In my house, I am the keeper of the smoke alarms. Like most sensible families, we have white plastic disks all around the house silently sniffing the air 24/7 thanks to the clunky 9 volt batteries that power them.
My relationship with the smoke alarms is a love-hate one. The love part is easy: I realize that they will probably save my family from smoke inhalation if something was to catch fire. The hate part is down to the way these little plastic disks behave when the battery runs down or it is my turn to cook indoors.
Let’s start with the 3am chirp that lets you know that the battery is about to die. Whoever designed these monstrosities spent a lot of time figuring out what unholy pitch of electronic chirp would penetrate through doors, walls, pillows, sleep and the hope that maybe this time your wife will volunteer to venture out from under the warm blankets. Why 3am? Actually that is a bit of an exaggeration. Over all the years that I have had to deal with smoke alarms, batteries have died at almost any time between 1am and 4am. The second aspect of the chirp is that it is infrequent and its location is very difficult to pin down. In a decent sized house with two floors, it could be any one of 10 different white disks. This is as close as I am going to get to employ the skills one can learn from a classic submarine movie. After about 5 chirps (or 15 minutes), the offending plastic disk is identified and it is time to teeter at the top of a step ladder to twist the plastic noisemaker out of its perch so that one can disembowel it of its dying battery. Getting the battery out of its hiding place and removing the connection (which is at once sealed to the top of the battery and incredibly flimsy) while trying to maintain some sort of silence is always a challenge. And of course, there is at best a 50/50 chance that one will have a fresh 9 volt in the drawer.If there isn’t, it could be a week before that smoke detector gets back to work.
The second instance where I hate the smoke alarm is when it is my turn to cook up some hamburgers or a couple of steaks. My much more culinary-skilled better half can prepare meals for months at a time without ever tripping the alarm but the kids know better than to stand in the kitchen when I am flipping the burgers. The tiniest wisp of smoke from the beef sets off a shriek that could bring bats down for several miles in all directions. Because I bear no particular ill will towards bats and any other creatures that I might be harming, I have learned to shinny up the step ladder and preemptively remove the battery from the smoke alarm before I turn my hand to indoor cooking. The funny thing is the kids have yet to figure it out and reckon that I am just getting better at flipping cheeseburgers.
Is there a risk to preemptively yanking the battery? Of course there is because the chance of me putting the battery right back in after cleaning up is considerably less than 50/50. Short term problem solved, longer term, another smoke alarm is out of action for at least a week.
What to smoke alarms have to do with markets?
There are plenty of smoke alarms perched in high places around the financial landscape and I feel like most investors are developing the same attitude towards them as I have towards my smoke alarms. They are either annoying or something to disable when we have something else to get on with. We know what we are doing after all and when it is safe to ignore the warnings, right?
These alarms are chirping and going off all around us. But at each stage, we are finding reasons to rationalize the noise. US to lose AAA rating? Everyone knew that. Greek interest rates going to the moon? Not a biggie, surely the Germans and Finns will pony up when it comes to crunch time. China pouring more lending fuel onto its property bubble fire? What does that have to do with me? QE2 about to end? Surely they will start talking up QE3.
One of the core investing assumptions rests on a weak and almost free (to borrow, if you are a financial institution) US dollar to fund speculative trades around the globe. This has been largely driven by the Federal Reserve which, along with the stimulative fiscal policies of the US Government, has been buying up 5-7 year Treasuries to free investor cash for more risky ventures. The result is a massive carry trade which has pumped up asset prices around the developing world from Hong Kong to Australia to Brazil and over to Russia.
But, looking over the past few weeks, my best performing asset has been SLV, the Silver ETF. The ratings on most of my other assets have been falling into the low teens as the breadth of the market has quietly shrunk this quarter. It looks like some of the sizzle is coming out of this latest rally.
It would not take much to knock the financial markets down a few pegs and with still high levels of leverage at almost every point, it would not take much of a change in the weather to turn a correction into something more serious. A reversal of the US dollar carry trade could result in a sharp reversal of currency flows and values which would throw a monkey wrench into many a well laid investment scheme.
In the next few months, the risk of things getting much better are well outweighed by the risk of a capital damaging correction.
What to look for?
The most obvious sign of a reversal would be strength in the US dollar. The US dollar is weak because the Fed is printing new ones to any bank willing to play. Euros, Yen, Aussies, just about anything that isn’t US dollar grounded has surged lately. Unfortunately, a big component of that game is about to change as QE2 draws to a close. If investors demand higher interest rates to pick up the slack left by the relatively price insensitive FED, the entire playing field for financial assets could shift and demand for cash (in terms of short term US Treasuries, for the most part) could surge. The shift back into the US dollar will likely be temporary (a few months) but the volatility and change of direction could force speculators to close out open positions and shift money to hedge exposures.
What should you do?
As assets roll out of the top rankings, there is nothing wrong with holding back 20% of the proceeds from the next switch. Putting a bit of cash on the sidelines is a good idea now because most of the risk in the markets is political rather than financial or economic. If we sail through the end of QE2 without any significant change in market direction, one will have missed out on a few percentage points of return. If, however, there is a short sharp correction, one can avoid some of the drop and have cash ready to redeploy in to cheaper assets during the summer months.