Trade Idea | A Compelling Contingent Trade

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Elevator pitch: What if I told you there was a trade that would hedge your whole book to a Chinese correction AND had the idiosyncratic risks that suggests it probably may just make 7x anyway… Would that be something you’re interested in!?! 

Introduction: Forgive me for doing the Hugh Hendry to kick off, but I get a buzz out of this idea. The following piece is on FMG AU, the Western Australian miner who’s HQ I live adjacent to in Perth, Western Australia. Previously, I wrote a post on FMG here in 2012, I had been bearish iron ore for a while and the strategy worked out well. If the success of that early trade is anything to go by, then this could be a cracker. Forgive the mediocre quality of analysis, at the time I was very green and still working out my process.
I am an extremely average salesperson, but I think my grasp of logic and reason make up for it… So now that I’ve given you the sales pitch, let me indulge you with the analysis!

Hypothesis: Due to the comprehensively low volatility environment we find ourselves in, idiosyncratic opportunities are significantly mispriced. To invert the old adage, the receding tide runs all boats aground!

First Principle: Our first principle, or presupposition if you will, is that iron ore is the first derivative of China’s economy. Thus, following this logic, the companies most levered to iron ore will be the best expressions of the thesis. So the logic goes like this… If China’s economy rolls over, then iron ore will fall and FMG AU will be impacted most adversely.

Fundamental Macro Context: Presently, market participants and geopolitical analysts are parsing the words of President Xi’s speech at the 19th National Congress of the Communist Party of China, looking for hints of what the future holds for China. Some seem to think that now Xi is so well entrenched that he may be confident enough to take the risk to delever the economy. I am completely agnostic, as I have no predicitive function in that analysis. In fact I am ambivalent to the growth prospects of China.

What do concern me are the probabilities, and in the following analytical framework I hope to lay out the reasons for my conclusions as to what the risk reward proposition is, the probabilities and why this is a positive expected value trade.

Fundamental Equity Context: It’s simple, FMG is the most financially and operationally levered stock to the iron ore price. Principally, because the quality of their ore is not 62%Fe and thus, they likely have to pay penalties over and above.

As you can see in the below chart, FMG is the most financially levered to an iron ore price drop with a cost of production of USD ~ $57/t, whilst they are also the most operationally levered with a cumulative seaborne iron ore production somewhere close to 1300mt.

CHART 1: Iron Ore Miners Cost of Production & Cumulative Production

Commodity Context: Iron ore is still within the grips of a long term bear market, one which I was able to correctly anticipate back in 2010. Relief since the late 2105 bottom has been a function of Chinese stimulus, which seemed to directly flow into commodity prices by way of construction and thus steel production. Indeed, it’s only reasonable to expect the causality to flow the other way.

CHART 2: Iron Ore Weekly Price Chart

Equity Context: Since that bottom, FMG has meaningfully outpaced iron ore, as a function of its leverage.

CHART 3: FMG (blue) vs Iron Ore (orange) Normalised as at Jan 2016

Intermarket Analysis: Similarly, FMG has also outpaced its Australian peers with much lower cost profiles RIO & BHP. Both have only managed to outperform the commodity marginally.

CHART 4: FMG (blue), Iron Ore (orange), RIO (light orange), BHP (yellow) Normalised as at Jan 2016

Technical Analysis: FMG is forming a top-like pattern with $4.50 looming as the support. Classical pattern traders might call it a head and shoulders with a sloping neckline, but typically, what is the most obvious is best. Presumably, the reasoning for such a level being meaningful is that new longs will likely look to cover as new lows set in and a new trend takes force. Whilst technicals would logically seem to have unreliable claims upon reason, the other reliable method of understanding reality — experience — suggests otherwise. Thus, I hypothesise that objective and intersubjective technical methods work because humans are prone to patternicity and other type 2 errors, and so they become self-fulfilling. With respect to the below chart, support is indicated by the red horizontal range, if breached, the propensity for sustained selling is likely.

CHART 5: FMG Technical Support

Historical Mean: Further, as we look back at a monthly price chart, we can see that $4.50 is roughly the mean of the volume at price historical distribution on the left axis.

CHART 6: FMG Monthly

Bimodal Distribution: Zooming in once more to the fortnightly price chart, we can see the bimodal nature of historical prices on the left axis, which should arguably suggest that FMG is unlikely to have normally distributed price action in the future. Thus, an option seller using a model which prices options off a normal probability distribution will more than likely be misled, if the future looks anything like the past.

CHART 7: FMG Fortnightly

Implied Volatility: Which leads us to FMG’s implied volatility. Yesterday, when I clipped this chart, FMG’s implied vol was in the 6th percentile over 10 years at 30.46. Albeit, that percentile data might be slightly skewed given the single low data point in 2009 of 13.92 is wrong. Further, over the last 5 years, FMG’s implied vol is in the 3rd percentile of observations.

CHART 8: A Decade of Implied Volatility Data

Realised Volatility: Arguably, this is anomalous, and doesn’t comport with the facts presented here. But why has it happened? This opportunity exists for two different kinds of reflexive reasons: behavioural and mechanistic. Behaviourally, implied volatility tends to follow realised due to recency bias, which is the tendency to overweight recent data. Mechnistically, implied volatility tends to follow realised volatility, this is because options buyers delta hedge according to daily or weekly moves and are unwilling to buy and bid up implieds if there’s no volatility to realise. Together, they can form a self-reinforcing virtuous cycle that otherwise is referred to as reflexivity. With this in mind, it is unsurprising then, that FMG’s realised vol is particularly low, around 1 standard deviation below the mean of historical vols.

CHART 9: Realised Volatility:

Key: -1σ (green line), mean (green dotted line), 1σ 2σ 3σ (red dashed line)

Implied vs Realised: Looking at the last 40 months of data in interactive brokers, we can see that at 29.6% implied is presently significantly below the 200 day realised vol of 41.3%… Which had been as high as 67.8% in May 2016!

CHART 10: Implied (white), 30d Realised (orange), 200d Realised (purple)

Skew:  Volatility skew shows the difference between implied volatilities of options against their moneyness – how in or out of the money they are.

It can suggest a few things:

  1. Volatility Smile – shows that out-of-the-money volatility is higher than in-the-money volatility.
  2. Volatility Skew – shows that puts are cheaper than calls or vice-versa, and thus, suggests where the options market is hedging directionally.

For the December skew below, we can see that calls are priced relatively cheap vis a vis puts, which may allude to the options market’s estimate of directional risk.

CHART 11: December Skew

Volatility Timing  Model:

I made a volatility timing model to signal alerts when certain conditions are met and it is a favourable environment to get long vol. It is difficult to test its empirical reliability due to lack of options data, because I don’t yet know how to layer it onto bloomberg data… Nevertheless, it’s was what alerted me to this trade recently, so its job is done!

CHART 12: Long Vol Statistical Timing Model

Expressions: There are various ways to express this trade, here are some…

  1. Short the stock outright and keep an eye on iron ore as one’s guide.
    Sizing: I wouldn’t size much more than 250bps of one’s book.
    Stop: $5.49.
    Target: $1.50.
    Risk/Reward: ~5x.
  2. Buy 3m FMG strangle @ 105% & 95% moneyness and roll quarterly.
    Delta hedging: it’s path dependent, so hedge accordingly.
    Backtest: With a 50% win/loss ratio and a positive equity curve (without hedging), it’s arguably safe to assume that entering at these vols will suggest a higher probability of gains

  3. Buy June expiry $4 puts for $0.27
    Originally, I priced this up as a $4/$2 put spread, but cheapening it with the put leg at 2c is almost pointless… I’d rather buy it for 2c! The r/r of the put spread was up to 7x, to give some idea.
    Pricing:

    Return Profile:

  4. Buy 9m OTM $2 puts
    Theoretically, they cost 2c!?!

And that’s my two cents!
Regards,
Prometheus


If you made it this far, thank you for reading.

Support: To see my trades and ideas in real time, sign up to follow me via Premo Social.  Alternatively, please support me on Patreon if you find my essays and trade ideas of value, I only write publicly infrequently about my highest conviction ideas, so support per post might encourage me to dig a bit harder!

Disclaimer: Please read the disclaimer on this site.

The Common Law Premium | Buying the Pound Sterling

Dear readers, below is a piece that went out to members and friends of Prometheus Macro Research on the 12th of February. We hope you find it informative. Note that although the trade’s horizon is multi-year, we take into account some shorter-term considerations such as positioning and sentiment, for the purposes of developing a compelling argument for action, as well as to attempt to gain an additional edge from timing.


Universally, markets tend to ascribe a greater risk premium to political uncertainty than they will to its antithesis. So, perhaps there is a subtle irony that I would develop a compelling argument for action on the long side, coincident to the announcement that the British Parliament has authorised Prime Minister May to begin the process of invoking Article 50 of the Lisbon Treaty. A consequence of the vote to leave the European Union succeeding in the referendum on the 23rd of June 2016. A vote which left the freshly minted portmanteau ‘Brexit’, indelibly imprinted upon the popular lexicon.

BEHAVIOURAL CONTEXT

I’ve written before about the implications of ideology in speculative and investment decision making in Biases in Trading, where I made the case that through an evolutionary tendency toward emotional reasoning and various other fallacies and biases, people are predisposed to mistakes when making trading decisions according to their underlying political ideology. Indeed, perhaps this is why I didn’t fully exploit the fall in the Sterling whilst I was confident the ‘leave’ vote would prevail. A lesson which reminds me to focus on expected value and the potential asymmetries of political outcomes.

Politically, I leant toward Brexit, yet I didn’t appreciate that the outcome of its triumph would be so significant in the Pound over the short-term. Nevertheless, with new information and the iconoclastic tendency to question ideas that to others might be sacrosanct; I am inclined to face the other way. As the politics of Britain leaving the European Union has unravelled, it has appeared to me the emotional fervour has been distinctly in the Remain camp. Thus, I contend it is rational to diverge from the crowd amidst this cynical frenzy, and instead embrace an opportunity.

FUNDAMENTAL­ CONTEXT

Let us consider, that to the many people around the world living in countries with a less well-entrenched rule of law – if at all – that presently the Pound represents an opportunity to buy a share in the common-law system at a steep discount. The assurance of the common law system, as well as the land rights and other liberties which come with it, is a significant factor in the robustness of the world’s most successful commercial economies. Similarly, as opposed to its counterparts in customary and religious law, common law underpins the geopolitical position of the countries who employ it, by attracting capital.

IMAGE 1: LEGAL SYSTEMS OF THE WORLD
1
Source: https://en.wikipedia.org/wiki/Common_law

It is no surprise then, that the 16% drop in the ‘cable’ since ‘Brexit’, puts the currency in value territory against the dollar on a Purchasing Power Parity (PPP) basis; as evidenced in the chart below provided by one of our members at The Macro Trader.

CHART 1: GBPUSD PPP Valuation with 20% Bands
2

HYPOTHESIS & TIME HORIZON

Given our behavioural, statistical and technical reasoning, then temporally speaking the British Pound is likely to be near a multi-year cyclical bottom.

TECHNICALS

The British Pound trade-weighted index is approximately in the 3rd percentile of observations over the past 17 years as evidenced below.

 CHART 2: STERLING TRADE-WEIGHTED INDEX (TWI BPSP Index)
3

Whilst, the BOE Calculated Effective Exchange Rates UK Broad Index is presently in approximately the 4th percentile of observations since 1990.

CHART 3: STERLING TRADE-WEIGHTED INDEX (CEERUKEB Index)
4

Given these compelling statistical inferences, one must then consider the relative fundamental and technical characteristics of the Pound against various currencies.

GBPUSD

Technically speaking, the pound looks attractive on numerous fronts. The classicists are focusing on what many regard as a potential “double-bottom” pattern, indicated in red below, although a channel may be the more likely interpretation.

CHART 4: GBPUSD Daily with 200MA in Blue
5

Further, on the weekly chart the cable is resting and potentially bouncing-off long-term trend support. From an elementary statistical standpoint, it is not unreasonable to anticipate a move toward the mean of the histogram on the left axis, which is why statistical extremes with support, such as these, are appealing. Particularly, considering it is currently within the 2nd percentile of observations since 1993.

CHART 5: GBP Weekly
6

Of course, currencies are priced relatively, thus other crosses need to be considered beyond simply the technical attractiveness vis-a-vis the dollar.

EURGBP

Similarly, on a daily basis, the euro-sterling appears to be a more compelling short, with a confluence of technical events occurring. Firstly, a seven-month head and shoulders pattern has the classical traders talking about a move which they measure down to the 74 handle. Further, the neckline of this chart happens to converge with both the 200-day moving average and an uptrend line that has held on the pair since it bottomed in late 2015.

CHART 6: EURGBP Daily with 200MA in Blue
7

Turning to the weekly, the cross doesn’t yield too much in terms of a constructive technical insight. Although, fundamentally speaking the euro seems like an ideal candidate to express this trade as the political uncertainty baton has now been passed from the United Kingdom to the European Union, whose fragility is far greater without the Brits as a member state. Indeed, this is heightened by the risks posed by the various European elections this year.

CHART 7: EURGBP Weekly
8

GBPJPY

The short term chart appears to have potentially bottomed and reversed trend, given the price looks to have almost cleared the 200 day moving average. Albeit, there is little else technically compelling about the cross in the short-term charts.

CHART 8: GBPJPY Daily with 200MA in Blue
9

However, one constructive observation is the long term support against the Yen which has held since the mid-nineties. Perhaps one’s view of whether Abenomics will devalue the Yen would be the dominant factor in deciding the Sterling-Yen cross is the best expression.

CHART 9: GBPJPY Weekly
10

Indeed, further consideration must be given to the regime of a given market and whether it fits with one’s strategy. In the case of sterling-yen, it is traditionally a great cross to trend follow as evidenced overleaf.

Our weekly trend-following model recently signalled a buy on the cross. As mentioned, historically this strategy works favourably, going back to the beginning of our data in mid-1975. Certainly, it is a somewhat cherry-picked, lowbrow observation and whilst it is important to avoid over-fitting to the past, one must also consider the particular characteristics of a given market.

CHART 10: GBPJPY Weekly Trend Following Model
11

Whilst we don’t follow this systematically, it does provide meaningful insight into the probabilities of the approach one might take on the sterling-yen cross.

CHART 11: GBPJPY Weekly Trend Following Model Performance Summary
12

­­

POSITIONING & SENTIMENT

Positioning data for spot foreign exchange transactions is not available (hopefully one day), however we can look at the futures non-commercial positioning in the Sterling as a proxy. Notably, it is presently at relatively extreme levels vis-a-vis history.­­ In fact, the levels are nearing the extremes set in 2013 when speculators and hedge funds were almost unanimously bearish, and wrong.

CHART 12: GBPUSD Weekly & COT Net Non-Commercials Speculative Positioning
13

As a behaviourist, one must consider that positioning is a real-time referenda on financial speculators’ sentiment, which evidenced by short positioning reaching the same extreme levels as 2013, is extremely bearish. Hence, we are inclined to take the other side.

CHART 13: GBPUSD Weekly & COT Non-Commercial Shorts Positioning
14

­One of our members brought to our attention that these numbers must be adjusted for Open Interest, which he has done and ranked by percentiles on his site freecotdata.com. Presently, hedge fund positioning is in the 17th percentile, having recently increased from the lowest decile.

CHART 14: GBPUSD & COT Positioning Adjusted for Open Interest
15

VOLATILITY SURFACE

The GBPUSD volatility surface indicates market makers are more willing to write calls than puts presently. Rephrased and inverted, that means there is more demand to hedge via puts than calls. Suggesting that the market’s intersubjective probability assessment – or collective agreement of the Sterling’s future pricing – is fairly bearish. Consistent with our inferences from positioning data regarding the market’s sentiment.

CHART 15:  GBPUSD Volatility Surface
16

Further, this skew indicates selling downside structures to the hedgers may be of interest, so we shall turn our attention to implied volatility overleaf.

IMPLIED VOLATILITY

GBPUSD one month implied volatility is presently quoted in approximately the 89th percentile of the last 5 years’ data, as evidenced by the chart below.

­

CHART 16:  GBPUSD Implied Volatility
17

These implied volatility levels are invariably elevated as a function of the grey swan-like impact of Brexit. Arguably, they price a measure of recency bias given the likelihood of another ~14 sigma daily move is low, which fits with my unpretentious observation that markets ascribe a greater risk premium to political uncertainty than to its antithesis.

This view justifies the perspective that both implied volatility and realised volatility will revert toward the mean as markets re-calibrate to a more certain political reality, in a market where the weak hands have been shaken out due to such high realised volatility.

Simply put, less fragile positions reduce the probability of high realised volatility. However, this is not to suggest exposure to unlimited loss structures is ever prudent. Instead, loss-limited structures, such as short put spreads; enable the ability to collect this elevated risk premium with a pre-defined and limited loss. Similarly, for those who trade esoteric structures, selling one-touch puts provides a similar return profile to put spreads as they are loss-limited, non-recourse structures.

EXPRESSION & STRATEGY

Long: GBPUSD & GBPJPY (trend following)

Short: EURGBP

Derivatives: short gamma GBPUSD can add carry to the position

Rates: cheapen VaR by receiving LZ17

Equities: we shall follow up with our equity views when the timing is right

Given we have a multi-year time horizon on the Sterling and a fundamentally bearish bias over a similar temporal horizon on the euro, a strategic long with no stop is our chosen methodology. With the sterling-yen, trend following is our chosen strategy given its historical efficacy.

Further, whilst we don’t take unlimited-loss short gamma positions, selling the downside on GBPUSD remains an attractive proposition, particularly taking into consideration the skew and richness of the implied volatility, as well as providing the opportunity to add carry to the position.

PROBABILITIES & POSITION SIZING

Typically our position sizing process is one shamelessly adopted from James Leitner of Falcon Management Corporation who was kind enough to share his Kelly Criterion or optimal leverage sizing process with some of the Drobny Global Advisors members along with the presentation The Evolution of a Macro Portfolio. However, given we haven’t yet expanded upon this methodology and our variant of its application – looking at frequentist and intersubjective probabilities, and the expectations gap between them – for the purposes of keeping this piece as concise as possible we will leave this to a later date. Further, given a 100% allocation to a single currency exposure ­is everyone’s default position, sizing strategic long-term currency positions requires a somewhat different process to the one we would otherwise undertake for other asset classes. Of the various approaches one might employ, a risk-targeted approach is what we shall adopt. Accordingly, it is necessary for those who implement this trade to size according to their own risk tolerance. We shall follow up with an explanation of our sizing methodology and an introduction to our macro tracking portfolio in the coming days.


Best,
Carl Hodson-Thomas

Nb. For those of you interested in learning more about receiving our research, please visit http://www.prometheus-am.com.au/subscribe/

Prometheus Research Distribution List

Dear readers, friends and comrades; although many of you may already be on my database, I would appreciate if you can take the time to submit your information via the link below. Any double-ups will be promptly tidied up.

http://eepurl.com/cjgTc5

As you may know, I write infrequently, primarily because I want to distribute only the highest quality ideas with arguments for action that are well-reasoned and logical. Both personally, and politically, I tend to think independently; this autonomous bent often sees me well prepared cyclically.

My communications will be one of three distinct pieces and will be published as often as the opportunity set allows.

Contingencies: covering derivatives trades on the short end of the probability spectrum.

Risk & Reflexivity: elucidating an idea’s arguments for action, as well as its best expression, expected value, probabilities and sizing.

Reason & Biases: reducing fundamental and behavioural thematic arguments into a tractable process.

Depending on the criticisms and feedback, I may include follow ups with comments from subscribers & members, I’m sure this will prove fruitful as there are a number of sharp thinkers amongst the network.

The first piece to this database will be going out this week.

Please take the time to fill out your details to be included.

http://eepurl.com/cjgTc5

Best,
Carl

“Tha Squeeze” – A Gold Vol Trade Idea

If you read my last piece, you’ll be aware that gold is my favourite battleground for numerous reasons. As a disclaimer I’m already short and I also own some GCZ5P 1150 strike puts. As the title suggests, the trade outlined herein is to trade vol outright.


Last July I went to the Drobny Macro Summer School Conference in NYC. My favourite trade at the time, one that I suggested at the conference, was to buy precious metals vol below 12 vol points and it preceded to trade up throughout the rest of 2014.

2014 vol

The trade was predicated on essentially the very same reasons I outline below. This post may provide some good insight into my process. Eventually these posts will become much less thorough as I don’t need to flesh out the fundamental narratives and there becomes less need to elucidate on my thinking.

IDEA
Type – Contingent: potential breakdown, potential vol expansion, potential catalyst in rates.

Fundamental Context – Gold is a story in decline, its failure to break higher has continued to impair expectations of the “believers” in a positive outlook. Meanwhile, despite the drama over the Drachma, gold has failed to stage a rally. All whilst the Fed looks ever closer to raising rates, with 6.71 months until the first rate hike indicated by markets.

MSM1KE

A good friend tells me that “these are still doomsday prices”, expecting the mean reversion has much further to run. Further, the financialisation of commmodities markets as a result of the internet allowing every man and his dog to trade anything from home, means a huge build-up in positioning transpired through the zeroes. Coinciding with the meme that inflation was coming due to the Fed’s QE program. Gold was bid to outrageous levels and has since sold-off in similar fashion to historical bubble analogues. For further reading on the fundamentals, see Mark Dow’s blog.

Hypothesis – Gold looks set to break down and given that vol is compressed, we have the opportunity to play a mean reversion in the absolute level of vol. with the added benefit, that if the Fed raises rates during our trade horizon, it may be a catalyst for gold to collapse.

Timeframe – 4-5 months.

Trade – Buy a four month straddle on GCZ5.

PRICE ANALYSIS
Trends:
LT Trend – Strongly negative
Intermediate Trend – Negative
ST Trend – Negative

GCQ5 Trends

Price Levels:
I think of price as the outcome of a contest of ideas in markets and reflective of the strength of conviction to which traders believe in a given story. With this interpretation in mind, the charts tell the story.

GC1 Price Levels

1165, 1140 and 1130 are the key support levels, yet as we can see in the below chart, the range of support may be quite wide.

Gold Price Chart

Regression:
Gold is sitting right in the middle of its regression channel which has been in play since the April 2013 selloff that occurred right after gold failed to stage a meaningful rally during the events of the Cyprus bailout in March 2013. I remember thinking at the time this essentially invalidated its supposed purpose as a financial hedge.

Regression+RSI

Selling on overbought conditions proved quite fruitful since, as gold continually made lower highs. This is a strategy worth following until this regime breaks in one direction or the other. As evidenced by the below (very basic and obviously cherry-picked) backtest.

Backtest

Nevertheless, even this mean reverting price behaviour has been sufficient to see large spikes in gold vol, but a breakdown of the magnitude of 2013, perhaps on the Fed raising rates, could see a significant vol spike.

Implied Vol:

“The single best predictor of future increases of volatility is low historical volatility.” – Jamie Mai, HFMW

If we think of price as the function of a contest of ideas, then the inverse of volatility is the measure of participants’ confidence in those ideas. For this reason it is a particularly valuable insight into a given market for a behaviouralist.

The low in implied vol in 2008 is obviously some bad data which skews the statistics somewhat, but even at the 9th percentile, we can be confident we are buying vol cheap.

implied

Looking at the XAUUSD vol for confirmation, we can see that over the last 10 years only 319 observations have been below the current level.

XAUUSDV3m

Bollinger Band Width:
As a technical proxy for vol, we can also see that Bollinger Band Width is particularly narrow. In the same vein as the Jamie Mai quote above, as a technical indicator, BBWidth is often used for a situation called “Tha Squeeze” whereby it often tends to contract before periods of high volatility.

BBand Width

Skew:
As we can see in the below skew, risk is to the downside.

Skew

Seasonality:
To gauge whether history is on our side, let’s look at vol seasonally. Most notable is the fact that August & September have the greatest average monthly positive changes.

Gold Vol Seasonality

Certainly if the 5 year average is anything to go by, July isn’t bad timing for entry.

Seasonality 5 yr average

EXPRESSION

Directionally speaking, as mentioned, my bias is to be short gold. If your strategy is to sell breakdowns, there may well be some interesting entries in the next few days. In terms of playing vol, we can either do it via delta-hedging an option or with an option structure.

Straddle:
Here is an indicative structure.

Straddle

Payoff:
Obviously it’s path dependent, but presuming there are some good moves before expiry,  delta hedging may well pay for the trade as implied vol here is only indicating a daily volatility of 0.95%. Below is the payoff chart if you hold til expiry without hedging along the way.

Straddle Payoff

IN CONCLUSION

Due to the length of this piece I’m leaving out my expected value and position sizing process for a later post. Don’t do a trade like this if you don’t know how to size or manage it. I’ll likely hedge moves to the topside more aggressively given my directional bias is that gold goes lower.

Gold looks like it could break down tonight, so let’s see how this trade goes.

Please read the disclaimer.

 

China, Iron Ore and a Future Bust

“The numerous misfortunes, which attend all conditions forbids us to grow insolent upon our present enjoyments… For the uncertain future is yet to come, with every possible variety of fortune.” 

– Solon’s Warning

CONTEXT: 

I am one of the very few Aussies who is concerned about the future of an industry, iron ore exports; which represent a large portion of Australia’s GDP. From a fundamental top-down perspective I concur with the Hugh Hendry/Jim Chanos observation that China is amidst a credit bubble and is running an unsustainable economic model. The Chinese steel sector would be unprofitable in 2012 based on Chanos’ forecasts, yet they continue to add more and more capacity to a decentralised steel sector which is directed by local municipal government employees so they can meet their GDP targets.

From Barrons (emboldened emphasis mine):

“China has an investment-driven model where they simply want to produce GDP growth. They can continue showing GDP growth, as long as there is credit to support that investment. The problem is that most of these investments, at this point, do not generate an economic return and haven’t for a while. So you have the dichotomy of a country growing its GDP but destroying wealth. I view it as a stock that’s rapidly growing, but whose earnings are below its cost of capital. Any finance professor would tell you that’s a company that is liquidating and going to run into the wall. That’s what China is doing. But it can go on for a while.”

Essentially, China responded to the financial crisis with a massive stimulus via credit expansion in 2009.  From a historical standpoint, this was the single largest monetary expansion as a percentage of GDP ever undertaken.

CHINA M1:

China M1

CHINA M2:

China M2

With the CCP’s politburo aggressively directing the economy from on high and trying to stimulate growth via incentivising construction, massive overcapacity was inevitable.  Most notable examples: construction (property developers, cement makers), steelmakers (steel companies, iron ore miners, coking coal miners), shipping (ship builders) – all suitable industries to be short when the timing is right. This view is my fundamental bias, albeit I am agnostic to timing.

Below are a couple of videos on the Chinese real estate over-construction/overcapacity problem, the first which aired on Dateline in 2011 gives some insight into the idle-capacity which represents the liabilities side of China’s balance sheet, the second by Stratfor gives a more recent look at the policy implications and the difficulty the CCP are having in maintaining growth, whilst increasing the standard of living and attempting to convert from a investment-led growth model to a consumption-led one.

In order to monitor the fundamentals on the ground in China there are two main considerations, 1) policy (which I will be monitoring going forwards) and; 2) Shanghai rebar (short for reinforcing steel) is essentially the secondary market of iron ore and is the best proxy to Chinese domestic demand.

SHANGHAI REBAR INVENTORY:

Shanghai Rebar Inventory

SHANGHAI REBAR PRICE:

Shanghai Rebar Price

IRON ORE:

Iron Ore

Today, iron ore prices are reflecting the positively bullish assessment of global growth (read Chinese) demonstrated by equity markets. Early last year I spoke with World Steel Dynamics, who reinforced my bearish bias with a view based on their brilliant research that Iron Ore would sell off by July and they were very nearly correct with timing and their target price level. So I will look to discuss with them again in the near future what their views are for 2013.

From the information we do have however, we can see that Iron Ore is leading rebar, this divergence would (normally) encourage me to look for an entry to be short once rebar falls over, however, 93 mines have been shut down in India due judicial activism which may have contributed to short-term supply constraints.

Shanghair rebar and Iron Ore

CORRELATION – Iron Ore & Shanghai Rebar:

Iron ore and Shanghai rebar are usually fairly tightly correlated as we can see below, yet they have diverged to the 99.59th percentile over the last 12 months’ spread – perhaps this is due to a disparity between on the ground demand in China and iron ore prices reacting to a supply squeeze out of India?

Shanghai Rebar Iron Ore Correlation

All things being equal, I anticipate a continued short-term global economic rally, however, one thing we can be certain of is that the underlying reality will again rear its ugly head and demonstrate that Iron Ore demand is not as significant as many companies have bet. The largest bet by an Iron Ore producer on this demand is that of FMG with a total debt to equity ratio for FY2012 of 2.26x.

FMG’s expansion plans have eclipsed targets of 95Mtpa for FY2013, with an annualised Dec12 run rate forecasting a possible 100Mtpa, with an ultimate target of 155Mtpa.

CORRELATION – FMG & Iron Ore:

FMG and Iron Ore are very tightly correlated at the moment, given FMG’s highly levered bet on the price of Iron Ore, its fate is invariably sealed to the price staying above $90/t for the next 2 years (I will get to this in my next post) – making the future of FMG very binary.

Correlation Iron Ore FMG

TECHNICAL ANALYSIS: 

FMG is in a long term down trend since it hit a post financial crisis high in January 2011, the key resistance line since that time is drawn in below and FMG has continued to sell off on approach to this trend line. However, given Iron Ore prices are nearing $150/t and FMG is running a potential 100Mtpa, one must assume FMG’s equity price will advance on Iron Ore prices at this level and break out through this trend line.

FMG trendline

FMG is testing some very important price levels at $5.04 which is a key resistance level, I suspect it will roll over slightly from here and bounce off support at $4.67 to rally and break out through the resistance at $5.04. Thereafter, $5.50 and $6 are the key resistance levels. Between these price levels I anticipate FMG’s price action to encounter resistance, at which point I will look to pull the trigger on my bearish positions: short the equity and long OTM puts at previous key price levels of $3.50 and $4. 

FMG resistance breakout

FMG IMPLIED VOLATILITY:

Implied volatility, which is the market’s best estimation of future price volatility and hence an input into option price models; often falls during rallies, which provides an opportunity to take an option position with an increased probability of making a profit. Nb. the longer the timeframe the higher the likelihood volatility will mean revert. In this case I will look to pull the trigger on the put positions with different tenors (I hope to outline for you in the future) as well as a buy a long-dated strangle, to express a view on FMGs binary future, as well as to take advantage of the flaws in normal distributions – an inability to accurately gauge the probability of future price trends that are deemed improbable by the pricing model.

Implied volatility is a key caveat when I enter options positions, if implied vol is high (which I like to think of as a price) it means I am paying more for my options, and less likely to expire in the money from a probabilistic standpoint. Typically I like to buy volatility in the quantiles, near long-term lows – areas where I am comfortable the Implied is near a floor. If we look at implied volatility below, we can see it is heading towards April 2012’s lows in the low 30’s – remember, low volatility is the single best predictor of higher future volatility.

Implied Vol

Implied Skew Steepness

EXPLOITING OPTIONS MODELS:

A normal distribution, the mathematical basis for options pricing models imply future prices are more likely to be near the current level, while probabilities decrease significantly for prices further OTM from current levels.

Standard_deviation_diagram.svg

However, I think the reality for FMG is a fairly bimodal distribution, something more like this:

bimodal

If this is the case, regardless of my bearish view on FMG’s future, we can de-risk our directional view, expend a small amount of premium and buy a long-dated strangle – this position could have some potentially large upside when FMG’s price moves to acknowledge that Forrest/Power have either succeeded or failed… We will find out in the next 9-18 months.
In the meantime lets keep our fingers crossed FMG’s Implied Volatility falls and it rallies to $6, so we can make the bet!

Enjoy your weekend,

Carl