The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

11 May 2010

The lessons of '92

A reader asks, "Please spell it our very plainly for those of us with history deficit disorder, what were the lessons of ‘92?"

Back in the 1980s, hedge funds became laden with lots and lots of money; too much money to utilize their tried and true tactics. To deploy all that new money, a new perspective was required, a global perspective. And thus arose the macro funds. I have forgotten many of the names but you likely recall a few: Mark Strome, Julian Robertson (Tiger Fund), etc. And, of course, George Soros (Quantum Fund).

Several of the macro funds decided correctly that England did not measure up to the ERM’s standards. To wit, the European Exchange Rate Mechanism (ERM) enforced specific measures by which each nation must abide; the Pound Sterling clung tenaciously above its agreed lower limit, but the fundamental situation betrayed that it should not. The macro funds smelled blood in the water and shorted Pound Sterling. They had calculated that the Bank of England (BoE) lacked sufficient reserves to combat their short sales (what with leverage, etc), and if and when the BoE responded to their short sales, it only worsened and weakened the BoE's position... which, in turn, further strengthened the macro fund managers' belief of the Pound Sterling’s fundamental weakness. They piled in: one fund after another, and one position after another. And when that was not enough, they used the inherent leverage in the futures contracts to short even more Pounds. All the while, the BoE kept jawboning the currency markets. The BoE’s position: the Pound must not weaken.

The BoE never did commit fully to backstopping its position... until early-September 1992, and by then it was too late. On the fateful day of 16 September 1992 (Black Wednesday), the Conservative government and the BoE gave up the attempt, and the Pound Sterling tumbled. Big time. Media blared the news with huge headlines, “George Soros, the man who broke the BoE!” and “George Soros, the man who made $1 billion in one day!” What the media had forgot, or never understood, was that Soros had been grievously underwater on the position; in fact, ~$2 billion in the red when the calendar flipped to 1 September 1992...

The lessons?
1) Fundamental shorts trump technical shorts
2) Stay with your conviction (easier for Soros with his track record than Dr Burry, et al)
3) Do not let anyone or any institution frighten you out of your conviction and position

The situation today is eerily similar to Britain’s in 1992. In an excellent, and exceedingly well-written essay, Robert Samuelson encapsulates the true problem, "The welfare state's death spiral..." Samuelson also posits, "There are no hard rules as to what's excessive, but financial markets -- the banks and investors that buy government bonds -- are obviously worried."

Well, yes, but that is an understatement. Investors might be leery, but speculators and traders smell blood in the water. Again. So, in a replay of the events of 1992, they short the currencies and sovereign debt of the countries in the worst fundamental position. I mentioned previously, and as Samuelson articulates, this problem afflicts welfare states everywhere (Japan, England, and the US), but especially those countries with an aging demographic. Especially hard hit, though, is Europe, because its monetary confederation never did give rise to the cultural and political hegemony many European leaders believed would occur.

Will the speculators learn from Soros' success, and repeat that triumph? Or will they panic?After some initial jawboning, the EU learned its historical lesson (England and the BoE in 1992) and committed $1 trillion to its behemoth effort of crushing the speculators. So far, the EU’s effort looks golden.

Will sovereign debt and national currencies tumble in price and value due to speculators' short sales? Will the effort to crush the speculators (further) bankrupt the welfare nations? Answers await to all of these questions, and other questions unasked. And, as with the impoverishment Soros' success inflicted on the English, however ephemeral, so too will the fallout from this story afflict us all.

Your comments and remarks welcomed, as always.
-- David M Gordon / The Deipnosophist

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