only $300B remains truly available, leading to speculation that China will be forced to let its currency fall, with estimates ranging from 10-50%. While devaluatuon might help with local inflation, ease real local debt loads and cushion exporter income, a lower yuan will ultimately increase pressure on other EM countries to also devalue.

Combined, China’s projected currency depreciation and slowing economy represents a dual-hit to EM countries, simultaneously slowing export growth (i.e. commodities like iron and copper) while threatening export margins of products sold into developed markets. As stated above, this increases the probability for EM corporate (and government?) debt default.

Meanwhile, the Fed feels compelled to tighten, despite underwhelming recent US economic data. Why? The Fed is deeply concerned about what will happen to holders of the $23T in global government debt (read: both banks and shadow bank actors) presently trading at interest rates of less than 1%. CPI has perked up the last several months, even with massive declines in energy. The Fed knows that if it gets too far behind the inflation curve and has to raise too rapidly, the resulting credit market dislocation will be severe, increasing the probability for (yet) another global financial crisis.

By the way, if you’re at all curious as to why Deutsche Bank stock is collapsing, it may be because they –and their +$70T derivative book– represent substantial counter party risk for god-only-knows how many institutional hedges, that may (or may not) be good when they are most needed. (This is the role AIG played during the 2008 financial crisis, acting as the primary seed to financial contagion.)

Despite this, I’m not a bear; I think the odds are good we get through this in one piece. That said, there are a number of triggers out there. If things go the wrong way, the resulting crisis has the potential to take place on a truly massive scale.

Until oil and China stabilize, risk remains high.

-g

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Too $SUNE To Tell? $TERP $VSLR

[Just a quick update. I closed all short positions (puts) in SUNE (Jan 12) on the initial plunge through $3. It rallied a bit yesterday, but today’s word of Appaloosa filing suit has brought it back down.]

 

SUNE could go lower –it should go lower– but I’ve always been wary of the high short concentration, most of which may be a hedge by SUNE’s convertible bond holders. IV on the Jan options are now over 600, having doubled since yesterday.

I’m holding what is now a decent-sized TERP long* but I still expect volatility ahead. My (unpopular) thesis is Appaloosa actually wants VSLR to close – but will then seek an injunction blocking TERP’s involvement. This should leave SUNE in (another) desperate scramble for cash, a situation Appaloosa will then use to negotiate majority ownership & control.

Not a believer? No problem. It’s what makes a market. (The lawsuit should determine if this is a correct view or not.)

Here’s the calendar view I put together of Appaloosa’s filings for Twitter a few weeks ago (backdropped against the daily headlines for context):

Screenshot 2015-12-28 21.17.31

What do you see?

What jumps out to me:

Week 1: Appaloosa starts buying in size – doubles down on their previous 200k shares – but only after SUNE/TERP ER collapse

Week 2: TERP drops an additional -35% (from $13 to $8.5) but Appaloosa only buys 1/3 of prev week’s volume? This is unusual.

Week 3: TRIPLES down (!) *AFTER* TERP board shakeup

Week 4: DOUBLES down AGAIN and completes full purchase on the day 1st letter filed w/SEC

The best part, Appaloosa ticks the absolute bottom on 11/30, buying 1/2 their TOTAL position at the all-time low (knowing its SEC filing is public on 12/1). That, my friends, is the power of carrying a big stick. What can be better than being your own catalyst?

Appaloosa filed another 13-D on Jan 7, updating their Demand for Inspection request. A lot of conjecture out there that using this approach shows the weakness of their lawsuit.

I disagree.  Anyone thinking Appaloosa is putting the reputation of itself and its founder – a member of the all-time investor’s pantheon – at risk of negative PR over a sloppy legal interpretation simply hasn’t studied them, much less how their buy was executed.

Ok, I already know the answer. There are a lot of folks out there who think exactly this.

Timestamp this post, folks, the guys that did *that* surgical buy probably don’t do anything without complete conviction of purpose. And in my book, 150bps isn’t going to cut it for them.  (Their position, should it go back to the all time high, would represent 150 bps gain to the greater Appaloosa $24B AUM)

Remember, the whole SUNE complex that was trading north of $35B 6 months ago now has a combined market cap of…exactly $3.1B.

(Fun Fact: SUNE at $1B now trades for exactly it’s remaining ownership stake in TERP and GLBL.)

Speculation Warning: I’ve wondered since the July announcement as to why the management team at SUNE levered up so high to pursue VSLR (and other renewables) in the first place. It never made sense. With the advantage of hindsight, probability is very high they had advance knowledge from their lobbyists that the US Congress was putting renewable tax credits (ITC) back into play in the Fall. Combined with the global climate summit in Paris, were they using M&A to front run what they speculated would be a 4Q run in solar and renewable stocks? Why else would they leave themselves zero contractual outs with BX? 

From that viewpoint, everything they’ve done since resembles a fully margined swing trader who was too early with his thesis – and is now raiding the wife’s 401k and the kids’ trust funds to make good on the margin call that just blew up their account. Frankly, I think the odds are better for the Shkrellied KBIO retail shorts to get Etrade to forgive their debts than Tepper’s allowing SunEdison’s C-suite to regain the value of their equity via his involvement. I could be wrong, but for now, I’m convinced he’s set on taking it all away from these foolish, reckless managers.

After putting the buy chart together, what stood out to me was the discipline, conviction, speed and precision of the Appaloosa buy. They had a plan in advance, they waited until they saw what they wanted, and then moved with astonishing aggression. Quite honestly, I’ve never seen anything quite like it, at least in the world of finance. They executed this buy like a special forces operation…or, even better, a lion hunting a gazelle.

For that reason, I’m sticking with the Tepp on TERP, and that likely means increasing the position should TERP tank on a possible dump from…oh, I don’t know. Say some large shareholder out there who’s desperate for cash.

And should Tepper gain control, could the capital and standing of the mighty Appaloosa allow TERP to revisit its former highs?

If that happens, I’ll likely close the long.

At the end of the day, the yieldcos still give bond-like return for equity level risk.

In the interim, I expect the market to continue getting this one wrong.

-g

*There are some concerns with the quality of some of TERP’s holdings in regards to counter party risk (a copper mine in Chile comes to mind) but these are difficult to investigate. That said, TERP’s distressed price & yield leaves something of a margin of safety.

 

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The Beginning of the Endgame? $SUNE $TERP $VSLR

 

What exactly does Appaloosa, at ~$25B AUM, one of the world’s largest and most powerful hedge funds, have in mind for Terraform Power, the battered yieldco of SunEdison?

With a 1.5B market cap, Tepper’s 10% TERP stake is worth all of ~$145M.

Based on filings, he’s up $50m (~$9 basis, TERP trading at $12) which is great for the PM’s EOY bonus, but relatively insignificant for the greater Appaloosa. To put this in perspective, if TERP goes back to its all-time $42.66 high, the 4x gain on Appaloosa’s initial $100M investment represents all of 150 bps.

Appaloosa’s 10% $150M stake in tiny TERP, with its best-case payout of ~150bps appears – underwhelming?

Equally curious, other hedge funds that are getting involved in the SUNE soap opera also appear to have aligned on the side of the yieldcos, TERP and GLBL. BlueMountain announced an activist TERP stake of >10% (cost basis of $11) and DE Shaw just filed a passive position of >5%. Greenlight, the original SUNE cheerleader, had reduced its SUNE stake by 25% (9/30 filing) and appears to have redeployed the funds into GLBL, the international yieldco.

To my knowledge, no one has announced an activist position in SUNE.

This positioning suggests funds are attracted to the yieldco’s shareholder rights. The avoidance of SUNE may limit conflicts of interest for any potential, future litigation proceedings.

The 12/30 filings will be interesting, to say the least.

Twitter followers know I’ve been curious about Appaloosa’s silence on the renegotiated VSLR deal. I’ve also been surprised that the majority of SUNE investors assumed the changes satisfied Appaloosa’s stated concerns and that they wouldn’t litigate to block. I’ve reread the letters, which I though raised a number of questions that increased SUNE’s uncertainty. On December 15, I flipped out of a SUNE long to buy SUNE puts, while doubling down on both TERP and GLBL longs.

Screenshot 2015-12-22 08.01.54

Today’s new letter from Appaloosa suggests their intentions:

In a letter to TerraForm management, Appaloosa asked for all documents related to their transactions, management changes and SunEdison’s planned acquisition of residential installer Vivint Solar Inc., according to a regulatory filing Tuesday.

Even if it is still low probability, should Appaloosa litigate to block the VSLR deal, today’s equities action offers an alternative view of where that would leave SUNE.

Tepper’s MO is to see and act on things that other investors miss.

The creation of the yieldcos meant ring fencing SUNE’s highest-value assets into standalone, legally protected entities. The purpose was to achieve a lower cost of capital, but now that SUNE is (still?) under a margin-induced liquidity squeeze –despite a number of (questionable) asset sales and canceled deals– could it be that the yieldco’s represent a critical vulnerability to a sophisticated predator?

The Yieldco’s are not SUNE’s private piggybank, to do with however they please. The world has changed, there are now other (veteran) TERP and GLBL shareholders, and they know their rights.

The replacement of TERP CEO Domenech and replacement by SUNE CFO Weubbels and resignation of multiple directors (an episode that has still not been properly explained to shareholders) suggests a blatant disregard for the new world order.

Its actions suggest SUNE still does not differentiate TERP & GLBL assets, cash and credit from its own. Out of desperation, the SUNE management team seems to be changing the rules as they go, whether its forcing low quality assets into TERP, selling unfinished projects into GLBL, or using the yieldco balance sheets to fulfill the parent warehouse responsibilities.

I’ve delayed writing this update as it’s been difficult to assign a probability until we saw Appaloosa’s next move.

Today, that may have happened.

With 50.3% and 30% ownership stakes in TERP (1.5B) and GLBL (.63B) representing about $1B of SUNE’s ~$1.3B cap (falling rapidly while the yieldco’s seem to have stabilized), the market is telling us how it values the standalone devco.

Again, what’s Tepper’s end game? Only he knows for certain, but there’s a finite number of possibilities.

Investors should consider that one speculative possibility is Appaloosa has been planning all along to force a vulnerable and weakened SUNE into relinquishing some or all of its holdings in TERP and GLBL.

Once freed of the SUNE albatross, there are scenarios where TERP and GLBL could rapidly recover as much as 2-4x while the remaining SUNE devco – undifferentiated in a highly competitive space where it’s unlikely to maintain its industry-leading margins- is devalued and left to fend for itself.

Interesting thought exercise: If Appaloosa blocks, what are SUNE’s remaining options in regards to satisfying obligations to BX/VSLR? That could be what triggers the liquidity event, and it’s what I’m researching now.

If so, what would then stop Appaloosa from acquiring what remains of SUNE in order to own the majority of a newco that tackles the 70T green energy opportunity?

Why wouldn’t Tepper do it? Why settle for 10% of TERP when you can take it all?

After all, it’s not just a $3.5B collection of devco/yieldcos. With Tepper behind them, it’s at least +$35B potential, based merely on where it all traded 5 mos ago. Now that’s a meaningful win.

Perhaps Appaloosa only squeezes SUNE until they cry uncle and give him what he wants – majority ownership. Perhaps SUNE bankruptcy not in the cards.

We shall see.

Stay tuned.

 

 

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$XLE Energy Is Looking (Even More) Increasingly Volatile and Binary

Recent events in macro energy have been, shall we say, “dynamic”:

  • Oil and natural gas prices have been absolutely pummeled. Inflation adjusted, the current bid on natural gas $NG is in the lowest 00.1% of the last 25 years and oil $CL is barely sitting above its 30-yr real price average.
  • The growing irrelevancy of OPEC, as evidenced by the most recent meeting.
  • Russian, Iranian and Saudi geo-strategy and increasing probability for conflict.
  • The commodity supply/demand narrative (another Oil inventory build this morning).
  • Near-record short-commodity/long-USD positions.
  • COP21 delegates from 195 countries voted for a global climate agreement over the weekend. (Signal vs Noise ratio of this deal can be hotly debated.)
  • The US Congress seeks to lift 45 year old US oil export restrictions, but a congressional deal appears to hinge on the renewal of ITC tax credits for wind and solar projects – which may have to do with today’s spike in SUNE to a high of $6.16 (presently trading at ~$5.87.)
  • The collapse of credit in high yield and junk.
  • Best for last, given today’s big event, the Fed’s impending policy move and it’s impact on the USD.

The aggregate has created an impressive negative feedback loop.

Despite the occasional squeeze, probability suggests conditions are unlikely to mean revert until either something very, very big breaks (war, producer country collapse) or the supply/demand narrative self-corrects over the next 12-24 months via “the cure for low prices is low prices” logic.

There is still much to be considered about what all of this really means at an investment level.

At a macro level, the secular trends for green energy appear to remain intact, and possibly gaining momentum. For what its worth, some analysts now project as much as $70T of renewable projects over the next few decades, with much of that falling to wind and solar.

In the short term, however, falling fossil commodity prices do have an impact on the profitability models of renewable energy projects. A CoC that is rising plus a falling rate per watt is deadly to NPV and DCF calculations.

Conclusion:

  1. Long term, renewable energy still represents a potentially massive disruption to the fossil based economy of the last 150 years.
  2. Medium term, fossil-based energy remains highly relevant.
  3. Short term, aggregate conditions behind the present energy trend have set the stage for a level of volatility that both shorts and longs may struggle to survive.

This post sets the stage for an update on the SUNE complex later this week. (Hint: Twitter followers of @graystoke have the jump.)

Stay tuned.

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It’ll do till the mess gets here

Wendell: You know, there might not have been no money.

Ed Tom Bell: That’s possible.

Wendell: But you don’t believe it.

Ed Tom Bell: No. Probably I don’t.

Wendell: It’s a mess, ain’t it, sheriff?

Ed Tom Bell: If it ain’t, it’ll do till the mess gets here.

No Country for Old Men is in both my all-time favorite movie and book lists.

No doubt about it, SUNE is a mess.

I’ve been motorcycling the last week across Death Valley, Yosemite (in the snow, which I would not recommend) and now back in San Diego. Sun & Internet! My dear friends, I’ve missed you so. (And BTW fellow adventurers, if you do these out-of-the-way trips, T-mobile is completely worthless.)

Back to SUNE. Worries exploded recently when CreditSights argued that the fall in TERP means that SunEdison now faces a margin call on a $410 million loan. SUNE later confirmed that it had paid $152 M to satisfy the call.

Yesterday the same analysts highlighted what appears to be a reclassification of more than $700 million worth of debt from “non-recourse” to “recourse,” meaning the company’s lenders now have access to additional SUNE collateral:

When updating our SunEdison debt tracking spreadsheet we noticed SunEdison subtelety [sic] reclassified its $403 million Margin Loan and $336 million Exchangeable Notes as suddenly recourse switching … from the non-recourse disclosure used in the [second quarter of 2015] 10-Q filing. We are not accountants and realize this might be sufficient disclosure but we are fairly confident many investors missed the dropped foornote “(a)” … It is also entirely possible this is just a typo but since SunEdison stopped returning our emails and phone calls over a month ago we have no way to confirm this.

Shocked –shocked– I am, that SUNE management isn’t returning calls/emails to CreditSights. That said, management’s behavior is probably the core issue with how the market is valuing SUNE right now, and it’s fixable.

This recourse debt probably has more to do with why the stock is down -34% today (TERP -21%!) than all the headline news that Einhorn, Loeb, Mandel and Cooperman have reduced or eliminated their holdings. The market clearly believes SUNE is in the midst of a full blown margin call on TERP, and with about $12 billion of debt on its balance sheet, with some $3 billion of that amount listed as recourse to the company, per Deutsche Bank, it’s hard to know where the bottom will be.

From my perspective, the only thing that’s changed are the probabilities. I finally have a 2% position at a basis of ~$4.5. Even though it looks increasingly likely this is going lower –perhaps all the way lower– I can’t lose any more than 2% of my capital on this SUNE trade. (Full disclosure, I also have 1% TERP at $11.07, so really it’s 3%).

Does this suck? Yes.

Do I think the market may be wrong about SUNE insolvency? Yes, but it’s sure not looking so great, is it? That said, if this isn’t negative sentiment, it’ll do till it gets here. (Anything – anything! – remotely positive comes out — even a “hey there y’all, we stayin’ in bidness!”– and how long a ride do you think the shorts are in for?)

Do I still think SUNE has positive optionality? IF it gets through this, clearly yes, but with what we know today, SUNE is probably not something you want to double down on right now:

Anton Chigurh: What’s the most you ever lost on a coin toss.

Gas Station Proprietor: Sir?

Anton Chigurh: The most. You ever lost. On a coin toss.

Gas Station Proprietor: I don’t know. I couldn’t say.

[Chigurh flips a quarter from the change on the counter and covers it with his hand]

Anton Chigurh: Call it.

Gas Station Proprietor: Call it?

Anton Chigurh: Yes.

Gas Station Proprietor: For what?

Anton Chigurh: Just call it.

Gas Station Proprietor: Well, we need to know what we’re calling it for here.

Anton Chigurh: You need to call it. I can’t call it for you. It wouldn’t be fair.

Gas Station Proprietor: I didn’t put nothin’ up.

Anton Chigurh: Yes, you did. You’ve been putting it up your whole life you just didn’t know it. You know what date is on this coin?

Gas Station Proprietor: No.

Anton Chigurh: 1958. It’s been traveling twenty-two years to get here. And now it’s here. And it’s either heads or tails. And you have to say. Call it.

Gas Station Proprietor: Look, I need to know what I stand to win.

Anton Chigurh: Everything.

Gas Station Proprietor: How’s that?

Anton Chigurh: You stand to win everything. Call it.

Gas Station Proprietor: Alright. Heads then.

[Chigurh removes his hand, revealing the coin is indeed heads]

Anton Chigurh: Well done.

[the gas station proprietor nervously takes the quarter with the small pile of change he’s apparently won while Chigurh starts out]

Anton Chigurh: Don’t put it in your pocket, sir. Don’t put it in your pocket. It’s your lucky quarter.

Gas Station Proprietor: Where do you want me to put it?

Anton Chigurh: Anywhere not in your pocket. Where it’ll get mixed in with the others and become just a coin. Which it is.

[Chigurh leaves and the gas station proprietor stares at him as he walks out]

 

Investing is tough business, yes? Einhorn, Loeb, Mandel & Cooperman are pretty smart guys who rode this down, what, 70%?

Howard Marks likes to say if you’re going to outperform, you have to go in a different direction than the herd, you have to concentrate, leverage, and be willing to lose. I agree, but you gotta’ know *when* and *what* to go to the mat for, or you’re going to get killed.

The most important thing about this whole series of posts on SUNE should be how much risk management discipline matters.

No matter what I deem the probabilities to be –e.g. the disruption the next 10 years represents to the carbon-based economy of the last 150 years– now is not the time to go all-in on SUNE, even though it’s both the largest global renewable energy development company AND the world’s largest renewable energy asset manager that is trading like it’s insolvent. (There may be a time, however, when this deserves more capital. Look for an upcoming post as to what conditions would need to look like in order to get me to invest more.)

I took a bike ride for a week across California as this thing dropped ~40% and didn’t lose any sleep. The equity is trading like an option and priced as if it’s going bankrupt. If it does go to zero, I’ll take my lumps –publicly– and try even harder to make up for it by finding the right play on the long term CAGR and TAM that renewable energy represents. (Along with, maybe, a way to exploit the longterm decline of fossil-related energy.)

Good luck out there. I’m rooting for us.

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Energy investing is looking increasingly volatile and binary

From AEP’s latest, the IEA projects oil demand will fall to 103m b/d in 2040 under even modest carbon curbs, along the lines of the climate pledges made for the COP21 summit in Paris by the US, China and India, among others. By 2025, a “two degree world” may be well within sight, collapsing oil demand to 83.4m b/d.

Meanwhile, Opec keeps forecasting that oil demand will keep rising, to the tune of an additional 21m barrels of oil per day (b/d) to 111m by 2040.

~30m barrels is a big delta. Somebody is 30% wrong.

iea_oil_demand_3498294b

The next leap foward in technology is going to be in energy storage. Teams of scientists at Harvard, MIT and the world’s elite universities are in a race to slash the cost of batteries – big and small – and overcome the curse of intermittency for wind and solar.

A team in Cambridge says it has cracked the technology for lithium-air batteries that cut costs by four-fifths and enable car journeys of hundreds of miles on a single charge. By the time we reach 2040, it is a fair bet the only petrol cars still on the road will be relics, if they can find fuel at all.

“Everything will be electrified. The internal combustion engine is a dead-end. We all know that, and the car companies ought to know that,” said one official handling the COP21 talks.

All this may be a long way off. Regardless, it doesn’t sound too promising for the future of oil, coal and gas-related investments.

iea_renewable_3498289b

Here’s where energy –particularly oil– investing gets complicated:

Al Qaeda in the Islamic Maghreb showed it could launch a devastating surprise when it crossed into the Sahara two years ago and seized the Amenas gas facility in Algeria, killing 39 foreign hostages. Variants of Isis can strike anywhere they find a weak link.

“We remain concerned that they may eventually set their sights on a major oil facility. These are obvious targets of choice, and none of this geopolitical risk is priced into the market.”

There have been five Isis-linked terrorist acts on Saudi soil since May. They include an attack on a security facility near the giant oil installation at Abqaiq, where clusters of pipelines offer the most inviting sabotage target in the petroleum world and where the aggrieved Shia minority sit on the Kingdom’s oil reserves.

The Shia, as in Iran. The guys the Saudi’s are waging proxy wars against in both Yemen and Syria. Yeah, Syria. The former country where all the newest Europeans are from. The place where Russia is wintering its soldiers, planes, missiles and bombs. (I wonder where the Russians want the price of oil to go?)

So, the probability of an “incident” that spikes the price of oil is increasing.

But such a move might only be temporary. Any spike allows the U.S. shale E&P sector to re-emerge, re-hedge, and re-flood the market, re-tanking the price of oil and gas.

Both the supply and demand sides of the fossil fuel story look increasingly poor. Energy investing, at least in fossils, looks increasingly binary and volatile.

Interesting times. So what can we conclude?

  1. Expect intermediate term volatility. Big binary up and down moves are increasingly likely.
  2. The long term trends indicate less, not more fossil fuel demand. The impact that has on both the global economy, and the underlying shadow banking system are far-reaching.
  3. The long term trend suggests increased demand for renewable power generation.

Are there other conclusions to be made?

Whether SUNE is the right, best investment or not, it’s tough to say. But it seems to me that it’s in the running for the most misunderstood & scary award.

Assuming it can make it through this bit, it also likely has the highest upside potential. (Priced like it’s insolvent but the data suggests it probably isn’t. Its debt levels are high, but perhaps not as high as believed, their counter parties are strong and while interest rates are going up, it’s going to be at a measured pace. At least that’s what the Fed promises. The biggest SUNE problems appear fixable. Meanwhile, we know it was a hedge fund hotel, and we’ve discussed the short-term, weak-hands issues that involves.)

Am I being too conservative to only allow this thing a 2% position? Hmmm. Probably not. Consensus seems split on it going to zero or being a multibagger. I’ve decided to treat the equity like a call option with zero theta-decay.

What are some other investments you see to play this increasingly probable green-energy carbon reduction  trend?

How are you managing shallow and deep risk?

-g

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Heads I win, Tails you lose

I’ve mentioned loss aversion theory a few times, so what is it?

Also known as prospect theory, or framing effect, loss aversion theory was developed by two psychologists, Amos Tversky & Daniel Kahneman. (Some of you may know Daniel Kahneman as author of the best seller, Thinking Fast/Thinking Slow.) To my knowledge, these are the only two non-economists to win the Nobel prize for economics, and they did it by telling economists that much of what they thought they knew about the world was wrong.

The basic experiment ran like this. You take a room of experimental subjects and divide it in half.

You ask one side of the room to make a choice between receiving $1k in cash, no questions asked, or taking an opportunity to win twice the amount –$2k– on a coin flip. If they lose the flip, they get nothing.

The question you’re essentially asking: “Are you risk averse, or risk seeking?”

¾ will take the money. Every time.

For the other side of the room, you frame the question slightly differently. “I’ll take $1k from you. I’ll give you a chance to flip a coin, and if it comes up your way, I’ll give back your $1k. But if you lose, you now owe me $2k.”

¾ will take the coin flip. Every time.

This shouldn’t happen! But because it’s framed two different ways, you get two completely different results.

Humans are risk averse when it comes to gains and risk seeking when it comes to losses.

This finding is robust across ages, cultures and even species! We are hard wired for it. The best explanation comes from evolutionary psychology. If you imagine you’re a species at the end of survival and you have the choice between a small gain or a risky larger gain – you’ll almost always take the small, sure win instead of a big win, yet risk a great deal to avoid even small losses.

Why? As a caveman, a sure loss likely means you’re dead, so you might as well take the gamble –since you’re still dead– but even a small chance that you may get out of the loss entirely is very attractive.

This thinking may have worked well for cavemen, but it has serious drawbacks in the modern world of finance.

-g

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