Maedhros Global Allocation Report - July 2008


Here we are, my friends.
The seventh month since this report was born has gone, and they've been interesting times indeed.
Notwithstanding the markets' schizophrenia however, our model portfolios have kept their promise to be your Pole Star navigating these dangerous seas.

Our Total Invested Capital have closed this month up 0.16%.
Year to date it's losing 1.97%, but even in red our overperfomance compared with our benchmarks has been simply monstrous.
The S&P 500 decreased 14.17% in the same period, while the Third Avenue Value Fund has done even worse, losing 17.99%.

Probably we could exploit better the rebound after July 15th, but it's not our job to time the market, even less in the short time.
In any case, I think the warning I sent Friday 11th was fully actionable by those of you bold enough to overcome the desperation and the fear spreading in the markets at the time. That call should also warn you how dangerous can be to time the market: even if it was almost perfect (it was just one and half trading day early), that "almost" may very well be the difference between making a killing and praying to break even.
I bought PRK for our Banking Index at the close price of that Friday. Had I waited for the next Tuesday, closing the position I could show a gain just shy of 50%, instead of a measly 8,28%. The same I can say for the other bank picks of that Friday (still in the Index).

In any case, both the Banking and the Insurance Indexes have enjoyed a good bounce this month, above all the first. Its performance year to date (-3.74%) has been nothing short of exceptional, if you compare it with the financial index of S&P 500. A very good timing and a conservative attitude, not forgetting the soundness of the picks, has done the wonderful job. We took profit from the rally in the second part of this month to unload a couple of dogs.
The Insurance Index has been instead a bit disappointing, its performance year to date is the worst of all the five Indexes composing our Total Invested Capital, a real drain on our performance, but I'm quite confident in the goodness of the companies I've choosed and I'm sure that in time even their prices will reveal them for what they are: powerful free cash machines!
Many of you have questioned the rational of including the Banking and the Insurance Indexes in our Total Invested Capital, when we have been expecting this financial horror circling us today since the beginning of the past year (not at this magnitude, to be honest). The answer is once more that it's not our job to time the market. Our job has been to structure an optimal allocation for your capital in relation to the assets class and their weighting, and that allocation will be the standard for every time, not depending on fads and momentum and perceptions.
It's true that our performance this year would be much better without our Banking and Insurance Indexes, but believe me: five years from now we would regret not having them in our allocation. Moreover, we have enough flexibility inside our Indexes to manage the short and the medium term.
In our age of global fiat monetary system the banks sit at the right hand of the money creator, and partecipate in that creation; it would be really stupid to avoid an exposition to that kind of business (provided that you avoid the ruthless devourers of the shareholders and the scams).
The same for the insurance companies. In an inflationary environment, which is the inevitable consequence of a global fiat monetary system, that is the best business you can imagine. They get paid now to pay (maybe) claims after years and years (when the currency will be less worthy), and in the meanwhile they pocket juicy returns investing the money received upfront (unless you do funny things like AIG did).

Our worst performer this month has been the Currency Index, down almost 3%. It confirms its nature of counterbalance in relation to the other Indexes, and I am comfortable with that at the moment. It's anyway our best performer year to date, up 7.87%.

The Distressed Value 25 Index has not enjoyed the last bounce and it's down slightly on the month (-0.47%). A little disapponting. It's being curbed by the 3-4 picks which have not done what I was hoping for, and are showing terrible return. They are still in the Index because I have not lost the hope about their turnaround, and their weighting is so light they can't do much damage.
Our valuation method can't save us from the quicksands of guessing about the future of the business we analize and the market's reaction to that future, and sometimes we fall victim of a value that was just apparent. Antyway the Index is holding well enough a year really challenging for equity investments, and we are confident the businesses choosed are solid, well diversified and able to generate plenty of structural free cash flows through the ups and downs of the economic and credit cycles. I have always urged you to consider your equity holdings as a part of an enterprise you own, with the plus that you can sell or buy it in a blink if you decide to. In the next report, when all the 10Qs will be out, I will show you how much structural free cash those enterprises you co-own have generated.

The Top of the Shorts Index held its position this month, down 0.54%.
To be honest, we should talk about underperformance here. The Index is up only 5.32% year to date while the equity markets have been ravaged in the period. Shorting is not an easy task, and a very dangerous one too. It's the reason why I limit the allocation for this Index to just 5% of the Total Invested Capital, even in a year that I was sure to be very difficult for the equity markets.
Notwithstanding some very good return on a series of picks (closed or not), our two greatest positions have not yet delivered; opposite they are hurting us a lot. I'm resisting anyway, because I feel my valuation about them is not faulted, and in time the market will realize the absurdity to pay those obscene multiples for those businesses.
We had also to be more aggressive shorting financials, but you know, I hate extremism in every case.

Maedhros Currency Index 107,87 -2,99%(monthly return)
40% standard allocation
base 100 - 19 nov 2007 +7,87% (since inception return)
1° gen 2008 - 103,04 +4,69% (ytd return)

closed positions ytd: SDS +15,61% FXY +2,7% EVF -1,55% JGT -0,17%

Maedhros P&C Insurance Index 88,15 +3,33%(monthly return)
25% standard allocation
base 100 - 4 dic 2007 -11,85% (since inception return)
1° gen 2008 - 99,3 -11,23% (ytd return)

closed positions ytd: AFG +2,43%


Maedhros Distressed Value 25 Index 94,9 -0,47%(monthly return)
20% standard allocation
base 100 - 8 gen 2008 -5,1% (ytd and since inception return)

closed position ytd: TMA +16,47% NVR +27,68% EDS +49,23% EK -5,1% IMN +22,93%

Maedhros Banking Index 96,26 +9,61%(monthly return)
10% standard allocation
base 100 - 8 gen 2008 -3,74% (ytd and since inception return)

closed position ytd: MCBC +18,28% - CRBC -2,99% CHFC +6,04% MBWM -42,83% PRK +8,28% IBCP -21,44%

Maedhros Top of the Shorts Index 105,32 -0,54%(monthly return)
5% standard allocation
base 100 - 9 gen 2008 +5,32% (ytd and since inception return)

closed position ytd: ALNY +26,55% - AMZN +6,36% DSL +64,48% FAST +2,81% PNC +8,67%


Total Invested Capital 495,29 +0,16%(monthly return)
base 500 - 19 nov 2007 -0,94% (since inception return)
1° gen 2008 - 505,2  -1,96% (ytd return)

S&P 500                              -14,17% (ytd return)
Third Avenue Value Fund   -17,99% (ytd return)

NOTE - in US dollars, dividends & broker's fees included, taxes not included.


Let's now talk a little about some of the Indexes' actual components and the picks of this month.


Turning to the markets, as I've said, there's a real schizophrenia all over the place.
Nothing new, you know. There's always schizophrenia in the markets, from one side to the opposite and not necessarily in different moments.

To summarize, I submit to you two statements.
The first is from Mr. Dan Ferris, dated July 15th:

"In 2005 and 2006, zero FDIC-insured banks failed. In 2007, three failed, including NetBank, the largest failure in 14 years. IndyMac wasn't even on the FDIC's list of troubled banks. So how many other depository institutions would succumb to a run on deposits?

Well, I hate to sound absurd, but the honest answer is... all of them.

Virtually all of the couple hundred banks I've looked at over the past few months have liquid assets amounting to less than 40% of deposits. Most have around 30%."

It’s like Mr. Ferris would have warned us that if we fall in a big pot full of hot water we’d scald ourselves. It’s true, but absolutely superfluous, don’t you think?

It’s almost forty years that we live in a fiat-money regime, with a banking system operating through fractional reserve. The logical, necessary consequence of that is that WHATEVER bank in the world has not the liquidity to redeem all the deposits due should they be claimed all at once.

I really don’t see the meaning of such a warning. To spread unjustified fear does not help anybody, not even those ones who has followed the bizzarre advice to put all their wealth in gold and silver. Even if the actual monetary system would blow up, and you know I don’t think it’s possible, at least not for endogenous causes, those people would wake the day after just to make the bitter discovery that all that gold and silver does not belong to them, but to the strongest.

All the people talking about the inevitable demise of our fiat-money system, pointing to the outcome of every similar experiment in the past, miss badly a fundamental fact: for the first time in the mankind history, this fiat-money experiment is global. This means that for the first time the real money has been throwed completely out of the payments’ system, globally; for the first time, every fiat-currency compares and competes in that system just with other fiat-currency. They can easily survive this kind of comparison.

Today money is not a good anymore, it’s just a concept. And physical laws, as the unsustainibility of an endless expansion (of money and credit), does not apply to the conceptual world.

You can divide the value of what they still call “US Dollar” ad libitum without never reach zero.

Please refer to my precedent essays for a detailed explanation of my theories; the links are provided at the end of this report.

(incidentally, you can note that Mr. Ferris’ statement marked the exact low of the stock market, with the banks in particular starting probably their best rally ever)


The second statement came out more or less at the same time from the Chief of some governmental accounting office (I don’t remember the name and his exact qualification, sorry). It stated the cost for the government bail out of Fannie and Freddie to be approximately 25 billions of dollars.

The less we can say is that this guy has to be a real optimist!

Alas, I’m afraid that the cost for the taxpayers (rectius: for every dollars’ holder) will be much, much more. The very probable outcome will be an enormous pressure on the US dollar.

As you know from my alerts, by the lights of the recent development in the financial crisis, the Fannie and Freddie affaire, I have doubled my target price for gold: from 1650 to 3200 USD. About silver, I can’t come out with a price target; so I’ll just say that it will go bananas!

I know, most of the time the price targets are just numbers shot out, but hey....don’t dismiss so easily my price targets. In this piece of mine edited November 5th 2003, you could read this sentence: “Ma di una cosa sono sicuro: tra non molto, ci vorranno 1,6 usd per comprare 1 euro…”

(translation: “one thing for sure: after a few years you’ll need 1,6 usd to buy 1 euro….”)

That price target has been reached April 23th 2008.

I still consider Euroland the most balanced economic and financial bloc in the world, but I’m not using the euro this time to profit from the dollar’s demise. Maybe it will continue to increase its value against the US dollar, but the hedge for a financial crisis is not another fiat-currency. Moreover Europe’s economies will not be immune to the consequence of this crisis, and the last data have showed a deterioration in their commercial balances.


Broadly speaking, I think the risks are all to the downside for the equity markets. It’s another reason why I’ve been extremely prudent playing this bounce.

A point could be made that this crisis is tied just to the financial sector, as you can see in this graphic (dated July 28th):


But while I can admit that finance is not the economy, not even in a global fiat monetary system, you can’t dismiss the great importance that money creation and lending has for the economic cycle and the consumers’ ability to spend (and for the assets’ price inflation). The consumer is the weakest part of all the economic picture today. Not only he’s being chocked by the dramatic increase in the cost of living, he’s also losing the availability of inflated assets from which get extra money to stand still. At the same time the job market is rapidly deteriorating. Don’t be deluded from the gain in productivity; I have many reserves about the way it’s calculated in the US, and in any case that gain ultimately means less workers needed. Don’t be deluded from the apparent resilience of orders and spending; they are just a function of the week dollar and miscalculated CPI (and rebates). The weak dollar (i.e. the reckless monetization currently under way) is also the reason why the price of fundamental commodities as copper and oil stand high in front of a clearly deteriorating economic picture. Finally, even if without financials the S&P 500 earning are increasing at 12,1% yoy, that grow is anyway slowing.

To sum up, I think the consequences of the financial crisis are yet to fully reverberate in the economy, and my educated guess is that the equity markets’ prospect will stay dire for at least the next eighteen months.

To be sure, the July 15th low could very well be a good low for the equity markets in the short term. But the bounce has showed all the features of a bear market rally: fast, furious, forced covering. To be sustainable I think it needs at least to smell again that low; the best thing would be a little violation of that level with a clear divergence on the relative strenght, maybe helped by the low volumes guaranteed by August. In any case, I doubt that this rally could bring us prices much higher than those already seen in the fourth week of July. My educated guess is that the areas 3420-3470 on the Eurostoxx (the precedent low and the break down from a pluri-annual head and shoulder) and 1300-1325 will prove too strong a resistances for these financial markets.

Whatever the outcome, we’ll try to be ready.

Let’s now face some of the questions you arised in your e-mail. Please remember that I can’t answer to your mail personally but in a few cases; be sure anyway I read them all.

Some of you have complained that it needs to be a very wealth investor to replicate slavishly all our Indexes; too many stocks to buy at once. This is true. The least minimum capital you need to optimally follow our Indexes is around 150.000 USD, but you can manage it even with less if you use a discount brokers on line (1-2 $ for every trade); besides, while the stocks to buy at the beginning may be a lot, after that the turnover is very, very low.

For those who have limited capital to invest, my advice is always the same: choose some stocks from every Index and try to create just one synthetic index representative of the Total Invested Capital, respecting the allocation and the weightings. I know it’s not an easy task, but you can do it. I’ll try to help creating it myself, so you can expect a Total Invested Capital Synthetic Index in one or two months.

I was anyway aware of this problem since the very beginning, the reason why I’ve been testing another model portfolio to address the needs of small investors. I’m glad to tell you that after more than three quarters of testing I can confidently conclude it’s suitable to be presented to you.

Its name is Simpliciter, its inception date was October 2007 with a capital of 75.000 USD (but you can replicate it with any capital), and it contains a maximum of 15 stocks with a very low turnover. Its performance has been really satisfying. Since the inception it has lost 1.45% (but I’ve still not accounted for dividends, so I think it’s breaking even); in the same period, the S&P 500 has been massacred, decreasing 19.3%. An exceptional overperformance, notwithstanding FOUR picks absolutely disastrous (we’ll do better, I promise). It was helped by a gradual deployment of the capital. In the period we have closed (and replaced) just one position (one of the four dogs, we’re confident in better times for the others). So please welcome Simpliciter in our family from now on.


Another complain is in regard to the fact that my researches refer totally to US listed stocks, while a lot of you are Euroland investors. Even this is true, but you should be by then aware that we get anyway international exposition (both to stocks and currencies) through our Currency Index. The fact is that I’m specialized in US stocks, above all because of an extreme ease gathering their data, ease that I’m simply not able to get in relation to the rest of the world listed stocks.

I intend however to address also this need. Starting next month you’ll find another model portfolio dedicated to very compelling income opportunities I’m beginning to see in euro stocks, above all in Italy. It will have a capital of 25.000 euro (but again it’s usable with any capital), and it will be deployed gradually. Its name will be EuroIncome, and I especially recommend it for retirement purpose. I’m enough confident in its approach to do not require testing this time.

I have received some questions even in relation to our Launch Offer, to know if it’s still valid. The answer is yes! The first 1000 subscribers will be able to pay just 100 € or 140 USD (we discount the cost of the money transfer for non-EU residents) for five years of subscription to the service. We have not yet reached that number, so it’s still valid. The Launch Offer will expire in any case by this year end.

I conclude reiterating my advice to sell call against your stocks holding. While it’s possible you will forgive some gains (but in most cases you’ll be able to come back in the position soon after they call your stock), that kind of income will result in a formidable cushion (even 15-20% annual) against capital losses. In tough times even the best business can suffer.

Don’t forget, finally, that what you do with your money is your exclusive responsibility, as you’ll be the only one to enjoy or suffer for the consequences.

Many thanks for your attention.

Sul sistema monetario contemporaneo
(english version still not available, sorry - hope not italian speaking can understand it someway)

Economic Goods and Money as a Good
(italian version)

Older Essays

Pubblicato il 5/8/2008 alle 11.52 nella rubrica Finanza.

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