Who is Michael Burry?
In 2006 Michael Burry looked like a fool. His hedge fund (Scion Capital) had just lost 17% after posting many years of incredible returns. His investors were mad and since his fund was only 6 years old the usual "track record" wasn't in place - despite research demonstrating how there is almost zero correlation between past and future returns.
Burry was confident.
“Never before have I been so optimistic about the portfolio for a reason that has nothing to do with stocks” he said.
“Despite our mark to market losses, we’re short the mortgage portfolio everyone would want if they knew what they were doing.”
Ah. Yes. The sub prime mortgage crisis. It's famous, and almost financial history now. But in 2006, it was a myth. People were getting rich betting on sub prime... very rich. And doom and gloomers predicting the end of the world were losing money... a lot of money.
Michael Burry trusted what the numbers told him and mistrusted what the people told him. By looking at default rates across various mortgage tranches, it was easy to see that people who had teaser rate loans that readjusted were defaulting at much higher rates "than expected." By looking at the increase in % sub prime mortgages, especially ones at teaser rates, it was pretty easy to work out what was going to happen. That is a basic market error, and it doesn't require any kind of advanced quantitative analysis to see it. Burry would go on to make about $100 million for himself and about another $700 million for his pissed off investors...it just took another couple of years. Not bad for a doctor in training starting a hedge fund with $100k. If you're interested in this story, I highly recommend "The Big Short" and just about any other Michael Lewis book... I think I've read them all now.
His confidence here is interesting because it is forward looking. I'm sure that at the time he was feeling quite different... stressed out of his mind that he may have missed something on the one hand... frustrated to all hell that people couldn't see something that was so painfully obvious on the other. Fortunately for him,vindication came over a 2 year and not 10 year period; but I suspect he had a very safe bet in this case, and I bet the speed and magnitude of the correction surprised even him.
Seeing what others can't
We have this strange idea that people like Warren Buffett or Michael Burry possess some kind of special ability to see the future. I don't think that's it at all. What they possess is the natural disposition to be suspicious of the crowd. When everyone is doing or believing something, it is nearly impossible to defy it, even if everything inside you tells you to doso,and even if the information is plain and obvious.
There are numerous experiments where people are asked questions like "which line is the longest" as they are presented with 3 or 4 lines. It's OBVIOUS which line is longest, but by having a few confederates answer incorrectly, the actual test subject will quite frequently go with the crowd despite the answer "being obvious." That's the "they must know something I don't know" effect working it's magic. Imagine in the world of finance, where information is far less clear and stories are much more complex, and it's not just appearing stupid that is on the line, but huge amounts of real money. Also, unlike in line experiments, in finance if enough people believe it, it becomes true, even if just for a time.
Being able to say "you guys are fucking idiots, the 3rd line is shortest" and hold that position even when most people tell you you're wrong... even when teachers are giving the wrong people A's and criticizing you for being blind to what is so obvious... is what makes people contrarian. I believe this might not be a learnable thing. There might be people who just naturally say "wait a minute, why are we all running towards the cliff" instead of just charging ahead. I think there are so few of them, because in most survival cases, running with the herd saves your life and being the contrarian gets you eaten. You don't see many contrarian tuna... and that's because they get picked off and eaten.
But the world has changed and so the contrarian mutation has an advantage in a particular set of areas- finance and investing being one of them.
So What's Next?
I think about this all the time. It's so easy looking back, but what about looking forward to the new year. So I'll put my head on the chopping block a bit so we can look back at the end of the year and evaluate.
A few things stand out to me as fairly large probability problems/opportunities.
The first is US Government debt. It gets larger every year and there appears to be no incentive to reduce it. Of course, it HAS to be paid off some time, so figuring out how that might happen represents an opportunity. The problem is we've been riding that real fiscal cliff for quite some time, and could ride it a lot longer. So while you could do something like betting on dropping US Credit ratings (the world stops buying our debt), betting on sharp interest rate increases, betting on inflation (printing our way out of the problem), going long gold (I think this is a bad idea, for reasons I wrote about earlier)... the problem is time horizon. The US could run these deficits for another 50 years and so you might be right, but you might also be dead :). So I think here its about risk mitigation. I expect interest rates will go up in 2-5 years, and I expect they will go up much more than people think. We could see the return of 10%-15% mortgage rates we saw in the late 70s and into the 80s. That would be fun. Of course, if you have cash, that means that savings accounts might actually be worth having. You can either do what PIMCO did in 2011, or you can just invest in PIMCO or similar strategies.
Personal Strategy: I think I'm going to leave this one alone for now, aside from getting out of government bond funds, which I did a few months ago. I just don't know enough to bet against it, but will be looking next year.
China's Real Estate Bubble. This is well documented... just search on Google. Of course, like US debt, it's hard to know when. Worse, the Chinese government can do all kinds of things to manage this crisis much more than the US Government can. The crash has been predicted for a few years, and it was around May that the numbers really started looking grim. If you're interested, there are some options to short Chinese real estate ProShares UltraShort FTSE China 25 and DirexionDaily China Bear3X Shares are two places to look (they are both down quite a bit this year, and looking at FXP over a 10 year horizon draws a somewhat inverse picture of the Chinese housing market). If you're really brave (i.e. much braver than me) you could directly short real estate and construction companies: here's three compared with each other. China Housing & Land Development Inc is the largest. I haven't done much research on these, so can't comment beyond the macro "China's is Overbuilt" assumption, itself questionable. Another interesting article here.
Now if you're REALLY looking for a fun project, you could go to the National Bureau of Statistics of China and grind out the monthly changes in the price index of large and small cities. It sounds like fun to me, but I'll reserve it for another day.
Personal Strategy: Similar to the US Credit Rating, there's a lot of noise here, so I'm just watching it for now. I'll probably do a deep dive on the Chinese data linked to above and that may change my mind. Unlike many people, I think that the data the Chinese government puts out is probably pretty honest.
European Recovery. There is a lot of skepticism around Europe, especially Greece, Spain and Italy. I suspect that will continue into next year, but I am very optimistic that Europe as a "project" will continue to succeed. Why? Not because of some deep insight or analysis, but simply because people are afraid of big changes and letting the EU collapse and moving away from the Euro is about as scary as things get. Of course, it could happen, but I think it's too hard to put the shit back in the horse.
There's funds like the iShares S&P Europe 350 Index (or the VGK, same kind of thing). If you're feeling braver, you could buy shares of the National Bank of Greece, I suspect they will do quite well if Greece manages to come out of its hole. Perhaps slightly less risky is the National Bank of Ireland; both of these banks got hit pretty hard since around 2008 - yeah I know... shocking. The "big banks" including Deutsche Bank and Societe Generale are less interesting to me. I have this covered with my long position in Citibank, which hasn't paid off as well as if I had chosen Wells Fargo.
Personal Strategy: I have this indirectly through a long position in Citibank. I might go crazy and buy some Greek banking stocks over the next few months, but I need to do a bit more research first.
Gold Bubble. Probably on the "less likely" side, but I believe Gold is overpriced which sucks because buying it would be a great hedge against what I assume to be coming inflation and volatility in US currency. Of course, it's possible that Gold goes to 2000 or 3000 or 10000 an oz., but I am very doubtful here. As I said before, it's spike above platinum and the number of "we buy your gold" stores to me indicates irrational human behavior. Lots of ways to bet against gold, I am not knowledgeable enough to know how to trade commodities directly, so I just took a long position in ProShares Ultrashort Gold.
Personal Strategy: I'm long GLL right now and won't be buying gold (shares or bars) in the foreseeable future.
Tech Turnaround. It's not that tech is doing badly, but it has been very volitile. This is mostly because of the whole social/mobile thing that's going on. High profile IPOs really got crushed last year and that has scared people outof the market. Darlings like Groupon have just gotten destroyed and so social media companies have a similar reputation to .coms in 2001. They have also dragged many companies down with them including Microsoft, Intel, and HP... in fact, HP can't seem to stop the bleeding. I believe all of those companies will eventually emerge from the doom and gloom and figure it out. I wrote about that previously so I won't go into tons of detail here.
Personal Strategy: I'm long Intel and planning on buying Microsoft if it drops below 20 or so. I'll probably accumulate HP and possibly Dell as well. I'm also long Zynga, but that has been a crappy investment so far.
Happy new year.