EARLY LOOK: Red Light Risk

// January 29th, 2010 // Keith

“As investors, we can’t change the course of events, but we can attempt to protect capital in the face of foreseeable risks.”
-David Einhorn

Admittedly, when “bottom’s up” hedge fund manager David Einhorn proclaimed his new macro mystery of investing faith at the ‘Value Investing Congress’ on October 19, 2009, I was smiling. Our Hedgeyes call this proactively managing macro risk and I do support Mr. Einhorn’s message.

Einhorn and I are about the same age. We both grew up in a hedge fund bubble. For a decade, we were probably both overpaid. He still runs money and I run my mouth, so I am thinking that he’s probably worth a lot more than me. But what does that mean?

To some in this business, that means a lot. To others, it means nothing at all. We all wake up early every morning with a passion to play this game. David’s Greenlight Capital now has its macro views. I have mine. Game on.

The global macro risk manager’s job in this business is to acknowledge amber flashing lights, before they go red. It’s also being keenly aware of when one of your big “ideas” is everyone else’s too. Measuring consensus is part of any repeatable Red Light Risk Management process.

Embedded in our macro risk management process are 3 dominating Global Macro Themes. We change them quarterly, because the math changes daily. As a reminder, my team’s current Macro Themes for Q1 of 2010 are:

1. Buck Breakout (bullish on the US Dollar; bearish on gold)

2. Rate Run-up (bearish on government bonds)

3. Chinese Ox In A Box (bearish on Chinese equities; bullish on Chinese currency)

I do not know what Einhorn thinks on Macro Themes 2 and 3 but, now that he does macro, he obviously better have a view. That said, I do know that he stands on the other side of me with regards to both the US Dollar and Gold.

In that same speech, Einhorn made the following conclusions about gold:

1. “Of course, gold should do very well if there is a sovereign debt default or currency crisis.”

2. “I subscribed to Warren Buffett’s old criticism that gold just sits there with no yield and viewed gold’s long term value as difficult to assess.”

3. “Gold does well when monetary and fiscal policies are poor and does poorly when they are sensible.”

After being bullish on gold since 2003, and vehemently bearish on what I labeled the “Burning Buck” in early 2009, I do think I have the credibility associated with understanding the bearish dollar/bullish gold case. There are many aspects to Einhorn’s conclusions that I agree with, but not at every price and every duration.

Now, if you really want to manage Red Light Risk in global macro, you better manage those two things dynamically – price and duration. I have written about this before, but it’s worth mentioning again. Duration Mismatch is one of the top 3 risks that has hurt me over the course of my risk management career. We need to monitor it systematically and measure it scientifically.

Back to Einhorn’s points on gold. On an immediate (TRADE) to intermediate term (TREND) duration (3 weeks to 3 months), gold has not done well in the face of sovereign debt default risks rising. Now maybe he meant a sovereign debt default crisis in the USA and, to be fair, we should give him the benefit of the doubt until he replies to this. But, so far, with CDS (credit default swaps) in Greece blowing out to 414 basis points last night, gold is still going down.

Gold is going down because I am right on the Buck Breakout. Yes, as Mr. Buffet pointed out to David way back when, there are many risks embedded in evaluating the gold price. But those difficulties work both ways! Today, in terms of measuring the risks of being long gold, the r-square is highest relative to up moves in the US Dollar.

Managing Red Light Risk is just that. You have to accept that there are many types of investors telling many different types of qualitative stories about what it is that they are bullish on. You also have to accept that Mr. Macro Market’s math will rule the day over all the storytelling.

This morning the US Dollar is making a 5 month-high at $78.94. Gold is trading down another -1% for the week to-date at $1083/oz. I am long the US Dollar and short Gold via the UUP and GLD etfs, respectively, and I have a zero percent allocation in our Asset Allocation Model to Commodities.

The long term TAIL of resistance for the US Dollar Index is up at $80.21, and I think it’s going to test that line this year. My long term TAIL line of support for the gold price is down at $997/oz. That’s another -8% of Red Light “foreseeable risk” that these Hedgeyes are calling out for you Mr. Einhorn. Welcome to the game of proactively managing macro risk. It’s a full contact sport.

Best of luck out there today,
KM