Trader’s Narrative

What better way to reliquify the world financial markets than sacrificing a currency?

If you’ll recall this is a well worn script. The last time we had a financial crisis, it was the Yen that was used as the vehicle of choice. Massive amounts of capital were borrowed in Yen and invested in other risky assets with the nudge-wink agreement of central banks that it was a one way trade.

Today it is the US dollar that is being sacrificed at the altar of the new bull market… in everything. Roubini has been among the most vocal to raise the alarm. But almost everyone else has decided to enjoy the trade while it lasts.

Of course, the sensible thing is to realize that you can’t drink yourself sober, just as you can’t dig yourself out of a hole. But since when have monetary policy wonks been fans of reality?

While it is difficult to prove definitively that the US dollar carry trade is the reason almost every single asset class has appreciated, its footprints are hard to miss. Here are David Rosenberg’s recent observations on the correlations across asset classes:

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April.

There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring.

Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

The scary consequence of the US dollar carry trade is that it has pushed almost all risky assets to be correlated. And when the music stops and someone starts to unwind the trade, it will get ugly. When everything you hold is correlated to each other and everything else in the market, even a small tremor of selling will lead to an avalanche as the value of your portfolio starts to decline all at once.

If you expect gold to be a safe haven, you’ll be sorely disappointed. Historically, gold and gold stocks have never been a stronghold in a severe sell off. So maybe that’s why short term T-Bill rates have been pushed so low.

Last week we reviewed the white hot Chinese stock market with a cautionary note. I wanted to return to it briefly because the situation is serious and deserving of much more attention.

Putting aside price charts of the Chinese equity market for now and turning to monetary measures, we can see something rather alarming happening. China’s M2 has enjoyed a constant rate of acceleration as shown in the chart below (in semi log scale). But in late 2008 the rate of acceleration suddenly increased dramatically:

This was a consequence of the massive stimulus plan put into motion by the Chinese government. They pumped unprecedented amounts of liquidity into their economy to offset the world-wide economic slowdown. There would be nothing singularly alarming about that since all central banks around the world, as well as governments in charge of fiscal policy, have orchestrated a collective burst of activity.

What is alarming is that the Chinese economy, stock market and especially real estate market are just now displaying bubble-like characteristics. The government controlled banking sector is a mystery wrapped in an enigma. No one can begin to fathom the amount of non-performing loans on the books. Unlike the US which went through a gut wrenching cleansing - thanks to the largess of the lobby-less taxpayer, the financial sector is once again back in fighting shape (privatized profits, public losses). China has yet to address their toxic assets

As we briefly touched on before, since last year’s low the Shanghai market has now appreciated more than 100%. Once again the stock market has enthralled the average person in China with thoughts of wealth and the possibility of making more in a month than what they earn in a year at their regular job. Speculation in the market is seen as not only a legitimate way to make money but a very lucrative one with low barriers to entry.

A sure sign of a bubble is extreme turnover. Recently, the total Chinese stock market turnover (in one day) reached $63 billion. That’s more than the combined total turnover of $58 billion in London, New York and Tokyo for the same day!
Continue reading ‘China’s Bubble 2.0 Threatens Global Recovery’

The big debate within Wall Street now is not over huge bonuses but instead over high frequency trading and flash orders. The issues surrounding HFT are complicated and require a careful balance to be struck between the need for continued innovation, liquidity as well as price improvement and on the other hand, equality, transparency and prevention of system wide risks.The issue is complex but it can be boiled down to one question: is the exchange ensuring that every single participant has equal opportunity and access to the same information?

I stopped watching CNBC years ago but every once in a while friends send me a link to one of their online videos like this recent one about high frequency trading and I’m reminded all over again why I don’t watch CNBC:

This is exactly what is wrong with CNBC. They spend more time designing and perfecting their chyrons and the makeup and hair of their hosts and seemingly none at all actually researching or understanding an issue. You know, that thing we used to called journalism. In the end what could be an enlightening and intelligent dialogue about an advanced function of the financial markets deteriorates into childish ad hominems.

The debate over high frequency trading reminds me of the controversy a few years ago when large institutions were able to transact in mutual funds units after the close. By getting yesterday’s price, that is buying after knowing the market close, they made millions of dollars. Until they were stopped.

Flash orders, per se, are not evil. Actually, they are quite useful and regularly allow large traders to get better prices than they would normally get. Here is a diagram illustrating how they work. The problem is that we now have opportunistic computer algorithms which out-trade the slower and larger institutional traders. And this segment of the exchange volume has exploded in recent years. The exchanges love it because it increases their volume traded and they get paid co-location fees for housing the computers that power the myriad instantaneous trades.

So it isn’t difficult to see the dilemma. It is the same one that faced the SEC recently when they looked at the regulations surrounding short sales. Finally, the SEC moved to fix naked shorting, a big problem. Hopefully the rest of their regulatory modifications will be the scalpel type - not sledgehammer swings.

Here are a few recently articles which explore the issue of high frequency trading:

• How to Understand High Frequency Trading
• Stock Traders Find Speed Pays, in Milliseconds
• We Fear What We Do Not Understand
• Demystifying High Frequency Trading
• High-Frequency Traders Say Speed Works for Everyone
• SEC Pressured to stop HFT

You can find many others at news.tradersnarrative.com (check in as interesting links are added regularly).

Here’s a short video discussing high frequency trading and flash orders, which is refreshingly nothing like the CNBC clip mentioned above:

Tabb is a contributing editor at Advanced Trading magazine and because of his day job, he comes at this issue with his own biases. Although the interview isn’t as polished and has lower production qualities, it is still infinitely more rewarding listening to Tabb than to the screechings from CNBC.

One of the very few economists that foresaw the financial crisis was Canadian David Rosenberg. He was the chief North American economist at Merrill Lynch but recently moved back to Canada and joined the boutique asset management firm of Gluskin Sheff in Toronto.

While the FOMC has held the Fed Funds Rate at zero to 0.25 since December, a recent report prepared for the San Francisco Fed claims that this policy will have to be continued for much longer than first anticipated.

In a recent report, Rosenberg shows the chart below and points out that the Fed may very well have stopped easing. Although the Fed’s balance sheet exploded in 2008 as they went on a liquidity rampage, it hasn’t budged so far this year. The ‘real’ rate (adjusted for inflation) is closer to +0.77%, having rapidly recovered from the extreme low in late 2008:

There are several relevant variables to watch: the 3 month Treasury Bill rate; Dr. Copper - which has already signaled that the worst is over; and the Baltic Dry Index which has now surpassed the March 2009 swing highs and begun a new uptrend.

You can sign up to receive Rosenberg’s daily market commentary from Gluskin Sheff.

Money market asset levels fluctuate much less than their equity counterparts. The general trend for cash holdings is to increase steadily every year. There are some cyclical effects for bear and bull markets. As people become fearful in the face of a bear market, they horde money and as the become convinced they are losing money by not being invested in a bull market, they reduce their cash holdings.

This bear market has given us a lot of unprecedented market situations. We are now seeing a rare exception to the norm of equity fund assets dwarfing money market assets. This has been caused by a double whammy. As the stock market has been pummeled mercilessly, losing 60% of its value since late 2007, the asset value of equity funds has shrunk. And on the other side of things, retail and institutional investors consistently raised their cash assets. In September 2008 I pointed out that there was an unmistakable stampede towards cash as retail investors hoarded cash. Not surprisingly then, in November 2008, we saw a rare occurrence: more assets sitting in money market funds than in equity mutual funds:

Source: Bloomberg Chart of the Day

The last time this happened was 16 years ago, in September 1992. The data for April isn’t available yet but I’d bet it shows money market fund assets almost equal to equity fund assets. Not because people have put the cash to work but because the market has been able to hang on to gains and thereby increased the value of the equity assets.

But as Jason Goepfert of SentimenTrader points out, this is not an automatic buy signal for the market: A Major Buy Signal! Well, Maybe… All we can definitively say is that there is a massive load of cash just sitting on the side, waiting.

A build up of cash is normal in a bear market but before we can transition to a bull market it needs to be put to work. As people become convinced that the worst is behind us, they start to take more risk and begin to put their cash into the market. So unfortunately, just noticing a massive pile of cash doesn’t really help us unless we can somehow pinpoint when and with what intensity this billowing mass of liquidity will start to be invested in the stock market.

But to give you an idea of the sheer monstrosity of the potential tsunami of cash, consider this: it currently represents 50% of S&P 500 total capitalization. Needless to say, that is jaw dropping. As it is put to work, even in a trickle, it will put an impregnable floor on almost all equity indices and then drive prices higher. When that may be, can not be determined by this metric itself but by other technical, monetary and sentiment measures.

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