When Caution Is King
"I regard the stock market as dangerous." That's the view of James Melcher, hedge-fund manager and founder of Balestra Capital, who sees disturbing macroeconomic trends and has positioned his fund accordingly.
Trends he worries about include the trade and budget deficits, the housing boom, and high credit card debt. Given his guarded view of the stock market, he is heavily hedged against a downturn by selling short junk bonds and buying equivalent Treasury bonds. He has been shorting certain individual stocks and also holds inexpensive derivatives.
Among Melcher's favorite holdings are energy stocks, particularly oil-services outfits Lonestar Technologies (LSS ) and Halliburton (HAL ). He also owns funds focused on certain emerging markets such as India Fund (IFN ) and Third Millennium Russia (TMRFX ).
As a hedge against a weak dollar, he likes the exchange-traded fund that tracks the price of gold (GLD ).
These were a few highlights of an investing chat with Melcher presented July 21 by BusinessWeek Online on America Online, in response to questions from the audience and from Karyn McCormack of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at aol.businessweek.com/chat.
Q: Jim, there was a lot of news today, between Greenspan's testimony and China revaluing its currency. What's your outlook for stocks now? A:
Q: Jim, there was a lot of news today, between Greenspan's testimony and China revaluing its currency. What's your outlook for stocks now?
A:Very guarded. Basically, it's going to take the market a while to digest these new factors, particularly the yuan starting to break the link with the dollar.
My view of the market isn't as rosy as some. There has recently been near-unanimous optimism about the market. I think that's not warranted by fundamentals. We all have access to the same factors, but interpretation varies.
My interpretation is that we have severe fundamental problems in this country that are going to be very difficult to deal with, and we're in for a very rough time over the next couple of years.
Q: What are some of those fundamental problems in this country? A:
Q: What are some of those fundamental problems in this country?
A:One is the trade deficit -- that's a problem, because even if the yuan appreciates against the dollar, a moderate appreciation will not make much difference. It would have to be enormous to make a dent in the huge budget deficit.
The deficit is basically caused by Americans spending more than they're earning. In fact, the entire country is doing this. We have a foreign trade deficit, as well as the budget deficit, that combined present a vast impediment to future growth and is vastly difficult to deal with.
Two is the housing boom, which is indeed a bubble because of the psychological aspect of it. There's a significant portion of the population buying homes for their value, not to live in them. Lending institutions are in a race with each other, bucking to make the terms easier, allowing more and more people to buy homes.
While it's very positive that more people can own homes, it's not positive when rates go up again and people are hit with expenses of owning homes. People won't be able to keep these homes.
These are just two of the problems facing this country. There are others. Credit-card debt is very high, and Americans in general have been borrowing substantially more than they're earning.
In the '60s, the average household borrowed 30 cents for each new dollar in earnings. This rate has risen through the years to where people are borrowing about $1.30 for each new dollar in earnings. Obviously we can't be too far from the limit. At some point, we have to pay the piper.
Q: Do high oil prices bother you too? I cringe when I get to the pump. A:
Q: Do high oil prices bother you too? I cringe when I get to the pump.
A:Sure. They bother everybody, but get used to it. While oil and, therefore, gasoline prices will be volatile, we've moved into an era of high energy costs.
The world has been, for some time, burning more energy [oil and gas] than it has been finding. New oil fields are more expensive and difficult to find. They're turning out to be smaller than a few years back, and play out faster.
The world will be able to satisfy its energy needs in the near future, but mostly by raising prices and, therefore, making it worthwhile to find these increasingly difficult oil fields.
We're seeing a problem not only on supply, but also on demand, because as the supply contracts, demand -- particularly from Asia -- is growing faster than experts have predicted. In China and India, there's a burgeoning middle class, and usage of oil and gas is expanding at a very rapid rate.
This type of supply-and-demand imbalance should result in even higher prices over coming years. Actually, therefore, these prices will serve as a brake on economic growth.
Q: I have two sons in their 20s. Should they invest in hedge funds or not? A:
Q: I have two sons in their 20s. Should they invest in hedge funds or not?
A:I think the hedge fund area has become dangerous. The classic disciplined hedge fund would be a very good investment now. Unfortunately, about 3,000 or 4,000 hedge funds have been created in the last few years, and many are not run in a mode that will enhance preservation of capital.
So the difficulty is in two areas. One is in finding the right hedge-fund manager, one who will be disciplined enough to control risk, even if it means producing some lower returns. The other is the fact that so much money is in the hands of so many hedge-fund managers who are aggressively staking gains.
Investment areas have become overcrowded and are vulnerable to quick spikes on the downside. This could be very dangerous to the entire area under certain financial conditions.
Q: How is your fund doing so far this year? And what's your strategy at this point, given your outlook? A:
Q: How is your fund doing so far this year? And what's your strategy at this point, given your outlook?
A:My hedge fund is up approximately 2.5% on the year. My strategy has been a combination of defense and offense. I'm heavily hedged against a downturn in the stock market, and the way I'm implementing these hedges is by selling short junk bonds, while offsetting the cost with purchase of equivalent Treasury bonds. I've sold short certain individual stocks.
This is a wonderful time to be a hedge-fund manager if you are truly looking to protect capital while seeking gains. It sounds like trying to have your cake and eat it, too, but actually, because there is so much money in the hands of financial institutions now, they have kept the cost of hedging very low.
It's the lowest I've ever seen. We can buy one-year puts against the S&P index, for example, at a cost of about 5%.... We can buy credit-default swaps, which are like insurance policies against default of specific bonds, for exceedingly low prices.
Our hedge fund is nearly $50 million in size, and we hold $100 million in credit-default swaps that cost us about one half of 1% of our fund per year. There's no additional cost, and no risk to holding these credit-default swaps. However, in the case of significant financial crises, we could generate profits on these holdings that would more than offset losses on the rest of our portfolio.
As a result of being able to hedge so cheaply, we can actually be heavily net long on a cash basis. As of today, my hedge fund is approximately 90% invested in equities, and about 30% short equities and junk bonds. But the inexpensive derivatives we hold provide us hedging that exceeds 100% of the value of the portfolio.
As for our strategy, Balestra Capital is a global macro hedge fund, which means we're playing certain major themes. One of these is energy stocks, which we bought starting three years ago. Another is that we're heavily invested in certain industries in the American stock market, such as health care and consumer staples.
I believe that the real growth over the coming years will be in certain emerging markets, so we hold equities in India, Russia, and Brazil. We also hold substantial equities in Canada, which is not exactly an emerging market but is attractive, particularly in the energy area.
Q: Can you name some of your top or favorite stock holdings? A:
Q: Can you name some of your top or favorite stock holdings?
A:Sure. Probably my favorite is India Fund (IFN ). Lonestar Technologies (LSS ), which supplies drilling pipe and related materials to the oil service industry, is another favorite.
Armor Holdings (AH ) is a smaller company -- they're putting armor plating in the Humvees in Iraq and provide armor plating and the like for law enforcement and the military. Halliburton (HAL ) is another we like.
Third Millennium Russia (TMRFX ) is an excellent fund. I'm a part-owner of the management company, I should disclose, but they are performing quite well.
Another would be Enerplus (ERF ), the Canadian company. I would also recommend gold, which can be bought under the NYSE under the symbol GLD. This does make sense in an era of broadly declining currency.
Q: Do you like any gold miners, or do you prefer holding the actual metal? A:
Q: Do you like any gold miners, or do you prefer holding the actual metal?
A:I prefer holding the metal, although Newmont Mining (NEM ) is certainly a good substitute. The metal can be bought on the NYSE as GLD or on the futures market. We hold a substantial amount of gold right now, and as I said, we regard it as a hedge against declining currencies in general, and also as disaster insurance.
Over an extended period of time, gold has not been a particularly good investment, but we've been holding at least some gold over the last three years, and it has been a good time recently. In the next few months, or even in the next few years, it will probably be an outstanding investment.
Q: I own General Electric (GE ) -- my broker says sell, but I say hold. What's your opinion? A:
Q: I own General Electric (GE ) -- my broker says sell, but I say hold. What's your opinion?
A:Well, I'm not normally bullish on the biggest blue-chip companies in the U.S. However, I do think GE makes sense here. Based on the businesses it's in, it will participate directly in the expansion of infrastructure and emerging markets, and the expansion of the airline industry, and recently the expansion of consumer credit in emerging markets.
I do think some of GE Capital's holdings aren't attractive, but on the balance, I like the stock. The hedge fund does own GE, one of the only major Dow/S&P stocks we own.
Q: What's your take on the tech sector? Will Microsoft (MSFT ) ever start moving again? A:
Q: What's your take on the tech sector? Will Microsoft (MSFT ) ever start moving again?
A:I think you can always find individual stocks that make a lot of sense, but because of the decade-long love affair with tech, the group is overvalued.
Microsoft has entered a much slower growth phase -- it's a mature phase, and it's hard to argue that it will ever grow like it did in its early years again. We actually hold almost nothing in the technology field. It's very overcrowded, and in an area of excess liquidity and low interest rates, there's too much competition.
Investors still insist on paying too much for technology over comparable businesses elsewhere. I've actually been consistently selling stocks in the area short in the last half-dozen years.
Q: Which companies or sectors do you like in India, Brazil, and other emerging markets? A:
Q: Which companies or sectors do you like in India, Brazil, and other emerging markets?
A:I've been actually buying the entire market in both cases, either by buying exchange-traded funds (ETFs) or mutual funds. I started by purchasing India Fund (IFN ) a few years ago. I was able to buy it at a 12% discount from asset value. It's currently substantially higher from the point where I started buying it, and there's no discount in it at the moment.
I bought the exchange-traded fund for Brazil, and I entered Russia initially at the end of 1999, after the Russian stock market collapsed more than 90%, and bought Third Millennium Russia Fund, an open-end mutual fund. That fund has appreciated over 600% since I made that purchase, compared with about 6% for the S&P Index.
Q: Are you bearish on the dollar -- like Warren Buffett? A:
Q: Are you bearish on the dollar -- like Warren Buffett?
A:Longer-term, I would say I'm somewhat bearish on the dollar. Short-term, the dollar may do better than other currencies. It's important to understand, however, that currencies rise and fall in relation to each other.
It's more useful to look at how currencies are priced in value of hard assets. Basically, all paper currencies are depreciating because of massive infusion of liquidity by government actions and actions of central banks. As a result, I don't like any currency in the long run. That's the main reason I'm holding a significant position in gold and energy stocks in growing economies like Russia and India.
I could add, I did short the dollar starting three years ago against the euro, the Canadian dollar, and Australian dollar at various points. That worked well, and I got out of my foreign currencies and back into the dollar in January, fortunately.
At this point, it's hard to make a short-term position because of recent events such as rising interest rates in the U.S. and the recent de-linking of the yuan's peg to the dollar.
Q: Is China a good place to invest, especially in view of the fact that it is finally unpegging its currency? A:
Q: Is China a good place to invest, especially in view of the fact that it is finally unpegging its currency?
A:I'm not recommending buying stocks in China, at least until there's more regulation and controls on their stock markets. While I've liked the Chinese economy for several years, I've avoided buying equities there because of the specific risk associated with a market that's at times completely out of control. There's the opportunity for manipulation and fraud in the market; it could be rampant.
You have a very different situation in India, which I do feel has at least as good growth prospects as China, but with far better-regulated markets and an excellent legal system.
Q: What's your advice to someone looking to invest money in the market now? How can they preserve their capital while keeping risk low? A:
Q: What's your advice to someone looking to invest money in the market now? How can they preserve their capital while keeping risk low?
A:Well, for anyone who wants to preserve their capital and keep risk low, you're talking short-term Treasuries. I regard the stock market as dangerous, and longer-dated bonds are also risky. This is due to fundamental problems in the U.S. economy, and by extension the world economy.
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