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Chinese Generals - asset allocation010609

“All men can see these tactics whereby I conquer, but what no one can see is the strategy out of which victory is evolved.”
-The Art of War, Sun Tzu

Whether it was Team Canada earning its 5th consecutive World Junior Hockey Championship over Sweden last night or our perpetual quest to have our feet on the floor to help our clients earn a world class annual return – it’s all one in the same. This is a global “Trend” that knows no time and no bounds – it’s all about proactively preparing yourself to win.

The Art of War is a Chinese military book that has had a meaningful impact on how many of the world’s top strategists think. At Research Edge, we religiously adhere to the core strategy of changing our positioning as facts and prices change. At its core, the Chinese lesson is that within the confines of a dynamically changing battleground one requires a process to respond not rashly, but quickly, and accurately.

This is why we “Trade” around our exposures and positions. We think we understand investment “Trends” as well as anyone, but what we respect above all else is keeping our feet moving in the face of “improbable” outcomes manifesting themselves into reality. If and when those “unexpected” outcomes occur (like say a +30% 6-day “re-flation” in the price of oil like we just saw), we have already proactively positioned ourselves with a defense that can quickly turn into an offense.

Notwithstanding the wonderful history lessons written by a 6th century BC Chinese strategist, today is just another day in The New Reality of investing in 2009. After all of the nonsensical narrative fallacies of 2008, it has actually proven to be “global this time.” Quantifying the “re-flation” moves that we have seen in stock markets from Hong Kong to Brazil is not a trivial exercise. After starting 2009 off with a meltup (Brazil is +10.4% in the last 2 days), the Hang Seng and Bovespa market indices have both climbed over +40% from their October/November lows! While the manic media was focusing on the “Depression” and “what Bill Ackman likes”, the Sun Tzus of The New Reality were marching forward.

Per his friends in the media, poor Billy Ackman ended up having a down -68% year in 2008. While calling that out onto the mat may be considered “mean” by the old boy network, I’d like to hold this media maven accountable for his performance. Not unlike highlighting Sweden’s loss last night, or Peyton Manning’s loss this past weekend, that’s just the way warfare in its highest halls of competition works. There will be winners and losers. There will be transparency and accountability. Gone are the days of investing in your best “hedgie” club’s “idea dinners”. Gone are the made up Madoffs… Gone, baby, gone…

China’s stock market tacked on another +3.3% move last night, taking its 2-day rally since the New Year’s break to +6.3%. Not that I am keeping track or anything, but our Chinese long position in the FXI etf is up +24.82% now since we bought it on October 6, 2008. For the better part of October and November, no one wanted to talk about that place with all the people – but they do now… especially as the Chinese government is starting to show the world some of the “tactics whereby I conquer.”

Rather than trade their market’s future (s) on what Barney Frank is chirping at Congress, the Chinese make their announcements surgically – and almost always after the markets close. This morning they “reiterated” that they have a “moderately loose” monetary policy. In English, that means “we will cut interest rates whenever we feel like it, because we can.”

Unlike the American, Canadian, or Swedish governments, the Chinese proactively prepared for this economic tsunami. After all, Wall Street’s “Chindia” thesis of 2007 had very basic implications that the Chinese had an “edge” on… like managing their fiscal and monetary policies ahead of their foreseeable domestic slowdown. Now that the dark clouds of sentiment have lifted, whether you believe the Chinese reported numbers or not, it’s hard not to see them self-perpetuating their own economic blue skies in early 2009.

I think China can and will cut rates by another 200-300 basis points. This will both deflate the Yuan, and “re-flate” Chinese Bonds. Since bonds in China actually earn a return that isn’t ZERO, this puts the “Treasured” US Bond market in a precarious position. The largest holders of US Treasuries are China and Japan. If Obama and Volcker don’t ultimately issue these Asian governments a return, my guess is that they will go find it elsewhere – God forbid they look to the Chinese bond market! Imagine that… investing in themselves…

From the Eurozone to the Philippines, we are being issued deflating Consumer Price Inflation reports again this morning. The Europeans saw December inflation drop to a new cycle low of +1.6% y/y growth, and the Philippines saw a 200 basis point drop in month over month inflation! This, as Tim Russert would say, “IS BIG!”, as it will continue to provide the cocktail for the New Year and New Reality’s global rate cutting party.

Beware however… not all ZERO interest rate regimes are created equal… and those countries who provide their citizenry with a rate of return on their domestic savings are watching every other country’s tactics very closely…

Until this interconnected global market’s critical battles have been won and lost, what consensus may not see yet “is the strategy out of which victory is evolved.”

The US Bond market is shaking, and it is making me nervous. My SP500 support level is now 889. Wait for your prices; don’t chase them.

Best of luck out there today,
KM

Chinese Generals - etfs010609