Trying not getting killed

“We live in the trenches…we fight. We try not to be killed. Sometimes we are. That’s all.”
- Erich Maria Remarque, comment by some soldier fighting WWI

I was watching American Idol last night and was laughing my head off when the boxing guy, some trainer / motivational guru / snake oil salesman, was talked about the ‘knock off’ between the two David, he’s a whole lot of bull. I was thinking about why David Cook chose songs that were less popular. I suddenly think that it was his ‘evil ploy’ to not win the competition. Look at all the past winner, other than Carrie Underwood and Kelly Clarkson, none of the other winners continue to shine in the cut throat music industry. Maybe there’s a winner’s curse at play (literally), btw i’m not talking about the finance type of winner’s curse (will blog on this someday).

Winning in the game of investing is often about not losing in this game. Bill Gross of PIMCO shared his latest insights on his bi-monthly outlook .He shared with us PIMCO’s investment strategy since 2006 and the rationale behind it.

Essentially, it was a clearly defined 5 steps battle plan;

(1) Avoid the subprime mortgage meltdown – Mission accomplished
(2) Anticipate changes in monetary policy – Mission nearly accomplished
(3) Reinvest in high quality financial institutions which suffered impairment – Mission uncertain
(4) Ultimately invest in lower quality bonds as corporate defaults rise to peak levels – Mission for the future
(5) Be mindful at all times of the effects of a globalised economy – Mission ongoing

Gross talked about how PIMCO got to a defensive position in step 1 and 2 by purchasing long term high quality corporate bond and gave up a quite a few basis point earlier on when high yield / low risk instruments seems plentiful. However, this defensive play allowed PIMCO to “survive, and gained territory and are eager for further advances”.

Mission #4 seems to be a very interesting play. As corporate defaults rate rise to a peak, bonds would usually have higher yield to compensate for the higher risk. However, as default rate decline (since it has peaked), investors of these seemingly high risk bond would get higher yield for ‘free’.

However, Gross cautioned that RECESSION and its vicious cycle lurks around the corner. Furthermore the de-leveraging of the global economy may be lengthier and more painful than history suggests. Deflation of home prices, for instance, could once again turn the financial market upside down.

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(upnext, I will give an amateurish attempt to explain the impact of deflation of home prices)

Home equity = Fair market value – unpaid balance of the mortgage (and debt on the house).

It goes something like this, you can get home equity loan in the US. For instance, at the beginning of the year, your unpaid mortgage is $600k and market value of house is $1,000k. You can thus borrow on the 400K at a low interest rate of say 5%. So say if you borrow the whole sum, you'll get to borrow 400K and at an interest of 20K.

At the end of the year, your market value of house is $1,150k and you are allowed to borrow up to $550k, so you can pay of the interest comfortably with newly borrowed money. This could go on forever as long as the home prices in % rises faster than the interest %. This also allows you to spend like a king financed by the inflated home prices.

But now the reverse is true, interest on loans are going up as default risk has increased, and home prices have fallen as many people couldn’t keep up with their mortgages. Following from the previous example, as home prices decline, fair value = 500k and unpaid mortgage = 600k, you have a NEGATIVE home equity. You have to pay off the loan in full plus interest within short notice. So you spend less to try to pay off your debt. But the economy is softening and unemployment rising. You give up and default on your Home equity loan and even your mortgage and decide to stay on the streets. This vicious cycle goes on and on and thus wrecking havoc in the real economy.

Moral of the story for me, (1) what goes around comes back around, (2) it’s hard to be fearful when others are greedy, but we should darn well try, (3) My knowledge of such financial issues are really limited, if you find anything that’s inaccurate of plain WRONG, please tag or blast me with an email.