After 3 days of a rollercoaster ride with huge moves up and down, the markets finally settled into a solid trend, this time to the upside. The markets opened down but reversed and continually trended consistently higher throughout the day (see 1 Day S&P 500 Graph).
The rally was on decent economic data, especially compared to the rest of the world. Initial Jobless Claims came in better (lower) than last week’s report while Retail Sales rose. This provided enough impetus to give our markets a needed boost.
Total Volume was up from Wednesday’s volume. Up Volume was a solid 85% on the NYSE and 81% on the NASDAQ. Advancing issues were 82% and 75% respectively. So we had a broad based rally with mid and small caps participating.
We have bounced off of the 50 day moving averages (50 DMA) on both the S&P and DOW, and also bounced off of the important psychological levels I spoke of in the last few previous newsletters. Volatility has been increasing and what we need is a solid follow through day on good volume and broad participation. That would be just what the Doctor ordered.
One of the current biggest risk to the markets, especially the overseas and emerging markets, is the liquidation of the carry trade. Large institutional investors and hedge funds have been borrowing the weak Yen at very low interest rates and investing in emerging market bonds making a profit on the spread. This works well as long as the Yen remains weak and rates stay low in Japan.
But recently the Yen has strengthened and interest rates have spiked in Japan. You have already seen a huge selloff in emerging market debt and equities.
This “arbitrage” play works well until it doesn’t. These large investors begin losing money on both sides of the trade. They lose borrowing in Japan and with their long positions in the emerging markets.
They will quickly unwind this trade with literally billions and billions flowing out of emerging markets. They will also unwind their Yen borrowing thus decreasing demand for the Yen. The problem is it can trigger computerized trading and stop losses thus accelerating the problem.
The result is you will get a huge dislocations of capital and a big selloff in emerging markets. It causes large dislocations of capital quickly.
Do you remember hedge fund Long-Term Capital in 1998? They were borrowing/shorting U.S. treasuries while going long Russian bonds making money on the spread, or interest differential between the two.
The idea is that if interest rates rise, they will rise together and bond bonds will go down in price. The losses in Russian bonds will be offset by the gains in the gains on your U.S. short position when treasuries go down too. So theoretically you have a hedged, arbitrage position.
The only problem was Russian bonds are not the same as US Treasuries, especially back in 1998. In fact, that is the very reason Russian interest rates were much higher the U.S. rates. Because the risk was much higher.
So it really wasn’t true arbitrage. When investors got nervous, Russian bonds sold off and treasuries rose as there was a flight to quality.
Long-Term Capital, who had a huge leveraged position, went belly-up within weeks and caused a global meltdown with a big equity correction in our markets. I have attached a graph of 1998 showing all 3 major indices – the DOW, the S&P 500, and the NASDAQ – correcting over -20%.
Now I am not saying this is imminent, and even though Japan is in trouble, most investors (not me) still feel Japan is safer than emerging markets. I am still bullish on U.S. stocks, but you need to remain vigilant to a strengthening Yen and rising Japanese rates. That could be a Black Swan event.
Once the unwinding begins to take place, the Yen will likely reverse and weaken, but it will be too late for the emerging markets. I cannot stress this enough; the U.S. is the place to be right now from a risk reward standpoint.
We have a whole slew of economic reports out today, and no companies reporting on the S&P 500. We do have 3 companies reporting in the broader markets all before the open.
If you have any questions, e-mail me at dstewart@old.noramassetmanagement.com and I will be happy to respond.
Dan Stewart CFA®
NorAm Asset Management
Economic Reports Today:
Producer Price Index
PPI Ex Food & Energy
Industrial Production
Capacity Utilization
Manufacturing
University of Michigan Consumer Confidence
US Current Account Balance
Annual Revisions to Current Account Balance
US Treasury International Capital Net Monthly Inflows
US Foreign Net Transactions
Some Notable Earnings Reports Today:
Smithfield Foods (SFD – before market)
American Superconductor (AMSC – before market)
Magnum Hunter Resources Group (MHR – before market)
