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Liquidity and the Yen Carry Trade Redux

(June 3, 2007)

Dear Subscribers and Readers,

Before we start our commentary, I want to alert our readers to a couple of things.  First of all, a new board has been set up in our MarketThoughts discussion forum.  Titled “Mutual Funds, Hedge Funds, and ETFs,” the board's purpose is to allow our readers to discuss the latest developments in the mutual fund, hedge fund, and ETF industry.  Under our old organization, too many of these posts were getting “lost” in our “Market Commentary” board. Moreover, I also believe that there is an "untapped market" out there of potential posts, since many of our subscribers have a disproportionate interest in individual funds but who just have never posted since most of our posts did not revolve around this topic.  Hopefully, this will change going forward.

Second of all, a friend of mine recently sent me a link containing Warren Buffett's old letters to shareholders from 1959 to 1969.  These are a must-read.  You can't find these letters anywhere else – not even on the Berkshire Hathaway website.

Now, let us continue the rest of our commentary.  First of all, following is an update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As the bulls continue to have a “field day” with the bears (the Dow Industrials, the Dow Transports, and the S&P 500 all closed at all-time highs for the week), there are now storm clouds arriving on the horizon.  Besides the many things that I have previously discussed – such as weakening relative strength of the American Exchange Brokers/Dealers Index, rising bond yields, and the fact that many of the popular bear commentators have now “capitulated” to the bull side – I have also mentioned that liquidity conditions have been deteriorating.  That was discussed in our mid-week commentaries during the last couple of weeks, and I would again like to discuss this in today's commentary.

I would like to begin this discussion by giving our readers an update of our MarketThoughts “Excess M” (MEM) indicator.  This is an indicator that we have not discussed for a while now, but I still believe it is a relevant indicator, even in today's globalized world of financial flows.  Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages).  The rationale for using this is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve.  One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base.  By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and ultimately, fighting the Fed usually ends in tears more often than not.

  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity).  On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking.  If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing.  Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3.  Instead, M-3 is directly affected by the ability and willingness of commercials banks, hedge funds, private equity funds, and foreign central banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has stopped publishing M-3 statistics, this author has now revised our MEM indicator accordingly.  Instead of using M-3, we are now using a monetary indicator that most closely resembles the usefulness of M-3 – that is, a measurement which tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy.  We went back and found one measurement that is very close – that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 which the Fed is still publishing on a weekly basis).  That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator.  Following is a weekly chart showing our “new: MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:

Since our last discussion revolving around our MEM indicator, it has continued to decline – signaling a further deterioration of prime liquidity vs. “secondary” liquidity.  That is, while foreign central banks such as the People's Bank of China and the Reserve Bank of India, hedge funds, and commercial banks are still busy creating liquidity, the Federal Reserve itself has continued to remove liquidity from the global financial system.  This is evident by the dismal 1.6% growth in the St. Louis Adjusted Monetary base over the last 12 months.  At this point (similar to the 1995 to 1998 period), the world is being “held ransom” by both the Bank of Japan, the Japanese Ministry of Finance, and the Japanese retail investor, as these parties are now playing the role of “liquidity provider of last resort” in the form of the Yen carry trade.  Since Japan runs a current account surplus, however, Japan is thus not a natural exporter of their currency (unlike the U.S.).  Moreover, the Yen carry trade – by any measure – is now way, way, overstretched.  That is – if this continues – at some point, there would be a liquidity squeeze in Yen – not unsimilar to what occurred during the Fall of 1998 (when the Yen appreciated over 10% in an hour).  Readers should continue to both watch the level of the Yen and the actions of the Federal Reserve for signs of a continued decline in world liquidity.

Just how overstretched is the Yen carry trade, you may ask?  While Yen carry trade data is very difficult to come by, the Bank for International Settlements (the BIS) does make a good attempt at gathering it, since it publishes data of the amount of foreign currency derivatives outstanding on a semi-annual basis, from both a notional standpoint and a market value standpoint.  Since looking at notional value is next to useless, we have chosen to look at the total market value of the Yen currency derivatives instead.  Following is a chart showing the total amount of Yen currency derivatives outstanding from June 1998 to December 2006 broken down by instrument:

Note that the December 2006 data was just released last month.  More importantly, the total amount of Yen currency derivatives outstanding just spiked higher in the last six months of 2006, and has now surpassed the December 2001 highs and is now at its highest level since December 1998.  The above chart is a good signal of how much of the Yen carry trade is taking place in the derivative markets – and the answer is: Quite a bit.  Moreover, it is important to remember that a carry trade only works in a low volatility environment, and given that the implied volatility of Yen options just touched an all-time low a couple of weeks ago, my guess is that the environment will be less conducive to all types of carry trades going forward, including the Yen carry trade.

Also note that the above data is now more than five months old – and given the weakness of the Yen over the last five months against virtually all major currencies (including the US$), there is good reason to believe that the short position of the Yen carry trade has  now reached an all-time high.  Coupled with the fact that the Fed is still taking away primary liquidity from the financial system, my guess is that this will be a tough summer for the bulls – not just stocks but on commodities and real estate as well.

The deteriorating liquidity condition will not matter too much, however, if stocks were undervalued.  However, based on the Barnes Index (see our March 30, 2006 commentary for a discussion on the Barnes Index), the valuation of the S&P 500 is now at its highest since May 10th of last year (the day immediately preceding the summer correction of last year).  In our commentary over the last 12 months, we have maintained that the ultimate top (or at least a top that is ripe for shorting) will most probably not come until the Barnes Index has hit a level of 70 or higher.  As I have mentioned before, this author uses the Barnes Index to measure the relative valuation of equity prices to bond prices.  Note that the Barnes Index was instrumental in getting us into our final 25% short position in our DJIA Timing System in early May last year (see our May 7, 2006 commentary “Playing the Probabilities” for a refresher).  As of last Friday at the close, the Barnes Index jumped two points from the previous Friday's reading – and is now a mere 2.8 points below our 70-point target.  Following is a chart showing the Barnes Index vs. the NYSE Composite from 1970 to the present, courtesy of

A huge part of this was due to the 5.1 basis point jump in the 30-year Treasury yields last Friday – although the 20-point jump in the S&P 500 definitely had something to do with it as well.  Again, a huge decline isn't imminent even if the Barnes Index hit a level of 70 – especially given the fact that the market has previously gone on to make higher highs until the Barnes Index touch the 90 level in 1981, 1983 and 1990 (or even higher such as August 1987, April 1998, and January 2000).  But a reading of 70 or higher would be consistent with the level made in the 1973 top, as well as the January 1980 top (which occurred in conjunction with the top in gold and silver prices).  One should at least expect a significant correction if the Barnes Index continues to rise higher in the coming days, especially given the lack of desire of the Federal Reserve to cut rates.  On the contrary, many of the world's central banks are still either in a hiking cycle or looking to raise rates – thus creating a further headwind for liquidity and thus equities in the coming days.

For now, I would not commit to initiating a short position in our DJIA Timing System should the Barnes Index reach the 70 level in the coming days, although we will definitely consider it.  Sure, liquidity is stretched, the private equity buyout boom is stretched, and the Yen carry trade is stretched – and more importantly, liquidity conditions are going to get tighter by the day, but for now, we will just evaluate the situation on a daily basis.  There is simply no sense in committing to a position – given that there are so many variables in the equation.  Readers please stay tuned.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2005 to the present:

For the week ending June 1, 2007, the Dow Industrials rose 160.83 points while the Dow Transports rose a whooping 178.43 points.  While the Dow Industrials has certainly gone on an impressive run – rising in 8 out of the last 9 weeks – the more important event, from a Dow Theory standpoint, is the besting of its all-time high of 5,243.60 made on April 25th last week.  However, given that the confirmation of the Dow Industrials on the upside by the Dow Transports came after more than a month, this latest confirmation is really not that encouraging for the bulls.  For now, we will continue to maintain our completely neutral position in our DJIA Timing System and will probably initiate a 50% short position in our DJIA Timing System should the Dow Industrials hit the 13,800 to 14,200 area in the coming weeks – unless the Barnes Index stays below the 70 level or unless breadth indicators in the U.S. stock market start to improve.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators increased from last week's 23.7% back to 25.2% for the week ending June 1, 2007.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Given that significant tops do not necessarily need to be preceded by highly overbought sentiment indicators, there is no need for a highly overbought reading in this indicator before the market tops out.  However, what is necessary is at least a moderately overbought condition in the market.  This is where we are now – and should this sentiment indicator experience a spike over the coming week, preferably to over 30% (accompanied by a Dow Industrials close in the 13,800 to 14,200 range), then there is a chance that we will initiate a short position in our DJIA Timing System.  Moreover, we will most likely not go long again unless these indicators again reach an oversold signal at least consistent with what we witnessed during the April 2005 and October 2005 corrections.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

While the 20-day moving average of the ISE Sentiment (at a current reading of 136.5) is still not close to overbought levels, its rally from a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) is now definitely getting “long in the tooth.” Should this experience some kind of spike in the coming days, and should this be accompanied by a DJIA reading in the range of 13,800 to 14,200 and a Barnes Index reading of over 70, then we will most likely initiate a short position in our DJIA Timing System.  Moreover, unless the 20 DMA gets more oversold again, we will continue to avoid a long position our DJIA Timing System.

Conclusion: Make no mistake – liquidity conditions continue to deteriorate all across the board – even as the commercial banks, hedge funds, and private equity funds continue to create and supply liquidity to the world's financial system.  The marginal investor, the subprime borrower, has already fallen.  The question now is: Who will be next?  Will it be the hedge funds that engage in leveraged Yen and other carry trades?  Or will it be funds that are loaded with debt, such as the infrastructure funds of Macquarie Bank?  Perhaps it will be the marginal emerging markets, such as Indonesia, and to a lesser extent, India, or even the Chinese retail stock market investor?  One thing is for sure – an accident, almost by definition, can never be predicted by the majority of participants, and any upcoming financial accidents will most likely have been unforeseen.  Given the huge amount of leveraged buyouts in recent years, I would not surprised if we see an October 13, 1989 scenario sometime in the coming weeks or months.

Moreover, as I mentioned in last weekend's commentary, as defined benefits pension plans embrace liability-driven investing (or “LDI” for short), the exodus from under-performing mutual funds will turn into a rout – and many mediocre money managers will find themselves out of work.  The advent of LDI and other alpha strategies will complete the job that index funds began 30 years ago – making underperforming fund managers accountable for their mistakes or missteps.  On a more immediate basis, this exodus of funds from the mutual fund industry will also be a huge headwind for U.S. stocks – as approximately US$1 trillion is estimated to shift from mutual funds into other strategies, such as LDI, immunization, hedge fund, and private equity fund strategies over the next five years.

Combined with the fact that the market is now overbought, and given the many divergences we are seeing – as well as “capitulation” of many mainstream market commentators, I am going to maintain that U.S. stock market investors will have a tough time during this summer.  At this point, we will thus stay completely neutral in our DJIA Timing System – and may actually even initiate a 50% short position in our DJIA Timing System should the market continue its rally over the coming days or weeks.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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