Wednesday, February 28, 2007

A Yen for a Correction

Why did the stock market sell off over 400 points yesterday? The standard explanation was the sharp correction of Chinese stocks which was caused (allegedly) by fears that the Chinese government would take measures to reduce speculation by locals on their exchange. Why would selling on the local Chinese market cause a worldwide selloff in stocks? The Chinese stock markets have a combined capitalization of about $350 billion. A couple of well heeled US private equity funds could LBO the whole thing. And the Chinese have about $2 trillion in savings so even a 10% plunge in prices shouldn't have that much of an effect on the Chinese economy. The selloff in world stocks was only partially related to the Chinese stock market fall.

The real culprit was the Japanese Yen. Huh? I haven't seen any news story yet that even mentions the move in the Yen yesterday, but that was the real cause of the selloff. Let me explain. Hedge funds have for many years executed a trading strategy called the carry trade. The funds borrow yen at a low interest rate (rates in Japan were just raised to 0.5%) and convert the yen to another currency where they can get a higher yield. Borrowing at a low rate and investing at a high rate means the trade has what is called positive carry. In other words, the yield on the investment more than offsets the interest cost from the loan. Once upon a time, the carry trade was primarily a bond trade. Borrow at 1% in Yen and buy Treasury notes with a yield of 5%. If the exchange rate stays the same, the fund makes the 4% difference. Leverage this up and you can generate high returns with seemingly low risk. The problem is that the exchange rate never stays the same. Over the last several years though as more and more funds have engaged in the trade, the very act of doing the trade caused the yen to fall which actually increases the profits of the funds who got in early.

Now funds have wandered away from the bond market with the carry trade. If you can make 4% buying Treasury notes, why not take the borrowed money and invest in the S&P 500 and make more? If you borrowed in yen last summer and put the money in US stocks you would be sitting on some big profits. These yen loans are now financing trades all over the world. Brazilian bonds, Turkish bonds, US stocks, Russian stocks and bonds, etc.

Here's the problem with the carry trade. If the yen starts to rise, the funds start to lose money as the cost of buying back the yen to repay the loan rises. And that is what happened yesterday. As the yen started to rise, the hedge funds took action to limit their losses. To do that they needed to buy yen which caused the yen to rise further which caused other funds to buy yen, pushing the yen higher which get the picture. To pay back the yen loans, the funds then needed to liquidate the investments they had bought with the loans. That would be the aforementioned bonds and stocks. And we get a 400 point loss in the Dow.

So here's the question. Did the funds start buying yen because they wanted to reduce their risk after the Chinese stock market fell? Or were the funds buying yen because they feared that other funds would buy yen to reduce their risk? It's a circular argument for which there is no answer, but one thing is certain. If the yen rises - for any reason - the pain will be felt a long way from Tokyo. I have talked for many years about the excess liquidity in the world financial system. The source for much of this liquidity is Japan and if it dries up the consequences for asset prices will be severe. I wonder if US politicians who believe a stronger yen would help the US economy by making our exports more competitive have any idea what the consequences would be if their desires came true? I suspect not.

I wrote our latest tactical update last Saturday and got it out to clients on Monday. The main theme was the need to reduce our equity exposure:

This past week felt like a turning point in the markets. I find it hard to explain why a seemingly uninteresting week with no major economic news felt so important, but I have learned, after many years of investing, to trust my instincts. And my instincts tell me that something changed this week....I have advocated an overweight position in stocks since our first tactical update in August, but the time has come to make a change. During most of this rally the average investor has remained skeptical. When I wrote that first tactical update back in August, the surveys showed more bears than bulls. As the market has risen, the number of bulls has increased steadily; as the market has rallied, more and more investors have jumped on the bandwagon. This week for the first time, bulls represented more than 50% of the survey participants. And that alone warrants at least a minor change. I am reducing our overweight position in stocks. I am still recommending an overweight but reducing our exposure to a more comfortable level.

I was able to get some selling done prior to yesterday's big selloff, but frankly I wasn't able to do everything I planned. Timing is everything in this business and while I'm proud of the call to sell some stocks, I can't help but think that I waited a little too long. One thing for sure; no client should have been surprised by the selloff. We have been talking about the likelihood of a correction since early in the year. In fact, we've been hoping for some kind of correction so we can put some money to work, but this was a little too much too soon. Oh well; you take what the market gives you.

The market will probably try to make some kind of rebound over the next couple of weeks. I doubt it will make new highs though and a retest of the low yesterday would be routine. I will probably be looking to do some selling on the rebound and save my ammunition for the next downdraft. That's the plan anyway. Let's hope my timing is a little better this time.

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