Sir, Yen Sir

The yen destruction is just beginning, and while it might have second thoughts, the eventual end is clear. It's got a long way to go to get to where it was five years ago and even further if you look at the currency (not the ETF): Regardless, everything priced in yen is shooting up.Viewing the remainder of this article requires a Subscription

The most important ignored story

While Fed minutes, housing numbers, etc. are all important, it's important for investors to look around the world at stories that will impact their investments.Viewing the remainder of this article requires a Subscription

Japan – it happens

Japan was hit with another earthquake. It happens. I guess it more likely to happen in certain places than others, but such is life. They’ll rebuild, they’ll have more earthquakes. Is there any new story there? Not for me.

The real story is in energy and food. As I write this, oil is trading at $110! Seriously, are equity investors aware? Are government officials aware? I am not so sure.

Not surprisingly, we see that CORN is also making new highs:

Food and energy are inter-related for a whole host of reasons, not the least of which is that current government policies that encourage taking a need (food) and making it into a want (energy) lead to a constrained supply. I’m actually quite concerned about the next shock to the system. I’m not predicting where it will come from, but historical precedent (and Murphy’s Law) suggests that shocks come at the worst time. Fundamentally, with a slowing world GDP, we would expect oil to go down. However, the monetary policies and geopolitical turmoil are trumping the supply/demand dynamics and we’re maintaining our exposure to ag and energy.

Relevant ETFs: OIL, CROP, MOO, DBA, NLR, KOL, FCG, EWJ, DXJ, FXY

The Hard Trade

As readers know, I have had exposure to Japanese equities, currency hedged, for the past year. That position has been difficult at times, especially since the yen’s strength confounded me. So the recent events have erased any previous gains we witnessed, and in fact turned a winning position into a losing one – not a great turn of events under any circumstances.

The tsunami forced me to reassess the position and as of yesterday, the research into nuclear meltdown made me ever-more hesitant to maintain my exposure. I am still wary. However, as a contrarian, I am often early, and often making uncomfortable decisions with a lot of headline risk. I do not know the complete fallout from the nuclear reactors, nor do I know the full force of currency repatriation. All the models I’ve seen are guesstimates at best.

That being said, the hard trade is often the most profitable! In this case, buying Japanese equities is hard and selling the yen is hard. However, the logic of the trade is in tact, and a natural disaster, while unexpected, hasn’t changed the dynamics, and in fact, the revaluation lower by 10-15% (equities+currency moves) or more has only made the expected return higher.

Relevant ETFs: DXJ, EWJ, FXY

Japan

All eyes are on Japan and the markets worldwide are moving FAST. If you’re a trader, this market is dangerous. If you’re a longer term investor, this market is also dangerous. As an example, in the course of writing these two sentences, the Dow was down almost 200 points then rallied to being down 90.

The yen is catching a Kobe bid as everyone is playing the repatriation of the yen carry trade. I’m not buying it and I’m staying short. I’ll be looking to increase that exposure if this move continues…but then again, I’m a long term holder.

Nuclear companies were up, now they’re giving up those gains. Fed canceled their daily POMO purchases. And on and on and on.

I don’t have much to add to the headlines except to say that I wouldn’t try to trade them. Just too difficult to play these swings. If you are going to play them, play them small, since the moves are happening fast and furious. The flip side of that, is that opportunities are going to open up for long term holders to start taking positions. We’ll keep monitoring the situation and updating readers.

Does every dip deserve to get bought?

Japan is off 11%, and the yen is stronger – I guess that’s what happens when a natural disaster moves a country 8 feet over and brings it to the bring of nuclear meltdown. Following the sun, European markets are off 3-5%, and closer to home futures are down 2-3% on the US equity futures.

So why are not all dips created the same? The easy answer is magnitude, but that is a false perspective. 3% looked big a few days ago, for example, so it all becomes relative. Second, it seems more dramatic when it happens in one day, but what if the markets had lost 3% over the course of a week? Suddenly that same dip doesn’t seem as extreme. Lastly, part of the conversation has to revolve around the underlying causes for pullbacks, namely, is it just technical, or moneyflows, or valuations, or a natural disaster.

When a pullback happens at high valuations, as we have seen sporadically in the US markets, traders can buy the dip for a bounce, but the risk is to the downside. With fundamentals working against you, shortening holding times and position sizes will work to reduce risk. It’s not my bag, but some people do it successfully and more power to them. It’s the reason people will buy into the gap down this morning, hoping to catch a bounce. I will stay short the market, because valuations are working against it.

Japan, on the other hand, is a different type of dip. I thought the Japanese equity markets were attractive on a fundamental level BEFORE the earthquake and I thought the yen was overvalued. Both positions have now moved against me and wiped out any gains I had. The question here is whether Japan is an opportunity to buy the dip?

Before answering that, I want to point out another “buy-the-dip” question that has come up around our portfolios…nuclear companies. We are still sitting on nice gains in our positions, but those will probably be wiped out today. Is this the time to get out?

So let me share with you my thought process. Japan is a buying opportunity IF (and that’s a big IF) they can contain the nuclear reactors. Barring that, they may face a huge demographic shift out of near-by cities and in the short term will face a recession or depression that will make their 20 year slow moving recession seem quaint. That makes me wary of adding to the position. I’m not selling, but I’m comfortable with the risk in the portfolio, and I usually don’t like to pyramid positions in either directions anyway, so this position will stay. In essence, but losing our gains in the position, it is just down to it’s original allocation. Nuclear is much more interesting to me. The nuclear companies are down 15-50% in a few days. The main question is whether there will be nuclear energy in the next few years and I believe there will be. While the media talks of the potential damage, the other alternatives have their own environmental and human toll. The difference is that the alternatives are not dramatic in their impacts. It’s like people being afraid of planes crashing because they are dramatic, but not thinking about the risks of driving which are much higher. Nuclear, in this case, being the plane.All of that was to say that I’ll be looking to add to this exposure in the next few days. Not immediately, but eventually.

Lastly, these types of markets provide opportunities for disconnects – NAV premiums/discounts, ADR pairs, spin-offs and cross holdings, etc. all tend to trade inefficiently. Those opportunities should be at least noted, or if you’re a professional trader, they need to be harvested.

Relevant ETFs: NLR, DXJ, EWJ, IWM, RWM, SPY, SH, FXY

Japan down 14%

Yes, you read that correctly. Japanese stock markets are down 14% and have in 2 days experience more than half a trillion dollars in wealth destruction. There are separate conversations to be had…

First, there is the human tragedy. On top of losing homes, jobs, schools, etc. in terms of infrastructure, millions are left stranded without water and electricity. To really top it off, now millions will lose invested wealth and face an investors worst-case scenario – permanent loss of capital. No amount of standard deviations does that type of risk justice on the human level.

Second, and a distant second at that, is the conversation about the investment implications. I have viewed Japanese companies as undervalued on their own after being down roughly 75% from their peak in the late 1980′s. On top of that, they are facing favorable headwinds with a relatively strong currency (relative to their tax base, demographics, etc.). So a currency hedged investor should do well in the long term. I continue to view those shares as an opportunity and will look for selective entry points to add exposure.

Lastly for tonight, there are the additional implications felt globally. Nuclear energy firms, a portion of my energy overweight, are under significant stress, while on the flip side, my exposure to natural gas has benefited. Overall, I am maintaining my exposure to energy and will look to gain exposure to specific uranium related companies in the next few days and weeks.

The US equity futures, on the other hand, are pointing to a significant gap down tomorrow morning, and assuming they don’t rally may provide a bounce for the active trader. However, I am short the US indexes, and will not be covering. I will not add to the position here, but my valuation metrics continue to point to increased P/E compression. In a scenario where we face a worldwide economic slowdown, coupled with relatively high energy costs and continued margin compression, inflation fear mongers will look silly. Deflationary pressures continue to be the main risk, and in that scenario, we will first have significant margin and valuation compression, and then will actually bottom on high P/E (low q-ratios). The reason for this counter-intuitive statement is that in a deflationary environment, the E goes down, and for a while the P goes down fast. Eventually, the P stabilizes, while the E continues to go down. In that scenario, P/E will no longer be a good valuation measure, and investors must focus on q-ratios to understand replacement cost, return on assets, and the setup for the eventual price stability and upticks in inflation.

We have years for that to happen. I am not a buyer on the dips.

Relevant ETFs: DXJ, FXY, NLR, RWM, SH, SPY, IWM

Tsunami’s all around

The Japanese stock market is hitting circuit breakers with a 5% drop as Japanese officials scramble to inject liquidity into the system. I’m sorry to say that BoJ has not proven its ability to influence markets over the past couple of decades, so while the liquidity will help the immediate requirements (maybe), I don’t think it will actually make a big difference for Japanese citizens. They’ll get hammered with a double whammy: higher import prices AND higher energy costs specifically from energy strains on the system. And as the third largest economy in the world, the potential for a chain reaction is not insignificant. As I mentioned before, I’m a big believer that the yen is the most vulnerable developed nation currency in the world. Any bounce from repatriations will be short lived and Japanese export-focused firms are trading at relatively low valuations ANYWAY. That’s a powerful combination and I’ll be looking to add to exposure. Easiest way to play this is through DXJ.

Meanwhile, a political tsunami is raging in the Middle East, which is no longer getting front page status. Bahrain invited Saudi troops to help stanch their uprisings. A curious situation: a sovereign nation inviting the military of another nation to use force against its own citizens. Hmmm. Doesn’t sound like a place I want to move to in the near future. Regardless, with Sunni and Shiite friction increasingly tense, look for Iran to ride in to the defense of their brethren. Not sure how it plays out, but it certainly provides a bid for oil. I’m still wary of going long the region and see more downside than upside risk. That also means that domestic energy producers might benefit.

Relevant ETFs: DXJ, MES, EGPT, FCG, NLR, KOL, YCSm FXY

Asia is the real story

The world is worried about oil, and rightfully so. The Middle East is in turmoil – I get it. However, as an investor, now is the time to focus on the marginal buyers and sellers, and while securing energy supplies is a key theme for my energy focus, I am now more focused on the stories that are being under-reported in Asia.

Yesterday, I mentioned the social unrest that is happening in China, which few are talking about. The day before we pointed to the bank runs in South Korea. Today, Bloomberg ran a story with the following heading: “World’s Biggest Pension Fund ‘Will Likely’ Sell Japan Bonds” (h.t. Mish’s Global Economic Analysis). Here are the opening paragraphs:

Japan’s public pension fund, the world’s largest, said it may become a net seller of bonds to cover payments in the world’s most rapidly aging society.

The Government Pension Investment Fund, which oversees 117.6 trillion yen ($1.4 trillion), in September forecast that it would sell 4 trillion yen in assets in the business year ending March 31 to fund payouts. Sales may be less than that in the year starting April as bonds reach maturity, said Takahiro Mitani, president of the fund, known as GPIF.

Why is this important? Because internal purchasers, most notably the pension system, have allowed the Japanese government to continue printing endlessly, and have made Japan the single most vulnerable developed country (in terms of finances, not politics). If Japan’s pension plans will become net sellers, the governments printing will only exacerbate the increase in yields and will force either a massive cut in spending, massive cut in entitlements, or massive inflationary pressures. This is zero hour for Japan. It also does not bode well for local Japanese sellers as they’ll face ever-higher input costs. It could be OK for exporters who will benefit from currency differentials, although that might be negated by internal taxes and politics. I’m staying short the yen and will look to increase the position in the next few months.

Japan’s example should serve as a warning for governments and inflation-mongers alike. Governments can print endlessly and still face deflationary pressures for years and decades, with no net benefit, and with huge eventual costs placed on their citizens.

Relevant ETFs: YCS, FXY, DXJ

Should Germany be happy about Ireland (?) and why BoJ should make a statement now

Let’s think this through: Germany is the strongest economy in Europe, is export oriented, and through no manipulation of its own is getting a weaker currency which will probably boost exports in a 6-12 month lag. Sounds like a good deal. Now, all Germany has to do is provide just enough support to keep Ireland from crumbling, but not enough to force a bid in the euro, and it will put itself in an even stronger economic position.

On the other side of the pond, the yen is finally weakening. The BoJ has an opportunity to achieve its long term objective of driving inflation by announcing a massive yen selling program. It will catch countless longs who went in to the yen as a store of value and USD-diversifier. For an interesting take, click here.

China – The Mother of All Grey Swans

New post from Vitaliy Katsenelson on China and Japan. The short version is that China is COMMUNIST! and the numbers can’t be trusted, while Japan is past the point of no return.

On China: I already mentioned that Russia used to do the same thing with numbers and ghost towns that looked great to observers, but were shams.

On Japan: The government won’t have an internal market due to demographics, and as the savings rate decreases, the international community will not continue funding JGB’s at 0% rates.

http://contrarianedge.com/2010/10/30/china-the-mother-of-all-grey-swans/

Look at the presentation. Understand the dynamics of overcapacity in China. Understand that demographics doom Japan’s currency.

Invest accordingly.

Early, but I’ll say it anyway

China. China. China. And the US dollar.

I wish the US government, along with all its subsidiaries and pro-government idealists would calm down about China. As long as China continues down the path of government-mandated loans, non-market based supply manipulation, and all the other games and number fudging it plays, we need to worry more about the political and military threat it poses rather than the financial. Instead, we should worry about our own internal policies that are moving in the wrong direction – namely, away from market-based practices and an increase in government debt that is unsustainable. That’s our own fault, not the Chinese government’s fault. Now, many readers have gone ga-ga for China, so I wanted to share some history. I took an article (see link at the end) from a few years ago, and replaced China wherever it mentioned the other country’s name. My reaction is at the end. Here are a few highlights:

Containing [China]

[China]‘s one-sided trading will make the U.S.-[Chinese] partnership impossible to sustain—unless we impose limits on its economy.

…[China] is more important to the United States, in more ways, than Saudi Arabia or most other countries will ever be. Yet [Chinese]-American relationships have a fragile, walking-on-eggs quality, which makes people think that it’s dangerous to talk frankly in public. Many other international relationships are robust enough to survive open discussions of disagreements; during the nasty little “beef hormone” war early this year, for example, no one imagined that the United States and the European Community were about to turn their backs on each other. But the American fraternity of [China]-handlers, which includes most diplomats and a number of businessmen, scholars, and journalists, instinctively stifles outright complaints about [China].

…Now, however, [China] has become too important to be treated with such delicacy. Excessive politeness prevents [China] and the United States from facing the conflict that in the long run endangers their relations much more than the comments of any bigoted [China]-bashers could.

For the foreseeable future [China] will be America’s single most valuable partner, because of what it can do in three areas. First is the U.S.-[China] military understanding…Second is finance: [China] has become America’s financier, providing investment capital and covering much of the U.S. government’s debt. Third is business: [Chinese]-American business relations provide technology, markets, talent, supplies, and other essential elements to both nations’ companies.

These three realities tempt many people, especially American diplomats, to assume a fourth: that [Chinese] and American interests do not clash in any fundamental way. This assumption is wrong. There is a basic conflict between [Chinese] and American interests—notwithstanding that the two countries need each other as friends—and it would be better to face it directly than to pretend that it doesn’t exist.

That conflict arises from [China]‘s inability or unwillingness to restrain the one-sided and destructive expansion of its economic power. The expansion is one-sided because [Chinese] business does to other countries what [China] will not permit to be done to itself. It is destructive because it will lead to exactly the international ostracism that [China] most fears, because it will wreck the postwar system of free trade that has made [China] and many other nations prosperous, and because it will ultimately make the U.S.-[Chinese] partnership impossible to sustain.

The [Chinese] do not desire any of these results, or the erosion of American power that would go along with them. Despite their pride, veering toward arrogance, about what [Chinese] business has achieved, most [Chinese] would feel more comfortable with a United States that is strong, stable, and rich enough to remain the No. 1 of the non-communist world. (Much more frequently than Americans, [Chinese] talk about nations holding No. 1 and No. 2 positions.) [China]‘s twentieth-century history in Asia implies that it will be much better accepted as an economic power and cultural force than as a major military power. As a diplomatic leader, [China] is still reluctant and inexperienced. It has given the world an example of what hard work can do, but in general [China] prefers to focus on its own affairs and let other countries proselytize for democracy, capitalism, communism, or whatever else they believe in. Most [Chinese] politicians say that they would like to leave non economic initiatives to the United States—if the United States can afford them. Unfortunately, the major external threat to America’s ability to pay the costs of leadership is [China]‘s uncontrolled, unbalanced economic growth. To keep a world trade system going, the strongest powers must be willing to make certain sacrifices—for example, keeping their own markets open, despite domestic political objections, as the British did during their free-trade heyday and as the United States has on the whole done since the end of the Second World War. ([Chinese] and Korean politicians now complain about American “protectionism,” but how protectionist can a country with a $10 billion monthly trade deficit really be? [ It’s much higher now!!]) [China] shows very little inclination to make these sacrifices itself, and its continued expansion will in time weaken the ability of the United States to do so.

Friends must sometimes help friends break destructive habits. [China] is in a good position to lecture the United States about its destructive business and financial habits, and more and more [Chinese] officials have been doing just that. But [China]‘s destructive habits are potentially more harmful to the rest of the world than America’s are. If [China] cannot restrain the excesses of its own economy, then the United States, to save its partnership with [China], should impose limits from outside.

…There is one further indication of economic imbalance: the continuing pattern of one-sidedness in many [Chinese] transactions. A few years ago the management expert Peter Drucker introduced the term “adversarial trade” to describe [China]‘s approach to commerce, which is characterized by resistance to high-value imports and by targeted attacks on established foreign industries. The contrast with Germany is instructive. Like [China], Germany chronically runs a large trade surplus; exports actually represent a higher proportion of its GNP. The reason there are fewer complaints about Germany, however, is not simply that it imports much more than [China] (20 percent of its GNP, versus [China]‘s six percent) but also that it imports more valuable things. Three fourths of the goods that Germans (and Americans and most Western Europeans) import are manufactured products; less than half of [China]‘s imports are. Germany’s trading patterns are similar to those of most other developed countries—Germany is simply more successful at carrying them out. [China]‘s are the exception. [China] is now starting to import more manufactured goods, but from a very low base.

Money Politics

IF NORMAL MARKET FORCES WON’T MODERATE [CHINA]‘S expansion, what about outright political control? For more than five years [Chinese] leaders have said, with seeming sincerity, that they want to reduce their nation’s trade surplus sharply, since it is the source of 90 percent of the ill will that [China] encounters in the world. So far their efforts have made little or no difference, because the basic elements of [Chinese] politics—the flow of money, the balance of power, and the underlying structure of ideas—all push the economy ahead on its unbalanced course.

…Capitalistic trade is not supposed to be reciprocal on the small scale. I buy from the local grocery store, and it doesn’t buy anything back from me. But capitalist theory assumes that life will be reciprocal in a larger sense. Each of us specializes in certain functions, and we use our earnings to buy from those who specialize in something else. This model, more or less unchanged since Adam Smith set it out in the Wealth of Nations, stands in contrast to several other ideas of how economic systems should work. One is the primitive-village model, in which small groups of people produce everything they want to use. Another is the mercantilist system that Adam Smith was directly attacking, in which the Spanish and Portuguese empires tried to store up as much gold as they could, rather than frittering any of it away in trade. And the latest and most relevant is what Chalmers Johnson calls the “capitalist developmental state,” whose prime example is [China]. Here the government uses a number of strategies to suppress consumption, channel personal savings to industrial investment, and convert industrial competition into a ratchet-like process. In the industries where the country has a lead-in [China]‘s case, consumer electronics and autos—it holds on to the lead, and in areas where it lags, it discourages imports until its own industries can grow. [Chinese] corporations typically compete with each other in every product line—each beer maker produces a draft beer, a “dry” beer, a lager, and so on; each electronics company tries to produce a full range of radios, TVs, and fax machines. Successful [Chinese] students are expected to get top marks in every subject; star pitchers in [Chinese] baseball often burn out early because they are expected to pitch in practically every game. Trying to be on top in every field, rather than specializing in some and leaving the rest to competitors, is a stronger impulse in [Chinese] society than in most others, and is the rule that [China]‘s trade policy appears to follow.

Americans may complain about the decline of their steel and semiconductor industries—that is, areas where the United States once enjoyed a lead and has had to watch factories shut their doors. But few Americans really think it is a problem if we have to buy our entire supply of CD players from overseas. The United States has no government project under way to create a domestic fax industry, and when government guidance is proposed—for semiconductors, high-definition TVs, and superconductors—it is always controversial. [China] acts differently.

What Will Change

WHAT PRECISELY IS THE DANGER FROM CONTINUED [Chinese] expansion? Some people say there is no danger at all. Three lines of reasoning lead to such a conclusion.

The first is that whether or not the expansion can be controlled, it is about to end. Many [Chinese] people, temperamentally pessimistic even though their country has repeatedly surmounted prophecies of doom, fall into this camp. So do some outside observers… The population will soon have the world’s highest proportion of retirees and will be using up some of the savings it is amassing now; Korea and Taiwan will exert unrelenting pressure; at some point the [yuan] may rise so far that it actually does price [Chinese] exporters out of the world market. And let’s not forget the next big [natural disaster]. In addition, certain divisions are opening within [Chinese] society, which could eventually impair the country’s ability to sacrifice, invest, and grow. Besides cynicism about [China]‘s money-politics system and the rise of an affluent and perhaps less self-sacrificing yuppie generation, a noticeable gap is opening up between [Chinese] haves and have-nots. This class divide has to do mainly with land ownership-land has become so expensive that people who do not inherit it from their parents can probably never afford their own house—but also with education, which is becoming stratified. In theory, such developments could limit [China]‘s growth quite soon. However, the limits are still purely theoretical; no symptom of slowdown can yet be observed. By every measurable indication—corporate profit, personal savings, industrial productivity—[China] is distinctly on the rise.

According to the second line of reasoning, [China]‘s expansion cannot, by definition, be threatening to anyone else, since it merely increases the wealth and welfare of customers in the rest of the world. This is the classic free-trade view, which often guides U.S. government policy toward [China] and which dominates the view of the American media. On its own narrow terms, it is obviously correct: consumers are always better off with fewer restrictions on trade. Indeed, the main reason American consumers now live so much better than those in [China] is that U.S. policy has hewed closer to free trade.

Inconveniently, offering consumers the best price is not the only thing involved in building a good society. Permitting children to work in garment factories, for instance, would lower the price of shirts and help the American consumer, but it is against the broader national interest. In the case of [China]‘s expansion, the harm comes from the erosion of numerous elements of American strength, especially those being left to erode because of a sense that the United States is so deep in debt that it can’t afford to do many of the things a leading power should do—explore space, improve its schools, maintain its military bases in [China] so that [China] doesn’t build its own army, and so on.

From the strict free-trade perspective, not even the accumulation of debt is necessarily a cause for worry. The borders between [China] and the United States are increasingly artificial to corporate managers and to consumers, who buy Sony Walkmen in Chicago and McDonald’s hamburgers in Tokyo. Perhaps the borders should be ignored in observing capital flows as well. No one cares about the Texas state “deficit” relative to Illinois; we concentrate on how individual firms are doing. Some [Chinese] internationalists suggest that the overall U.S.-[China] balances should also be overlooked. This is noble-sounding and forward-looking, but the fact is that [China] and the United States still are two separate nations, and America’s ability to pay its own way still is the basis of its strength. The United States can’t tax the [Chinese] to pay for its military—it can only borrow. Until national borders really don’t matter, America’s ability to meet its commitments will depend on its own solvency, not on the size of the combined U.S.-[Chinese] capital pool.

This is related to the third line of reasoning: that reasonably soon the borders between [China] and the United States will for all practical purposes disappear. [China] and the United States, which already interact closely in business and the military, will integrate themselves in other ways and, despite remaining separate countries, will function essentially as one unit.

Anyone who has spent time in [China] will recognize how attractive such a merger would be. These two countries, with their respective economic strengths, technical skills, political ideologies, and sources of social resilience, make up two complementary halves of the mightiest possible superstate. I would be delighted by the creation of a hybrid U.S.-[Chinese] state. For all its difficulties, [Beijing] is a more stimulating place to live than almost any city in America. I would rather work with my best [Chinese] friends than for most companies in the United States, and would rather bind [China]‘s strengths to America’s than view [China] as a threat. But like most other foreigners who have lived in [China], I consider such a de facto merger impossible, because of social resistance on the [Chinese] side.

…I admire the idealists and hope they turn out to be right, but nothing I have seen so far makes me believe that they will.

…Unless [China] is contained, therefore, several things that matter to America will be jeopardized: America’s own authority to carry out its foreign policy and advance its ideals, American citizens’ future prospects within the world’s most powerful business firms, and also the very system of free trade that America has helped sustain since the Second World War. The major threat to the free-trade system does not come from American protectionism. It comes from the example set by [China]. [China] and its acolytes, such as Taiwan and Korea, have demonstrated that in head-on industrial competition between free-trading societies and capitalist developmental states,” the free traders will eventually lose. The drive to break up the world into trading blocs—united Europe, North America, East Asia—is largely fueled by other countries’ desire to protect themselves against [China]. Even in their own inroads into the [Chinese] market, foreigners are tempted to settle for a small place [role]…rather than pushing for truly open competition in [China]. The ideal of free trade retreats, as the states that don’t really believe in it expand.

THE PURPOSE OF THIS ARTICLE IS TO MAKE THE CASE for containing [China]‘s expansion, rather than to discuss specific means of containment. The specifics will be the subject of a future article. But merely recognizing that American and [Chinese] interests do conflict is in itself an essential step. It frees us of the delusion that normal business competition will balance out whatever is unbalanced now.

Of course America needs to reform its own corporate practices, improve its schools, and reduce its debt. Of course our economic goal should be an open free-trading system around the world, not escalating trade barriers. Of course we have no business telling the [Chinese] how to run their own subtle, sophisticated society. But we do have the right to defend our interests and our values, and they are not identical to [China]‘s.

The article is much longer and I cut out as much as I could. I did my best to maintain the flow of the article with the changes in [] for clarity. Please click here for the full article. It was written by James Fallows in The Atlantic Monthly in 1989…about Japan! The fear of Japanese expansion was palpable. In the article, Fallows talks about the trend in trade and the continued dependence of the US government on Japanese financing. And of course, the final paragraphs encouraging active retribution, protectionist measures, and even military options is not surprising.

We all know how this ended. The Japanese miracle was ending, and Japanese economic expansion was halted. Japanese purchases of US assets with overvalued currency ended up being incredible burdens on Japanese firms, especially banks, for decades, in fact, they continue to this day.

What should have been the course of action: continued open markets, low tarrifs, encouragement of free trade, and an investment in US infrastructure and education. What should be our policy now towards a seemingly unstoppable economic superpower?

So I might be early in saying that Chinese economic might will be waning, but it will come. And I anticipate that it will come soon.

Japan – I just can’t look away and I think there’s an opportunity

I’ve written often about the challenges facing Japan in the next few years, from an aging population and the resulting transformation from savers to spender to the unsustainable debt that can only be financed with printing, all leading to an eventual devaluation if not complete collapse of the yen. I have been premature, but I am not wrong. Today, I actually want to point out a different opportunity in Japan – equities.

While the yen will top out (see chart below) if it hasn’t already, Japanese equities are looking relatively cheap. Trading at single digit P/E’s with an export focus that will only be helped by a declining yen, many Japanese companies will be poised for higher earnings going forward. The current yield on the Japanese market is hovering around 2%, but with potential for expansion with a declining yen.

Dylan Grice just put out a research piece highlighting how the Nikkei could rally significantly as a result of the coming devaluation of the yen. So the question is how to play it?

There are multiple ways from taking a currency position (we have been short the yen as we’ve written about endlessly) to going long the equity and hedging out the currency. This is not easily done by individual investors – or so I thought. When I started looking for different options, I came across a WisdomTree ETF that does just that – DXJ.

EWJ is the popular Japanese ETF. Most investors believe that because it is bought in domestic accounts on US exchanges with dollars, that it is dollar based; however, EWJ is NOT currency hedged. Meaning that if the index went up 1% and the yen went down 1%, USD based investors would not see any return.

DXJ on the otherhand, uses futures and forwards to hedge out the yen currency fluctuations for USD-based investors. Amongst some of the drawbacks it has: it’s small, has little daily volume, and the currency hedge can (and has) worked against it as the yen has strengthened. That being said it looks like a viable alternative for investors looking to get exposure to Japanese equity without the yen risk. For the record, this is in no way a recommendation to buy or sell any security, and at the time of this writing I do not have any position in EWJ nor DXJ, but do have a short yen position.

10 year treasuries – the time has come

I shorted 10 year treasuries today, as mentioned in an earlier post; and there’s a good chance that I’m early, also discussed. I decided to share some of the thought process, if not all the financial assumptions, because I received a lot of questions on the post.

Since some of the comments had similar themes, I’ll combine and paraphrase:

Is shorting treasuries an inflationary position?

The answer is a definite maybe. Historically, the thinking has been as inflation goes up, interest rates will rise and treasury prices will fall. Makes sense. The real issue is one of causality. It’s true that inflation might cause rates to rise, but so could other things (for example, China not showing up for an auction).

Is shorting treasuries a risk trade?

This series of questions revolved around the belief that the run-up in treasuries was a manifestation of risk being taken off the table. Agreed. But at some point, being long treasuries becomes its own manifestation of the risk trade. Locking in 3.2% (or less) for 10 years seems pretty risky to me in an environment of increased quantitative easing, increased taxes, slower growth, etc. Some of the comments suggested that instead of shorting treasuries, I should go long equities as a better expression of the risk trade. If that was the trade, I’d agree, but I believe there is a strong chance that we can have slower growth AND higher long term rates.

What are possible scenarios where we could see treasuries fall AND equities head lower?

Stocks and bonds might have low correlation on a short term basis, but on a longer term basis, equities had their biggest bull market run from the early 1980′s through 1999/2000 – a twenty year bull market. Simultaneously (correlation or causation?), interest rates went from 17+% down to 3+% in the greatest bond bull market in history. Looking forward, why wouldn’t we expect their bear markets to coincide as well? Asset allocation works well as long as assets aren’t correlated, yet throughout the investing public’s experience, all asset classes that they invested in (stocks, bonds, real estate being the major ones) went up. So one scenario is just a simple correlation without trying to explain the cause, but we can do better.

Digging deeper, let’s examine the famous deflationary argument (to which I happen to ascribe). Deflation is the ultimate fear trade. Investors get scared of holding long term investments and begin hoarding shorter term investments, ultimately preferring cash to pretty much everything else. There are a few commodities that end up being safe havens in deflationary environments (gold, perishable foodstuffs, etc.), but financial assets as a whole are not them. On a valuation perspective, if companies lose pricing power, margins erode, people spend less, and people have less money that they are willing to invest/lend believing that by waiting things might go on sale. So stocks go down. At the same time, governments are forced to pump ever increasing amounts of stimulus and spend increasing amounts on social services. How? Well, they print more and they borrow more, thereby increasing the supply of treasuries available. You get the picture.

But let’s assume you don’t believe we’re going that route. Here’s what really took me over the edge as I started looking at the different scenarios: China, Japan, and the Middle East. My argument is that being long treasuries is being long China, Japan, and the Middle East – none of which I want to be long. Let’s take China as the poster child. Equities are in a bear market. Social unrest is always a risk. Rural/urban disparity continues to worry those in power and the overcapacity built over the past 10 years is unprofitable. At the same time, their biggest trading partner, Europe, is facing its own problems and slower growth, rendering its investments in infrastructure, capacity, and stashes of commodities foolish (at best). And oh yeah, their surplus is concentrated in US treasuries, with the risk that Bernanke & Co. will inflate their deficits away. What’s a bureaucrat to do? One day (I believe soon), there will be a failed auction. By failed I don’t mean that the Chinese (or Japanese or Middle East block) won’t show up at all, just that they won’t bid aggressively, they won’t take down as much, or they won’t take down the long end. Guess what, they need to spend that money domestically, not lend it to the US so that we can lend it to Greece. No inflationary pressures, just fewer bids. A scary proposition and a huge game theory nightmare since all the other players will have to scramble to front run each other. FUBAR.

I’m probably early in my assessment, and treasuries might still be the safe haven trade tomorrow, and later in the week, as we get more auctions, everyone will show up as usual. However, the scenarios are real, and if nothing else, pose a serious risk to those who chose to use longer term treasuries to lock in 3+% for the next 10 years.

For reference and for those who like charts:

Positioning happens before the fact

As a long term value-oriented investor, I often find that much of my research focuses on events and possibilities that do not come to fruition. I spend a lot of time hypothesizing about different scenarios and planning “just in case”. Lest you think that I can plan for every eventuality, let me assure you I can’t. What I can work through, however, are the triggers that need to be in place for an investment to look attractive. For technicians, these set-ups tend to be focused on charts, time and price indicators, or specific patterns. For me, it focuses on valuation, spread/ratio analysis, and long term trends.

To that end, I thought it might be worthwhile to share some of the relationships we’re focusing on, though not necessarily acting.

1. Gold/Silver: This ratio should could get out of line if gold becomes the safe haven leaving its cousin in the dark. The 12 month average is hovering at 64, and the ratio currently stands at roughly 68, but it could get much wider. If it does, we’ll be looking to determine if there is a structural shift or an overextended move.

2. EUR/USD

This is an example of a ratio that in our mind will continue to move for structural reasons and may not revert to any mean. Even with short-term intervention, the structural problems of a unified monetary policy without a unified fiscal policy are obvious and require sacrifices that disparate politicians cannot make.

3. S&P 500 vs. Russell 2000

Until recently, small caps handily beat large caps. In the search for performance, investors looked towards small caps, and even RSP and EQL got a boost vs. the market cap weighted SPY. We anticipate that ratio to go back towards it’s average. Lots of ways to implement it, but for it continues to be a telling sign of risk reduction in the equity space.

So these are on radar screen right now. Where will we look for opportunities in the future? For starters, we are in a deflationary period, so absolute levels in financial assets globally will be under pressure. That’s OK by me, since I’ll be looking to pick up cheap assets.

1. Thailand: Not ready to take the plunge on an absolute basis, but this is one market I anticipate will have some good long term opportunities. Valuations, demographics (internal and increased tourism), and wealth transfer from west to east all play into it.
2. Europe: Eventually, Europe will look attractive. I purchased NBG and OTE (Greece) after posting about it last week. We’ll be looking for over-reactions in other European countries as the fear increases (euro exposure will be hedged out).
3. Japan: Same as Europe.
4. US markets: we get questions about the US markets all the time. We view them as 30-50% overvalued, but once valuations come in line, the US may end up being well positioned as the continued dominant player.

Let me be clear, I do not believe these are good values here. However, I believe you have to start thinking about positioning before it becomes obvious. Attractive valuations are a necessary but not sufficient pre-condition. An understanding of the macro environment must play a role in analyzing a long term investment.