Fasanara Capital | Investment Outlook | November 4th 2013
“Learn how to see. Realize that everything connects to everything else.”
― Leonardo da Vinci
November 4th 2013
Fasanara Capital | Investment Outlook
We maintain our current investment strategy for renting the rally in equities, while
preparing for Japan-style volatility. Artificial markets are structurally fragile, artificial
markets are gapping markets. Stay long, but only tactically so. Stay fully hedged.
Starting with the US, the market may gap down, in sizeable amount of 20-30%,
consequence of the glowingly larger disconnect between asset values and
fundamentals, in an environment of excess complacency, dogmatic confidence in
central banks policies, excessive and unbearable levels of debt and leverage, low
volumes / low inventories.
As we suspect markets to now be positioned for QE infinity, we believe tapering is still
currently the most likely trigger for a sizeable market sell-off. Central Bankers will do
attempt to implement it, within the next six months, while escape velocity is still being
debated, taking markets on the back foot yet again
The market would look at a 5% correction as a huge buying opportunity. We contest
that as we believe a 5% can quickly become a 6%, 7% ,8% correction, and from there
can trigger more panic selling and margin calls to feed on its next sizeable leg down.
Strong-hands large holders would sell in significant amount only beyond such levels of
market correction, forcing more sell-off all across. A one-way market, absent the usual
shock absorbers of liquidity, volumes and dealers' inventories, is therefore the precise
price action we feel compelled to be hedged against.
In Europe, as the ECB intervention is no longer delayable, it may happen and
determine a weaker EUR and a catch-up rally into year-end for European stocks.
VALUE BOOK, remains light, but reloaded selectively:, as markets are toppy, still
expensive vs fundamentals, at risk of a steep correction. HEDGING BOOK, active:
short S&P, long Credit Curve Flatteners, Long Interbanking Spreads & Currency Pegs.
TACTICAL BOOK, expanding: long Europe vs US in equities (similarly to September
2012), long China-led stocks and commodity for short term reflation to continue, short
EUR vs USD.
Illusory Stability, Debatable Sustainability, Brace for Volatility by Q2 2014
This month, let us get started from the conclusions. We maintain our baseline investment policy
for renting the rally in financial assets, mainly equities, while preparing for Japan-style volatility
(CNBC Interview). A re-pricing in realized volatility is well overdue, and more so than a re-pricing of
the absolute level of asset values overall. As we argued last month, so we do now: artificial markets
are structurally fragile, artificial markets are gapping markets. Stay long, but only tactically so.
Stay fully hedged.
In the month just past, equities rallied to new highs on positive resolution to the Debt Ceiling /
Government Shutdown negotiations out of the US and signs of China resorting to the bad old habits
of liquidity injections. A week before, postponed Italian elections had cleared the sky in Europe.
Our recent tactical longs were instated on the grounds that, while markets are overdue a
correction, the debt ceiling showdown was hardly going to be the catalyst triggering it.
Similarly, we do not believe that the Government Shutdown discussions resuming in December, nor
the Debt Ceiling in February, have the full potential to provoke a serious re-pricing. The same threat
repeated for the third time, may not be able to trigger a different result than the previous times over.
We suspect we will be consensus here, limiting the scope for valuable opportunities next time
Our conviction that the market may gap down, in sizeable amount of 20-30%, is rather a
consequence of the glowingly larger disconnect between asset values and fundamentals, in an
environment of excess complacency, dogmatic confidence in central banks policies, excessive
and unbearable levels of debt and leverage, low volumes / low inventories.
Starting from perilous levels of complacency in the markets, we cannot but suspect that such
investors who have been left behind October's rally may be the target of derision, on charges of
excessive prudence. A diffidence they may be feeling since the beginning of the year, if not longer
within the last 4 years. We have seen market participants giving up on their bearish convictions in
recent past, as the market can be irrational for longer than they can stay solvent, particularly
when confronted with severe monthly NAVs and mark-to-markets. New highs in the market were
then conquered, also owing to such investors dropping the towel on recent market advances and
starting to ‘rationalize’ current valuations.
However, valuations are indeed over stretched, by any objective measures. We will briefly review
a few valuation metrics before moving on.
Valuations in Stratosphere
P/E multiples are only acceptable when calculated against 70-year highs in corporate earnings
momentum. To us, that is the bubble within the bubble, brought in the house by zero-interest rate
policies and large fiscal deficits. Absent that, earnings would not be in stratosphere. We believe that
corporate earnings are toppish, temporary in nature, and not the basis for further
As we move to cyclically-adjusted earnings, taking the averages of the last ten years, Shiller’s P/E (or
CAPE ratio) stands now at staggering 25x. Hardly such overvaluation has gone by in the past
century without a market collapse of some magnitude down the line.
Also valuation-wise, looking through the lens of price-to-sales ratios (or P/S) of 1.57, we stand at
levels the most distant from historical averages.
More worryingly then, as earnings are already toppy, we observe that portfolio attribution for
market advances of the last two years is to be 80-90 % linked to P/E multiple expansion, not
even earnings growth.
To the same token, Doug Kass notes that, since 1990, the P/E multiple of the S&P 500 has
appreciated by about 2% a year; in 2013, the S&P's P/E has increased by 18%.
When looking at leverage, using updated NYSE data points, we also stand comfortably in bubble
territory: in September we crossed $400bn in borrowed money on the NYSE, to build more longs
than otherwise achievable. True, as some investors point us to notice, we should not read so much
in such numbers as tax considerations too affect the decision-making over leverage. Still, we think
the scope for margin calls on a falling market is there and makes for a powerful accelerator of
Why then are valuations where they are?
As always, we have to test our convictions against incoming data and price action, which leads us to
have to have a tentative answer to the following questions: if valuations are stretched on historicals,
with growth sluggish at best, why then are we reaching yet new highs? If the ice is to thin, why do
investors keep skating on it with stubborn resilience? Is it one for positive falsification to our market
theory, thus demanding a change in course for our investment strategy?
As a starter, it should be noted that market resilience is a recurring connotation of market tops,
historically. It is typical for markets to show resilience on toppy markets on the verge of collapse.
This should come as no surprise, as it is part of the process, landing markets to false beliefs. That
was true in 1987, 2000 and 2007, amongst others, when it took several months for the market to
nose-dive. So we should not read too much into the current resilience of the market itself.
Valuations can be so high as a consequence of one of three forces, in our eyes:
Rosy prospects for a strong rebound in GDP growth come 2014. A populated camp,
although not the most populated one in our eyes
Investors quest for real assets vs cash, in fight for survival over debased currencies.
This is probably why we are long ourselves, as we call for elusive nominal rally (not a real
one) in the markets and the need for hedging it out of its fake context. Not so much of a
real rally left, when adjusted for shadow inflation and currency debasement. However, if
Gold’s weakness is any guide, we estimate this camp too to be otherwise quite empty, at
Quantitative easing, or the perception of it, directly impacting asset values.
While this is very much of an untested theory, waiting for history to judge its real causality,
we suspect most of the market is in this camp. The perception of the market is that QE
magically equates to a floor to asset prices, in perpetuity. Such floor is being raised again
and again, at every coughing up of the markets, for 4 years in a row now. Its repeated
forceful application helped it become conventional wisdom. We suspect this to be the most
Now then, as we measure our convictions against market expectations, so as to understand if there is
a market opportunity out for grabs, we will assume QE being the sole driver of market positioning,
and assess from there the potential for a steep market correction in the months ahead.
When does a re-pricing may occur in the near term?
The trigger for a potential gap down may be provided by one of the following elements:
4) Disconnect to fundamentals reaching unsustainable gap, demanding a sudden correction
5) Exogenous factors: government shutdown, debt ceiling, war, unexpected oil shock,
unexpected failures (a’ la Detroit), EM-led bond crisis
As we suspect markets to be positioned for QE infinity, we do believe tapering is still currently
the most likely trigger for a sizeable market sell-off. As we argued last month (October Outlook),
we expect that Central Bankers will do attempt to implement it, within the next six months,
while escape velocity is still being debated, taking markets on the back foot yet again (for the
4th time this year).
Tapering may take place under the interplay of three main factors:
As QE effectiveness is increasingly questioned in failing to help the real economy, while
its diminishing returns are visible even on financial assets
As the FED may feel less of a motivation to fill the gap on fiscal consolidation. Should
government shutdown/debt ceiling be sorted out, as sequestration and fiscal cliff are past
us, as the deficit itself returned on check. Under the general feeling that fiscal policy will
play a greater role going forward in the US.
As the FED acknowledges that the prospects of more accommodative policies come as
the market anticipates a weaker economic outlook, thus inherently undermining its
effectiveness. Because, in such an instance, the rationale is weak for investments in neither
machinery (capex), nor hiring people (employment). Leaving instead the camp free for just
the unintentional consequence of mis-allocating capital across time (manipulation of
rates) and across countries (manipulation of currencies).
Within tapering, needless to say, we see the biggest stress factor being represented by higher
interest rates (nominal and real). We expect to see nominal 3% again on 10-year Treasuries soon
While tapering is our best guess, at present, other factors can easily play a role. Artificial
markets, disconnected to fundamentals, are structurally fragile, for any one exogenous factor
can legitimately take them down.
Regrettably, it is impossible to call the day, the month, or even the quarter in a reality-check
correction may take place. Policymakers can indeed buy more time. Money printing might still be in
its early days, despite evident diminishing returns (tending to zero). For all intents and purposes, we
are left to rely on a sustainable multi-dimensional risk management policy, intended to keep the
guard high for long enough, being able to finance the renewal of market protection strategies for the
quarters to come.
Volatility to Resurface
But there is an element of the current markets more unjustified and well overdue an inflection point:
realised volatility. On this basis, more than we contest the absolute levels the market is trading at,
we do contest the smooth linear interpolation it got there with.
In the absence of real economic growth, liquidity-induced rallies are to show liquidity-induced
volatility and sell-offs, sooner or later.
This is where we differ the most from market consensus. In the widespread feeling for the
'bondification' of equity we see the key vulnerability of the markets.
Investors expecting equities to behave like bonds, showing low realized volatility and pull to
par/infinity, are likely to be disappointed at some point down the road, leaving on the table most of
their earlier gains.
Beware of blue-sky markets where the only price they are prepared to pay for uncertainty is a
slowdown of the rally (Bloomberg interview).
Most market participants expect low volatility, as the VIX index points to too. Confidence in the
Central Bank follows smoothly in compressing risk premia to unsustainable levels. As such, most
market participant stand ready to buy on dips. How we look at such dips is how much we diverge
from market consensus.
The market would look at a 5% correction as a huge buying opportunity. We contest that as we
believe a 5% can quickly become a 6%, 7% ,8% correction, and from there can trigger more panic
selling and margin calls to feed on its next sizeable leg down.
Strong-hands large holders would sell in significant amount only beyond such levels of market
correction, forcing more sell-off all across.
Gold's demise this year has shown us all how the market winners can quickly turn into market losers,
as the tide changes fast, with little respect for flawed conventional wisdom. A one way road market,
absent the usual shock absorbers of liquidity, volumes, and dealers' inventories, with VARshocks and digital adjustment to the downside fuelled by margin calls hitting at right the worst
possible time, are therefore the precise price action we feel compelled to be hedged against.
Such is our positioning through our programs for Fat Tail Risk Hedging (FTRHPs). Our multidimensional risk management policy, is intended to keep the guard high for long enough, being
able to finance the renewal of market protection strategies for the quarters to come.
Long-Term View for the US
If we are right about the lack of economic growth remaining the elephant in the room, then after
tapering lies more Quantitative Easing. Perhaps, the new entry monetary tool of 2014 will be
Nominal GDP Targeting (NGDP). Which means by then the sea level of asset prices will be
stepped up once again. Visible inflation is better than stagflation.
Fast-Forward there, and inflation might look less of a prehistoric fossil than it looks today. Fastforward there, and Gold could have its day again, within 2014.
As we argued earlier on in this Outlook, we do feel aligned with that camp who looks at equity as
more defensive than bonds in a world of debt monetization and currency debasement. Especially
so, once proper hedging strategies are there to sustain the volatility that equities inevitably carry
over inside portfolios.
Not all equity, obviously, as some industries, and within those industries some players in particular,
are better able to withstand an inflationary environment. Wherever balance sheet has been taken
out already, while a market leading position commands pricing power, is where we focus our
attention. More specifically, a stagflation scenario is the one against which we map out our stock
Somehow counter-intuitively, what might trigger NGDP targeting is the confirmation that the
lack of economic growth is indeed the elephant in the room.
While excessive levels of debt have drained resources from productive private investments away into
debt services payment, as the excess debt has failed to create the income sources required to service
such debt, GDP is gripped down by QE policies themselves, in vicious unintended dynamics.
Critically also, the contribution to US growth of interest-rate sensitive segments of the economy is to
be downgraded: housing locally, emerging markets abroad.
Undeniably, debt is too large for QE to have an easy transmission system to the real economy
(interesting research). Still, QE might still look the only way out of trouble, as inflating out of the
debt overhang is preferable to be suffocated by it. It is not so much about the medicine, but
rather about the doses of such medicine for intake.
On our roadmap for debt and deleverage, Japan is the leading indicator of choice. After
unsuccessfully fighting over deflation for the better part of the last 20 years within conventional
policy tools, Japan has resorted to all-out unconventional actions, flooding the economy with
paper money, in a desperate attempt to achieve Debt Monetization through Currency
Debasement: ‘fight like a samurai, or die as a kamikaze’, we called their strategy a while ago.
The level for indebtedness above which such way out of trouble is considered the best relative
choice available may be public and private debt at 250% of GDP. Many countries are there already:
Japan led the way, making it with just public debt, but the US is above the threshold too.
The alternative strategy of cleaning up balance sheet via haircuts/restructurings seems less palatable
to political elites affected by populism and 'short-termism'. It is not for us to judge one way or
another, but we should rather limit ourselves to draw possible scenarios, attach probabilities to
them, and structuring the portfolio accordingly.
By then, inflation may turn out to be less a ghost than it looks today. Wage pressures have
already kicked off in the US, while ignored by monetary authorities who for the first time in decades
dis-attended the so-called ‘Taylor rule’ (rate actions had always followed an early rise in wages in the
past, preemptively, almost mechanically).
On the other hand, the weak global cycle, the shale gas revolution, the humiliation of Gold, made
demand for oil and other commodities weaker in 2013, thus mitigating the inflation threat to date.
But the loser asset classes of 2013 could well turn out to be the winners in 2014-2015, should our
expectation for a stagflation-type economy materialize by then. Don't call them out too early.
Trading around Draghi’s next moves
As we argued in previous Outlooks, we knew we needed to be patient for our bearish view on the
EUR to materialise. That moment may have come. On Thursday the ECB meets and one of few
measures could be delivered:
New cheaper LTRO: although with Germany's coalition not finalised yet (despite Merkel
undisputed leadership) a new LTRO might still be premature at this Thursday's meeting. An
LTRO would favour banks the most, serving as a recapitalization tool in disguise, while
calling for banks to simultaneously strengthen their capital position through new wave
Refi rate or Depo rate cut. This intervention is less favourable to banks, as it further curtails
their profitability: many banks in peripheral Europe achieve better margins by spreading the
rate on deposits. By lowering the rate to the zero bound further, any spreading is further
compromised. In contrast, cutting rates have a direct effect on weakening the EUR, and
possibly encouraging/forcing risk taking too.
We are currently short the EUR vs the USD, with outright positions opened the minute after
Bernanke's minutes last week.
Should the EUR trade already at 1.33 to the USD the moments before Draghi on
Thursday, we may determine to take early profits, on expectations that the EURUSD
may have run a bit ahead of itself. After all, Draghi's intervention has now become
consensus, and a disappointment could drive it fast back to 1.40 territory, where the same
short position can be re-instated.
Should it not, we are likely to keep the shorts in place.
Overall, we expect more catch up rally in European equities into year end and relative over
performance vs US equities.
None of this is to say that we agree with the consensus, when it sees more accommodative ECB
policies, lesser pressures on government bonds and funding markets and softer fiscal adjustments as
the reasons for a structural shift in sentiment in Europe. As we repeated ad nauseam, we believe the
EUR construct if structurally flawed and set for implosion in the few years ahead. Looking
through real GDP per capita massive losses in peripheral Europe, un-recoupable unemployment,
perilous youth unemployment on the rise, we cannot but confirm our bleak assessment for the
medium- and long-term.
But we are positive in the short-term. In contrast to the consensus, the two driving factors in our
assessment of the European situation for the next few months are as follows:
As Italian elections have been postponed, while we do not value the recent threat of
instability by Berlusconi's party at more than noise (differently than last time around, as new
elections in Italy would have set in motion a chain effect leading to a potential restructuring
of Italy within months). The same break-up of the Berlusconi's party may come as a blessing
in disguise in the short term, to the markets. Again, we see elections only postponed, at
best, but that alone should be enough for markets to have upside from here in the short
As Europe does not live of much life of its own these days, as the fact that it does not stand a
chance to a brighter future is discounted by most market participants, the potential upside
from here can depressingly be attributed to no more than the lack of imminent catalysts to
Until long-term trends resume their grip, tipping the balance once again in the direction of a
most possible EUR break-up.
As Draghi's intervention is now difficult to postpone further. Excess liquidity in the
banking system is now below Eur 200 bn, leading to upside pressures on short term rates
and an appreciating EUR. The strong EUR is visibly unacceptable to Europe, Germany
included. Europe is the only player who has not yet joined the global currency debasement
race in progress over the last few years. Actually, Europe rowed in the opposite direction,
with the self-inflicted pain of an ECB's balance sheet compressing by some Eur 500 bn in 12
months. As such, the EUR appreciated against every other notable currencies the world
over, as they pursued aggressive currency debasement through domestic policies (rate cuts
and QE-type policies) and direct FX intervention (amassing massive FX reserves). Not just
the usual suspects of the US and Japan, but also Australia, Denmark, Switzerland, even
Norway! Countries who should command a stronger currency on many fronts: better GDP
prospects, standing a better chance of survival, better recovery ratios, better everything.
As the ECB intervention is no longer delayable, it may happen and drive a catch-up rally into year
end. We are positioned for such event to take place.
Japan & China: interesting months ahead
Again, we do not have enough space here to discuss Japan and China. We aim to discuss more on
them at the next investor presentation, on the 21 of November.
Suffice it to say, that China is opening this month its Third Plenary Session of the 18 Chinese
Communist Party Central Committee. Back in 1978 and 1993 (but not so much in 2003), such event
proved to be pivotal in shaping China’s future for the years to come. President Xi may be trying to do
the same again, delivering bold talks and programmatic intents, if not bold reforms and actions.
Needless to say, one event to watch most carefully.
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During the latest Investor Presentation, we provided examples of positions over the 3 books in our
portfolio (Artificial Markets are Structurally Fragile | Investors Presentation | 19th September 2013).
Remains light, as we see a risk of
10%+ correction over the medium
We recently piled up a few
opportunities here, after profit
warning drove prices down on
selected stocks on our radar.
In absence of sustainable carry
generation in the Value Book
Tactical Long EuroStoxx –
also vs US - postponed ITA
Tactical Long single stocks
linked to EMs / Commodities
- catch up theme
L / S positions
This is where we see MOST
Short S&P, vanilla and
Long Credit Curve
Long Inter-banking spreads
/ currency pegs
At present, our Value Book remains pretty flat, as markets remains toppy, still too expensive vs
fundamentals, especially now that rates may be on the rise and the Central Bank support shows
the first cracks. Our current small allocation to longs in the Value Book is filled with select Special
Sits which still offer asymmetric returns vs risks in our eyes. We will change our bearish positioning
once the disconnect between the real world and financial markets tighten from here, as a
consequence of market correcting further or fundamentals improving (we remain skeptical on real
growth recovery, as argued extensively, but will remain open-minded as the situation develops and
more data come in). Also, we will change that stance if markets move side-ways for long enough
(which is just another way to digest their expensiveness, arithmetically equivalent in real terms
to a declining market if inflation is above zero). As argued last month already, we have been in
bubble markets similar to the current ones multiple times in history: 1) the Credit markets are all too
remindful of 2007 (at that time it was Investment Banks inflating the bubble through leverage, this
time it is Central Banks themselves, with obviously more margin for error, but not infinitively so). 2)
The Equity markets, the Mothership US in primis, are remindful of conditions we have seen already in
2007, but also in 2000, 1987, 1929, all followed by market crashes
We like tactical longs in Europe at present, fully hedged via shorts in the US. This is a tactical
position, which we expect to hold into possibly year end. Such view is independent from debt
ceiling discussions, as we expected them to have an eleventh hour fix. Such positioning follows
delayed Italian election, and Greece /portugal issues to arise with a time lag, thus leading to false
calm in the markets, and possibly an LTRO/rate cut by the ECB, weaker euro.
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Longer term, no change in views to this day: we maintain our bearish bias in Europe, for we expect
the crisis to flare up again and the EUR-peg to be dismantled down the line. In the same vein,
hedging overlay strategies via cheap optionality and positive carry formats are to be held
throughout the period.
Elsewhere in the Tactical Book, we look at China, and the impact of short-term push into fixed
investment-led growth all over again. While not sustainable, it is not to be underestimated for the
short-term. We look at beneficiaries of such flows, tactically for the short-term, before implosion few
months from now. Commodity stocks who fell out of favour with the market to levels where a
temporary catch up reflation looks possible.
Regrettably, it is impossible to call the day, the month, or even the quarter in a reality-check
correction may take place. Policymakers can indeed buy more time. Money printing might still
be in its early days, despite evident diminishing returns (tending to zero). For all intents and
purposes, we are left to rely on a sustainable multi-dimensional risk management policy,
intended to keep the guard high for long enough, being able to finance the renewal of market
protection strategies for the quarters to come.
At present, our task is made the most difficult as we have no significant carry generation within
the Value Book to rely upon in financing the cost of the hedging strategies. Ever since May, and
differently than in the last two years, we decided to keep the Value Book flat-ish, as carry strategies
would be exposed to digital downside risks in both equity and credit asset classes. When adjusted for
real risks, as opposed to deceptive historical vols, such carry strategies are a clear pass.
Consequently, the ability to fund and roll hedges and keep them alive for long enough will be the
key determinant of our ability to live to produce strong returns in the medium term.
We will offer an update on the portfolio to existing and potential investors during our Bi-Monthly
Outlook Presentation on the 21 of November in 55 Grosvenor street, London, where supporting
Charts & Data will also be displayed. Please do get in touch if you wish to participate.
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What I liked this month
Bubbles, Bubbles Everywhere. Mauldin Economics. Read
Southern Europe is on a precipice Read
JP Morgan sees 'most extreme excess' of global liquidity ever Read
Fasanara Capital recent interview with Bloomberg: Bloomberg interview
Code Red, written by John Mauldin, explains quantitative easing, zero interest rate policies, money
printing, financial repression, rising inflation and currency wars Book
China as a Superpower Read
Abundance is our future, Peter Diamandis Video
CEO & CIO of Fasanara Capital ltd
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