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 yen, and portfolio management

I have been short the yen since November 2009, but today, I'm closing the directional position (although we're still short yen against Japanese equities). This was a portfolio decisions, rather than a directional decision.Viewing the remainder of this article requires a Subscription

What’s a quadrillion?

G-Pap and Berlusconi are having some bad days, but do they know how to count to a quadrillion? Monday morning, Marketwatch reported:

Japan's debt to exceed 1 quadrillion yen: report HONG KONG (MarketWatch) -- Japan's national debt is on track to exceed 1 quadrillion yen ($12.8 trillion) by the end of the fiscal year next March, with the debt rising faster than Ministry of Finance forecasts because of spending tied to aid and rebuilding from the devastating earthquake and tsunami earlier this year, according to a report Monday in the Nikkei newspaper.

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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

A slow pain

Some pains are sharp and localized. They require a quick decision, but mostly, they're easy to work through because we can be confident that they'll pass. The headache that comes on quickly at work at 3:30 in the afternoon is usually bad, but after the first few times, it stops worrying us.Viewing the remainder of this article requires a Subscription

China and the Yen

Why would China bid up the yen? The short answer is I’m not sure.Viewing the remainder of this article requires a Subscription

G3 Currencies

G3 Currencies I’ll say it: G3 currencies are not making sense. Forget about irrational, or momentum, or fundamental, or whatever. There appears to be almost no underlying logic in some of the recent moves exhibited by the major currencies.Viewing the remainder of this article requires a Subscription

Right and wrong…

…or yen and euro. Long time readers know that I have maintained short exposure to both the yen and euro starting in November of 2009 – pretty long by currency traders perspective. I am staying with both positions, but one has been more right than the other, I’m just not sure why.

After toughing a 77 handle right after the tsunami, the yen has gotten progressively weaker and is now trading with an 85 handle. I get that, and I also maintain that it is the most vulnerable developed market currency at this point in time, so I wouldn’t be surprised if we see a 100 handle soon. Easy enough to hold on.

The euro, on the other hand, is more perplexing. We shorted it at 1.5, held on as it went to 1.2, and now are watching it break back up through 1.43. At the same time, Portugal is falling apart, Greece is already undone, and Ireland is shaving all the debt holders. More importantly, Spain is facing 20+% unemployment and about to face a major financial crisis of its own. Trichet has commented that the EU will focus on inflation pressures, signaling that they might raise rates. Two things can happen, rates will rise and the peripheral countries will fail bringing about the breakup of the euro, or Trichet will fall under the pressure and ease. Either way, the markets should be discounting the fact that in both scenarios the euro is in bad shape.

Some have stated that the euro is an FX vent as investors flee the yen. OK, but that is a two-sided statement. I understand the “flee the yen” side, but why flee to the euro? Almost any other currency seems in better shape, including multiple emerging markets currencies. See, for example CEW (no position):

Yet, they’re not outperforming the euro recently. Perplexing, to say the least.

Relevant ETFs: FXY, YCS, FXE, EUO, CEW

Currencies dominate

For those with long enough memories, the current currency wagging the markets is reminscent of 1987. There, I said it. Portugal gets downgraded. Ireland is gonna haircut every debt holder. Etc. And the euro…rallies? Meantime, all the repatriation in the world can’t help the yen rally? Expected, but still brutal in its swings. And gold, after touching all time highs is selling off. Hmmm. Curioser and curioser.

It feels like the carry trade is back in vogue: sell the yen buy anything else. Now, I’m all for selling the yen. Those who bought EWJ as opposed to DXJ (as I recommended) will come to understand that it’s not your daddy’s markets any longer. You cannot invest in an asset class without understanding the currency implications.

On the other side, you have Bill Gross out with a new piece on America’s $65 trillion unfunded liabilities and the inevitability of higher rates. So the equity markets are going up by default, but I don’t think of their own volition and certainly not on the basis of their fundamentals. To which, I’ll remind readers that without the fundamental backdrop, this will not end well. I don’t mean to be a downer and I know I’ve been saying the equity markets are vulnerable for a long time.

For the record, our concentration in energy has led us to significant outperformance. Our positions in precious metals continue to make new highs every couple of weeks. Etc. I don’t need to go there.

Regardless, I anticipate that an event will come after a close, or over a weekend, or from a different field, that will shake the foundations of this equity rally. After the fact, it will be called a black swan and be credited with the gravity to bring equity prices down. In reality, it will be a grain of sand that randomly fell on a system fraught with fingers of instability, and as in every power law distributed system, the implications will be far larger due to the foundations rather than the immediate cause. And again, currencies will be the markets that lead.

Relevant ETFs: GLD, SLV, EUO, YCS, EWJ, DXJ, UUP, FXE, FXY

Yen

What happened to all those repatriation of yen will end the dollar stories I kept getting last week? Turns out that a natural disaster is no match for demographics in this case. It’s not to say that the yen can’t strengthen, but rather, to point out that news of the death of the dollar may be premature.

…and to take it a step further, if I had to guess which currency is in more trouble (yen or dollar)…well, readers know I’ve staked my claim.

As a sidenote, someone asked me whether I’m “hoping” the yen will go down. I put hoping in quotes because it’s a very specific term that I want to highlight. I do not “hope” the yen will go down and even though I will benefit from it, there is no judgment or or feeling of elation if it comes to pass. Instead, the appropriate word choice is “anticipate” or “expect”, in which case I can answer, “Yes, I anticipate that the yen will decline relative to the dollar and because of that I took a position to implement my expectation, not my hope.” It’s a subtle difference, but an important one, I think.

Relevant ETFs: FXY, YCS, DXJ, UUP

The dollar

The dollar is once again the most hated reserve currency in the world. European peripherals are breaking down, with bonds hitting all-time high yields in Portugal, Ireland, Spain and soon others. The yen is getting printed so fast we should have bought printing presses in anticipation. And yet, the dollar continues to be the currency everyone loves to hate:

Congratulations, Bernanke! You are winning the devaluation race. Keynesians can breathe easy that people prefer almost any other currency and asset to our USD. It’s actually a pretty optimistic view of our economic leadership – namely, they set a goal and they are achieving it. You might disagree with the goal, but you’ll at least agree that they are effective. Except…

I might be the only one out there who believes that the Fed is actually IN-effective and WILL NOT achieve its stated goals. This is a pretty pessimistic view, both of our monetary leadership, and the inflation stimulation that the world central bankers are hoping (praying/planning /depending on?) for. In my world view, Bernanke & Co. will not succeed in stimulating long-term inflation. Why? Because for all of their efforts, they will not be as able or driven to make the dollar less attractive than the euro and yen. In my worldview, the Fed is so ineffective that they won’t even be able to devalue properly. Trichet, in the meantime, with his high-handed talk of raising rates, will be unable to strengthen the dying currency beyond periodic run-ups. Lastly, the Japanese CB will be the only one that will finally win (by losing). The Japanese will finally break the bank and drive the yen to new lows that will remind the world of what an economic disaster looks like.

Will the Fed get what it wants and stimulate long term inflation by trying to devalue faster than everyone else? I think not.

Relevant ETFs: FXE, FXY, EUO, YCS, UUP

Always looking for the ugly duckling

And right now, there’s one asset that looks pretty ugly…

What if I told you there was an asset that was sitting at 52-week lows. It has some negative fundamentals, and a few relative positives, but no foreseeable absolute positives. Long term, this asset has very little cashflows, is difficult to value, and everyone thinks is worthless. It has the potential to become a huge value trap. It has a brand name which has lost global appeal. It is vulnerable to macroeconomic whims of politicians. I can go on and on about the negatives and positives, but will say one final bit: almost everyone has some long exposure to it already and almost everyone believes that it will go down in the near future.

The asset, of course is the US dollar:

While I don’t know that this is the absolute low for the dollar index, I do have to wonder: how much of the bad news is already priced in? How much of the inflation fears are already priced in? How much more strength can the yen and euro (which together account for around 70% of the index) exhibit? I’m already short yen and euro in various vehicles, and I have to admit that I thought dollar strength would become evident as geopolitical turmoil generated a flight to safety mentality. The fact that this did NOT happen leads me to believe that either the US dollar is no longer the safe haven recipient or investors did not actually seek safe haven storehouses at all. The latter is hard to argue, since gold, the other safe have stand-by, continues to approach all-time highs.

Maybe that’s the end of the story. Investors have flocked to gold as the de facto reserve currency and are expressing their fear through the yellow metal rather than the greenback.

The flip side of that is that the dollar is still just a fiat currency and as it has gotten weaker, the euro and yen got stronger, presumably on weaker fundamentals and weaker demographic and tax bases. So I’m not that quick to draw the above conclusion.  There is nothing for me to do with this view right now, but – in line with our thoughts on everything being relative – we can wait and watch, because I believe there is an opportunity forming.

Relevant ETFs: UUP, FXY, YCS, FXE, EUO, GLD

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

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

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