Vindication of the Bears
Well, “it” finally happened.
It is virtually impossible to predict the exact times of dramatic mood shifts among herds, such as last Thursday's dramatic unwinding of the carry trade or the pop of the Shanghai Stock Exchange bubble.
Due to the trend of low-information Japanese investors pouring their own savings into the carry trade themselves, I had expected the yen to remain cheap and the carry trade to continue for at least another quarter. After lots of busted predictions that Chinese individuals will stop pouring money into the SSE and the SSE will pop, I have become very wary of pronouncing bubbles dead.
Anatomy of the Avalanche
One apparent catalyst of the Thursday-Friday unraveling was the collapse of the Sowood funds, two Massachusetts hedge funds run by a former desk manager for Harvard's endowment, which lost 55% of their value ($1.5 billion). I suppose that is better than the billions lost by Bear Stearns, but it certainly was not encouraging to the throngs of investors wondering if this augurs the beginning the long-dreaded “secular bear market” (a multi-year bear market).
At around the same time, the carry trade collapsed, and the yen snapped up from 123 yen/USD to 118. Everyone who ignored my advice last week to stay away from the yen made a healthy four to five percent profit. That doesn't change the fact that Japan remains an awful place to invest. Whenever the Chinese hangover begins, Japan will be one of the most adversely affected, because China is a huge export market and trading partner for Japanese companies.
Credit Spreads
The Markit.com credit indices indicate some stabilization in the credit indices (the ABX, CDX and especially the CMBX). Take, for instance, the skyrocketing spread between Markit's NA BBB- and Treasurys:
For the first time in a while, credit spreads did not close at their historic peaks. However, credit spreads are still above the point at which Russia defaulted in 1998. When the market must “reprice risk” to the extent that the CMBX apparently has, the impact is devastating and widespread. When Russia defaulted on its debt in 1998, the flagship of the American hedge fund industry (Long Term Capital Management) was destroyed, and Asian economies were destabilized to the point that the survival of some governments came into question. In the most extreme instance, Indonesia lost 9 percent of GDP in one year. If history is any guide, developing economies somewhere are due for a severe hit.
Amid all the anxiety about this week's trading, it nearly escaped me that China had ratcheted up its bank reserve requirements – again. China is in the midst of the most out-of-control boom in world history, and the government is doing everything it can to rein in bank lending so that the economy does not have an Indonesia-style depression.
China had to cope with enormous numbers of “mass incidents” during a time of historic prosperity (75,000 mass incidents on the government's books last year, which means that the actual number was several multiples of that), and in the newsletter's opinion, a recession of any magnitude would be a clear and present danger to the stability of the Chinese political system. Further, a critical storm of foreign debt problems, coupled with China's own inflation and overcapitalization, could result in an effective recession of 5 percent of GDP. Of course, no recession would be reported to the Chinese public, let alone the outside world. But if the actual recession is of wide enough scope, no amount of statistical alchemy could hide it, particularly as China has developed a significantly independent press.
China is also coming to grips with inflation hidden by Chinese currency controls. Wages in China's coastal provinces (which account for the bulk of Chinese GDP) have gone up by 50 percent in two years. Chinese attempts to delay the onset of inflation, by routing its $1.33 trillion forex reserves into foreign markets, have not fared well: China's $3 billion foray into Blackstone has since lost over half a billion dollars, as the value of Blackstone's equity has fallen from $31/share to $24/share.
At times like these, making confident predictions of prices' direction this week would constitute forecasting malpractice. I would say that now is a good time to buy small-cap equities, though: some of the hedge funds currently unwinding, such as the Sowood funds, used the vastly over-utilized strategy of longing small-cap stocks in one industry and shorting large-cap stocks in the same sector, on the assumption that small caps, which have historically offered higher returns than large caps, were underbought. That strategy has blown up dramatically, which means that small caps should be relatively cheap, and large caps relatively expensive.
I have always been extremely negative on Asian economic performance, and I am even more negative now. I would stay away from Asia until after some dramatic drops have occurred. Taiwan, South Korea, Japan and Vietnam are probably the ones to exit most quickly, because their export markets are so China-centric. Thailand has returned to a modicum of political stability, so if you must invest in Asia, Thailand is probably a good buy.
I still believe that the oil market is underestimating the probability of a Chinese contraction. Recall that in 1999, in the aftermath of the Asian economic crisis, oil prices dropped to under $20/barrel. When China contracts, an oil bear market of similar magnitude to the 1990's bear market will happen as well.
Changing subjects slightly, one major concern I have is that private-equity firms have hemorrhaged value even as bonds have gotten more expensive and interest rates have fallen. Lower interest rates are a godsend to private equity companies, because they are sitting on gigantic piles of debt. Apparently, traders of private-eq equities are predicting that interest rates will go back up significantly. If any equities traders would know, they would.
--Alex Forshaw,
http://www.bestwaytoinvest.com
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