Currency Archives

January Effect

Traditionally in the US, January is a time for chasing small caps. The NASDAQ has outpaced the S&P 500 almost 7% to 4.6% so far this month. In Asia, some of the larger markets will close or be affected by the closures around the Chinese New Year Holiday. Since the New Year will be a Dragon Year, expect at least a few strong sessions when markets reopen.

What does this mean for riskier assets? A bullish forecast off the back of a January rally is a dangerous one. Right now, the positives and potential negatives suggest another volatile year.

Housing Stocks Come Back to Life

There is no doubt that the US is starting to rouse from the GFC imposed slumber. A Financial Crisis induced recession is harder to bounce back from than the more common inventory cycle recession. One consequence (amongst many) is that one traditional avenue of entrepreneurial capital (residential real estate) has not be readily available to finance new business start-ups because of falling housing prices and general bank reluctance to extend credit to the private sector. That deep freeze appears to be thawing a bit. The bellwethers of the US domestic housing market (ITB and XHB for ETFs, LOW, HD, PHM, and LEN for individual stocks) have turned up strongly. Will this be a “head fake” like the last time XHB surged from July 8th 2009 to April 23rd 2010 (+89%)? Perhaps, but with other positive “green shoots”, this surge (from October 4th 2011, +58%) may not reverse as dramatically as the last one. Given the sharp run-up and some good earnings reports, don’t be surprised if there is a correction in the coming weeks, though.

The housing sector bears watching. If entrepreneurs can unlock capital in residential housing, the Great American Job Creation Machine can crank back into gear (recent job report numbers are rounding errors compared to what they should be for a full blooded recovery).

Summer in Europe?

Unfortunately in our interconnected world, the troubles brewing in Europe still look likely to cause more heartburn in the next few months. There is little doubt that Europe has failed to sort out the sovereign debt crisis of its periphery to the satisfaction of financial markets. Credit agency downgrades only confirm what most market players have been saying for months…the sums do not add up. The next “final deal” will just be one of a series of “deals” that will see a series of painful writedowns for the banks. Bank Capital is being bolstered largely by clever accounting tricks these days. And with hedge funds buying up troubled sovereign debt and relatively cheap Credit Default Swaps, the prospect for an orderly “voluntary” haircut looks somewhat diminished. The rot is spreading from the periphery to the core and until the Germans are forced to make some hard political decisions, the rot will continue to spread inward.

So what is left for Europe? Very likely…devaluation.

In a rambling article for Bloomberg, two professors from MIT make the case that Italy is crucial to the Euro’s survival and that unlike most other European countries, Italy has a significant amount of trade outside the EU (55% of exports according to the authors). Given those two factors, a Euro trading at parity with the US dollar should help Northern Italian exporters boost exports enough to make a difference. And, since Italy boasts a massive and vulnerable bond market, any improvement should help to relieve pressure on the Euro’s long term survival as a common currency (ETF: FXE).

How will this play in the US and other emerging markets?

In the short term, it means that a summer holiday in Europe might be a great bargain. In the medium to longer term, a more competitive Europe could hamper any manufacturing renaissance in the US as a large swing in exchange rates allow German exporters to price more keenly than US Midwestern component makers (and makers of commercial aircraft). For China, the authorities in Beijing probably have enough fiscal and monetary firepower to overcome the negative effects of a Euro devaluation (the Eurozone is both a large customer and competitor of China).

One can only guess whether China will continue to diversify its foreign exchange holdings into Euros. Given the likelihood of a significantly lower exchange rate in the not too distant future, it would not be surprising to see the People’s Bank directing its traders towards other currencies for the time being. Given the massive size of the foreign exchange reserves and China’s desire to hold down domestic inflation, the US dollar is probably the only reasonable home for recycling the trade surplus (ETF: UUP).

Presidential Cycles and Australia

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

Managing Uncertainty

Now that some of the dust has cleared from the international markets, it is a good time to assess the real impact of Japan’s triple disaster on your actual portfolio.

Why? Because it is sometimes important to look back and recognize that for most investors, the damage was in the 2%-4% range. It may seem cruel that financial markets can rebound so quickly after a massive earthquake, a tsunami and partial core meltdowns but, except for Japanese fund managers and the people who are suffering in the affected areas, the news cycle is about to leave the story behind.

The urge to “Do Something”

When we invest, we bring all the skills we have acquired in the non-investment world, especially those which have worked so well for us.

One of those skills is the ability to quickly react to stimulus. Our ability to survive in the world depends on quick reactions. Whether driving, walking, making decisions at work or social situations, our ability to react to our environment is critical to success. We actively seek to hone our reaction skills through education, training and experience. Some of our reactions are “hardwired” and so quick that when we put our hand on something red hot, our nervous system reacts even before sending the message to the brain. By the time the brain becomes aware of the incident, the hand has already jerked away from the hot surface.

What works well in the physical world does not always work as well when it comes to investing. For the short term professional trader, lightning fast reflexes may be important. But for the rest of us, letting the new information get all the way to the brain where it can be judged against the existing investment strategy is the way forward because trading, while cheap these days, is not cost free.

As the markets regain their pre-triple disaster pose, it is clear that “doing something” just for the sake of reacting to the news is not the best investment posture to strike. As the Nuclear plants are brought under control, we should see iodine and salt prices returning to normal, even in Mainland China.

What does Japan mean to the Global Economy?

Most observers reckon that Japan was either in or about to enter its next recession even before the triple disasters struck. That means the 4%-4.8% global growth rate that many economists are looking for this year did not rely heavily on a strong Japanese contribution.

What about Japan?

Although our initial reaction was that Japan’s financial prospects have not changed significantly as a result of the triple disaster, there has been one movement which bears further observation: the Yen.

The world’s Central Bankers are coordinating efforts to clamp down on the surge in the Yen that occurred in the aftermath of the quake (82.9 on March 10th to 76.25 on March 17th) as Japanese firms and individuals scrambled to bring money back onshore. Given Japan’s high level of indebtedness, one might expect the Yen to weaken as the scope of the disaster became clear. But, that would ignore the investment situation from the local perspective. Japanese individuals and institutions have spent the last two decades funneling money offshore to capture more promising returns than were available onshore. With a massive rebuilding program on the horizon, it would appear that investors are voting with their offshore accounts that there will be some attractive opportunities in the not too distant future. Japan has often only undertaken comprehensive restructuring as a result of Gaiatsu (outside pressure). Although usually a term reserved for foreign political pressure, the triple disaster comes at a time when Japan has largely exhausted its biggest source of finance (individuals saving through Japan Post Bank). That pile of savings is still very large but is more likely to be drawn down than grow given the aging of the population. Whether the rebuilding effort will be large enough to spur the economy out of its “Lost Decades” is something to watch for over the coming months. To succeed, a certain amount of intestinal fortitude on the political side will be required to allow for economic restructuring in addition to just reconstruction. The dramatic movement of the Yen suggests that the possibility exists.

So, how do we manage in such uncertain times?

There is no “System” that will predict an earthquake (large or small) or any other “Black Swan” event that might trip up the financial markets. Fortunately, the financial markets are more resilient than the 24/7 cable talking heads suggest. The problem with Black Swan events arises when one invests without a plan. Because, without a plan, all one is left with is panic and reaction. Unfortunately, with High Frequency Trading systems trading 50-70% of the daily volume in the US on timescales that are a tenth to a hundredth of the time it takes to blink, the reaction game is one in which an individual investor has no competitive edge.

The trick is to change the parameters of the game to play to your strengths. By taking a longer viewpoint, most of the market noise (intraday and intraweek volatility) cancels itself out. The remaining movement can be analyzed in terms of shifts in economic or financial fundamentals or investor perceptions of the same. This is an area where astute observations and an eye towards risk control can help one capture returns that will build wealth in the long term.

Whether you use the Fund King System or another investment discipline, it is important to keep a level head and make the important decisions (what to invest in, when to buy and when to sell) well before the markets inundate you with conflicting data. Not all of your trades will be winners but having solid parameters for judging winners and losers before the market starts reacting to the day’s events will leave you in a much better position to make astute investment decisions.

Or you can load up on iodine tablets…

What looks good this week?

Across the portfolios, we are seeing a deceleration in the small caps which performed in the first few months of the year. An interesting sector to watch is financials which may be poised for a big jump in top line growth if confidence in the US economic recovery grows. Banks in particular have been in balance sheet repair mode since the Global Financial Crisis started. If the focus switches to market share and revenue growth, we could see a big surge in financial shares in the US. XLF is currently ranking #2 in the US ETF Sectors Portfolio.

Silver (SLV) still looks solid both in the longer term portfolios and in the short term commodity portfolio. Energy looks good both in US terms (XLE) and Globally (IXC) and while events in Libya may influence prices in the short term, the longer term driver is increased demand from G8 economies that are still in the early stages of an economic recovery from the Global Financial Crisis.

The Seeking Alpha Portfolio

Seeking Alpha PortfolioThis week, we bid farewell to Taiwan (EWT) which has been nudged out of third place by the S&P 500 (SPY).

As noted in the past, the tech sector has shown signs of weakness that suggest either that economic growth for 2011 has been overestimated or that the tech sector is not going to benefit to the same degree as it has at similar stages in economic recoveries of the past. The fact that most of the tech innovation is actually taking place in software rather than hardware (apps vs. a new tablet; software as a service rather than installed applications) may be part of the puzzle as corporate budgets are spent on IT projects that deliver more efficiency rather than just building in new capacity. The system may be signaling that the pricing power lies with the corporate IT departments rather than the tech firms that will be supplying them.

Oil, Food and US Big Caps

With SPY nudging out EWT, we should be on the lookout for signs that confirm or contradict the idea that the US will grow at a solid 4% plus rate. Unemployment will continue to draw headlines as the Republican presidential candidates start to turn Political Action Committees into formal campaigns in the coming few months. However, it is important to keep two things in mind.
1) Unemployment is a lagging indicator of economic growth in the best of statistical times. And
2) US statistical methods tend to understate new employment in recoveries and overstate the situation in downturns.
So, with a double lag effect, investors should not put much weight on payroll releases. By the time they flash “green”, most of the recovery may be finished.

A Shiny Example

SLV has had a nice run since breaking north of $30 in the middle of February. That is not news but a checkable fact. For those investors who noticed that SLV was at the top of their rankings since July 12th of last year (when SLV closed at $17.62), it was a good opportunity to make money in a relatively non-correlated asset class. The only time it got sticky was at the beginning of this year when the price corrected.

The reason that we bring this up is not to brag. While SLV has done well, other investments that have made it into the top rankings have fared less well. The point is that most of those investments were eventually replaced by new market movers while SLV has hung in at the top of the lists despite the 10% correction that we saw in January. While we may have worried in these posts that the rerating between Gold and Silver may have run most of its course, the System kept pointing out that there was strong momentum behind the asset and that there were not that many more promising assets out there at the weekly measurement points.

My only slight regret…not swapping GLD for SLV a few weeks back when I was adjusting my Seeking Alpha ETF Portfolio. I would have looked very clever. But, in calmer moments, I realize that the regret and the emotion behind that regret is precisely why one should use an unemotional system to help execute one’s investment plan.

So, should you buy SLV now? Well, that all depends. Does it make sense as part of your universe? And, if it does, ask why? Make sure that you are not adding at this point because of past performance. Make sure that it is in there because you think other investors are worried about the US dollar or you think there is a chance that the Biomedical uses of silver are poised to go through the roof. In short, remember to separate the Asset Selection process from the Asset Trading process. And what happens when something better comes along in your universe? That’s easy, switch.

A Tarnished Example

Now that PIMCO has finally gotten it through to folks that, yes, they really are not keen on US Government paper (no link…too many choices), let’s look at how two bellwethers fared in the Fund King System.

TLT (which tracks 20 year plus US Treasuries) has been at or near the bottom of the US Sector ETF Universe since the beginning of November 2010. And less long term TLH (tracking 10-20 year Treasuries) has joined the bottom of the pile in another ETF portfolio since the end of November.

So, whether you were in the “Don’t Fight the Fed” or “Hyperinflation Around the Corner” camp, the Fund King System told you to steer clear of the asset class for the last three months. Even the FED could not buy up enough long dated Treasuries to keep TLT from dropping 10% over the period. Mr. Gross, the head of PIMCO noted in his newsletter that the FED has been buying as much as 70% of the newly issued Treasuries of late.

What does it mean?

There is nothing wrong with SLV , TLT or TLH in absolute terms. Each of these ETFs represents claims on perfectly good assets. The deep meaning to take away from these two examples is that it does not pay to fight the trends. If investors (on balance) are shifting money out of US Treasuries and into hard assets like Silver, there is little point in trying to stand in the way. At some point, the tides of money will change directions and other asset classes will get swept up or down. When interest rates rise a couple hundred basis points, Bill Gross and his PIMCO colleagues will be back on the bid side. Why? Because they are in the business to make money; and money is made by buying low and selling high.

An interesting read

Supporters of Ron Paul can sometimes be a prickly bunch. But, they occasionally come up with very thought provoking concepts.

I like a good bash so when I came across an article entitled: “How to End the Federal Reserve System” by Gary North, I was prepared for a rehash of the old arguments about an evil cabal on Jekyll Island in 1910. But the real strength of the article comes about halfway through when Mr. North analyzes the demise of a government agency which had also been granted monopoly powers: the US Postal Service. He draws some interesting parallels about what technology could do to the Federal Reserve System long before Ron Paul and his supporters in Congress are able to rescind the Fed’s legal mandate.

Basically, the ability to move into other currencies with a few well place computer key strokes or even to develop new mediums of exchange means that even an institution as powerful and influential as the Federal Reserve is not immune from obsolescence.

Part of the appeal of ETFs like GLD and SLV is that they are theoretically redeemable into a fixed amount of Gold and Silver respectively. While pitched as a new idea, the concept of convertibility into precious metals was once the cornerstone of the US dollar’s value (and most other currencies before that). In an interconnected world that can work with services like PayPal, it’s probably only a matter of time before someone reinvents a multinational global fractional banking and payment system backed by gold, silver or some other store of value. If it is tied into Visa, Mastercard and American Express, one need not worry about carrying about sacks of heavy metal to the grocery store. Just as email eclipsed the first class letter (something that was unthinkable as recently as 20 years ago), there is a risk of a new currency system taking the premier spot occupied by the US dollar today.

Just because the risk exists, however, does not mean it will come to pass. The biggest difference between the US Post Office and the Federal Reserve is that the latter is a privately owned, profit seeking entity. Long before we are all paid in PayPal credits or Googles, the Federal Reserve (which is owned by and represents the largest US banks) will feel compelled to take steps to shore up the value of the US dollar. That more than anything else will lead to a change in policy that will likely see higher interest rates in the not too distant future.

While you are pondering your long term investment strategy, make sure to include a plan for higher interest rates.

What happens to Japan now?

The earthquake and tsunami that hit Japan on Friday will impact the country and the economy in ways that are hard to foresee at the moment. Despite the shocking video and photos, however, the natural disasters are unlikely to have a significant long term impact on the economy. As long as the authorities can keep the nuclear fallout to a minimum, the biggest issue will be reconstruction and who will buy the fresh batch of JGBs. That points to another force for higher than near zero interest rates in the world’s #3 economy.

From an investors’ point of view, the Nikkei 225 was the best of a weak bunch (Asia has lagged since November of last year) in our universe of 11 Asian indices as of Friday’s rankings. The earthquake and tsunami do not significantly change the long term public finance fundamentals of the country and most of the familiar exporting names have transferred significant portions of their manufacturing base to locations around the world in the last few decades.

Should you buy? If your universe is only Asian Equities: then perhaps. But, if you are looking at a broader range of asset classes, there are quite a few commodity based ones that look more attractive. As Japan is import dependent for almost all of its commodity needs, there are better places to invest your money.

Those That Fail To Learn From History

Weighing in at 545 pages, the Financial Crisis Inquiry Commission has finally come out with a report that “didn’t produce new culprits or scandals” according to the Wall Street Journal report. It looks like the Commission has succeeded in its primary task…to bury any useful institutional lessons in a pile of paper.

The first paragraph of the article however, should give one pause:

Twelve of the 13 largest U.S. financial institutions “were at risk of failure” at the depth of the 2008 financial crisis, while at least 50 hedge funds tried to capitalize on it, according to a report released Thursday by a U.S. panel investigating how the financial system unraveled.

…are doomed to repeat it.

Whether you prefer the George Santayana or the Winston Churchill version of the famous dictum about the risk of ignoring the lessons of history, the lack of serious introspection on the Global Financial Crisis means the seeds of the next bubble are being sown right now. The must obvious suspect today would be sovereign debt but one shouldn’t concentrate all one’s attentions on the US and EU. S&P’s downgrade of long term Japanese debt (AA to AA-) may be the first signal of the next bubble getting ready to pop. With extremely low interest rates (ie. high bond prices) and a debt to GDP well into the triple digits, it would not take much of an interest rate rise to cause serious fiscal problems in aging Japan.

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