Tuesday, October 28, 2008

Sayonara Carry Trade Turmoil?


It looks like the lambs stopped screaming, for now. The Dow Jones industrials soared nearly 900 points yesterday in a spectacular rally. The Dow and the Standard & Poor's 500 index each shot up nearly 11 percent:

"There is nothing fundamental that came out today or yesterday that would take it up or down. We're all groping for something meaningful to talk about," said Bob Andres, chief investment strategist at Portfolio Management Consultants. "The market is exhausted from going down."

The explosive rally in stocks happened on a day where a key measure of consumer confidence fell to a record low:

The Conference Board, a New York-based business research group, said Tuesday that its Consumer Confidence Index plummeted to 38 in October from an upwardly revised reading of 61.4 in September.

Last month's decline brings the index to its lowest level since its inception in 1967.

"Consumers certainly appear to think the sky is falling," said Adam York, economic analyst at Wachovia Economics Group, in a research note.

...

"While the current reading may be an overreaction to the bad news in October, it does make clear that consumers understand that we have firmly moved into a recessionary environment and that this slowdown will be the worst in a generation," York said.

Even though gas prices have come down significantly in recent weeks, putting more cash in consumers' pockets, Americans now appear more focused on the deteriorating job market.

So far this year, the economy has lost 760,000 jobs, according to the Labor Department's September payrolls report.

So what is going on? How can the market surge 11% when consumers are so pessimistic?

This article from Time has some answers:

Ironically, within hours of the bleak consumer confidence report, the stock market posted its second biggest one-day point gain this month, with the Dow Jones Industrial Average rising 889 points to close at 9065. It's not the first time these two indexes have moved in opposite directions.

In fact, a 2002 investment research study found that low consumer confidence can, at times, be fertile ground for bullish stock market moves. "At extremes there does tend to be a negative correlation between consumer confidence and stock prices," notes money manager Ken Fisher, a co-author of the study.

But don't close the recession book just yet. While analysts had expected confidence levels to decline given the hammering financial markets have endured in recent weeks, the plunge was 14 points worse than the 52 rating economists foresaw. "Consumers are extremely pessimistic, and a significantly larger proportion than last month foresee business and labor market conditions worsening," said Lynn Franco, director of The Conference Board's Consumer Research Center.

"Their earnings outlook, as well as inflation outlook, is also more pessimistic," she added, noting that these conditions don't augur well for retailers "who are already bracing for what is shaping up to be a very challenging holiday season."

...

The sharpest confidence drop was found among households earning more than $50,000 per year, McGranahan says, noting that this group tends to have more money tied up in equity markets. "It's the top wage earners who are feeling this right now," King says, although "It's spread into every corner of the country. Nobody really feels safe."


Add to this grim news the fact that home prices sustained a record drop in August according to the S&P Case-Shiller index:

Home prices fell in August for the 25th consecutive month and prices in 10 major markets plunged a record 17.7% year over year, according to a key index of real estate values released Tuesday.

The S&P Case-Shiller Home Price 10-city index dropped 1.1% for the month. The 20-city index recorded a record year-over-year decline of 16.6% with a 1% fall in August.

The indexes compare the sale prices of the same homes each year to determine price trends and are considered one of the most accurate home price gauges.

The hardest hit of all 20 cities on a year-over-year basis was Phoenix, where prices plummeted 30.7% during the past 12 months. Las Vegas prices plunged 30.6% and Miami sank 28.1%.

So how could stocks surge on a day filled with grim economic releases? You need to remember that the stock market is a beast on its own.

My take on today's explosive stock rally is that it's a mixture of downside exhaustion, anticipation of Fed rate cuts tomorrow, institutions buying as we approach month-end to try to prop up those miserable monthly statements, hedge funds getting squeezed, and let's not forget the most important factor which I discussed yesterday, the reprieve of the unwinding of the yen-carry trade:

One of the biggest factors for today's rally was the plunge in the Japanese yen.

The yen has been on a tear recently, as has renewed fears about the unwinding of the Yen carry-trade. The last time I wrote about this phenomenon was back in March, when the spike in the yen back then sparked the same worries. Both instances were associated with dramatic selloffs in global stocks.

The chart above shows the dramatic reversal in the Yen ETF (FXY) today. This was the largest one-day decline since Jan. 1974, a month that touched off a huge rally in the stock market. The reversal in the yen could be indicative that large players that had been selling equities to buy back their yen positions are finally finished.


This would bode well for global equities. Last night, Asian markets surged higher, and right now it looks like they are set to open higher again. The Bank of Japan said it is considering cutting its already low interest rates from 0.50% to 0.25%. This would further pressure the yen, and help the overall cause.

I think the unwinding of the yen carry trade is related to the overall deleveraging that we have seen in the markets, and that has contributed to the unprecedented and relentless selling pressure in the markets. Any reprieve from this selling pressure would allow the markets to further lift, which could take the pressure off of funds seeing redemptions.

In recent weeks, these surges in the stock market have been one-day affairs. So it will be interesting to see if we get some follow-through to today's action. Tomorrow, the FOMC meets and will cut interest rates (I am now in the 50 bps camp). Will traders sell into the news? One has to wonder.

Will traders sell this rally like they did the last few monster rallies? There will be profit-taking, but I agree with Paul Kedrosky who is calling for a "savage" 20%-25% year-end rally but warned:

After you cover your shorts, however, the market will notice that 2009 earnings estimates are still way too high and collapse, proceeding to new lows in Q1.

How low? Try 700 on the S&P, predicts Kedrosky.

But for long-term investors, this drop would be good news, because it means you'll get to buy at prices significantly cheaper than today's.

A year-end rally would be welcome relief for U.S. public pension funds that are getting clobbered in this market rout:

Public pension funds dropped 14.8 percent in value for the year ended Sept. 30, according to Northern Trust, an investment company. The funds, which typically have most of their money in stocks, have probably dropped far more than that because the markets have dropped 20 percent more since then.

"We expect this is going to be the worst year we've seen since we've been tracking the funds," said William Frieske, of Northern Trust Investment Risk and Analytical Services, which began watching the funds 14 years ago. "It's got all the hallmarks of a bad -- really bad -- year."

Virginia's retirement fund, for example, has dropped about 20 percent since July 1, plummeting from $55 billion to $44 billion. Most of that fund was invested in stocks.

The California Public Employees' Retirement System has lost 20 percent of its portfolio since July 1.

The Maryland pension fund was down 17 percent for the year ended Sept. 30, and with about 58 percent of the fund invested in stocks, officials are expecting further significant drop-off when October's market plunges are calculated in.


You can add another giant public pension fund to the list above, New York state's pension fund, which tumbled 20 percent in value since April:

The fund had just under $154 billion in assets on March 31, 2008, and Comptroller Thomas DiNapoli said investments were designed to withstand "market turbulence."

The drop in the fund's value is due to the stock market's performance, a DiNapoli spokesman said, adding losses on some investments will not be realized until stakes are sold.

DiNapoli wants the state government to allow him to make more nontraditional investments, including in private equity, currently capped at 8 percent, real estate, which has a 6 percent limit, and hedge funds, which cannot top 5 percent.


Mr. DiNapoli should pay attention to George Soros who today warned that the global financial crisis will reduce the hedge fund industry to as little as a third of its current size.

Interestingly, the Globe and Mail reported yesterday that the Desjardin Group, Canada's largest financial co-operative, is winding down its hedge fund investments amid lacklustre returns on its principal protected notes (PPNs):

The credit union went into this market meltdown as one of the world's 50 largest players in what's known as 'funds of hedge funds.' Last year, the company held a $6-billion portfolio at its Desjardins Global Asset Management subsidiary that picked a variety of European, U.S., Asian and domestic funds on behalf of its clients. Many of these hedge funds have now failed. A significant portion of this portfolio would have been sold to the co-op's institutional clients.

Desjardins has been steadily redeeming holdings in hedge funds and sources say chief executive officer Monique Leroux decided on Oct. 1 to exit this entire line of business.

But others feel that now might be the right time to re-invest in hedge funds:

The portfolio manager of Gam’s multimanager Asian product is London-based Kier Boley. During a visit this week to Hong Kong, he spoke to AsianInvestor.

“Up to the end of this year and in the first quarter of 2009 looks like the best time to allocate to hedge funds,” he says. “The only good thing about a bear market is its ability to separate the good from the mediocre via the huge dispersion between returns.”

They are looking at hedge fund managers who are disciplined in portfolio construction, as opposed to ones who have tried to time the bottom of the market, then pile in only to find that the markets have carried on falling. Gam is finding that hedge fund managers are less keen to short now that markets have come off so much.

By disciplined portfolio construction, Gam means managers who take a top-down approach and then set very conservative gross and net exposure figures, then look for capital that they can justify and put to work, rather than try to use this as a chance to become a billion-dollar group.

“We have liked managers who use cash itself as a bet. In Asia, cash is the best form of defence,” says Boley. “There is the opportunity now for those managers to get on the front foot, to pick up assets at distressed prices as volatility is at highs, spreads are wide, and valuations cheap. But they should be able to generate returns on low exposure without leverage. Say, by taking gross exposure from 30-40% up to 50%.”

The Gam product is an Asia-Pacific multimanager fund of hedge funds which is down 11% in 2008. It is equity long/short dominated. And its risk profile is designed to produce exposure that is one-third exposed to the market downside and two-thirds exposed to the upside.

“We’re looking for an asymmetric return profile, not necessarily capturing all the upside, but we don’t want managers who capture 60% of the upside, and 90% of the downside. That’s not the sort of asymmetric profile we want,” says Boley.

“There are funds now which may find themselves uninvestable. Those which performed well in providing beta in the upward markets, but could not adjust quickly enough. They will find it difficult to raise cash in the next 2-3 years. An investor might as well go into a long-only fund."

Gam is finding that new managers are a rarity this year, but says it is on the lookout for profit-generating desks seeking to spin out from existing hedge funds, perhaps prompted by internecine disagreements about equity stakes in partnerships.

However, Gam expects that the level of hedge fund closures won’t be as high as observers have predicted. For, even if mass redemptions occur, a hedge fund manager, having gone to the trouble of setting up his platform might prefer to keep it technically alive, even if it is just managing his own money. Perhaps the hedge fund manager on a yacht might be about to make a comeback.

I happen to think that the Gam is right, however, I caution pension funds that want to dip into hedge funds: make sure you find talented fund managers that produce real alpha in up and down markets, get the terms right, especially now that hedge funds will work with institutions who can offer them sticky money, and monitor these funds like a hawk.

If pension funds do not have internal expertise, they should not invest in hedge funds or they should make sure they find the right fund of hedge funds to help them monitor these investments.

But keep in mind, the great deleveraging will continue unabated for many years and Soros is absolutely right: the shakeout in hedge funds will be brutal. In this environment, only the best of breed will survive.

***Morning update

Asian and European markets rallied strongly on the back of Wall Street's monster rally, but a sense of unease remains:

The FTSE 100 index of leading British shares was 149.47 points, or 3.8 percent, higher at 4,075.85 and France's CAC-40 was up 184.53 points, or 5.9 percent, at 3,299.45.

Germany's DAX index though was sharply lower as shares in Volkswagen AG, which have risen fivefold since Friday, dropped back by over 40 percent after the car maker's biggest shareholder Porsche AG said it will offer some stock to ease liquidity constraints.

Earlier, Japan's Nikkei index closed 589.98 points, or 7.7 percent, higher at 8,211.90 in the wake of the Dow Jones' 889 point, or 11 percent, rally Tuesday. The Dow's percentage rise Tuesday was its second biggest ever.

The renewed buying has been stoked by expectations that both the U.S. Federal Reserve and the Bank of Japan will cut interest rates this week and provide a further stimulus to the world economy which should foster some renewed risk appetite in markets.

The Fed is expected to cut its target fed funds rate by half a percentage point to 1 percent later Wednesday. Markets are also holding out the hope the Bank of Japan would trim its interest rate a quarter percentage point from the already low 0.5 percent.

The European Central Bank and Bank of England are also expected to follow suit and cut borrowing costs at their next scheduled rate-setting meetings next Thursday.

Despite signs that investors are looking for bargains after the turmoil of the last month, a sense of unease still prevails with the world economy and financial system fragile, evidenced overnight by the $25 billion package to help Hungary.

"This is still a volatile world as the bizarre 11 percent rose in the Dow overnight demonstrates," said Daragh Maher, an analyst at Calyon.

"Given that this was reportedly on the back of bargain hunting, one has to query why the market did not see similar value on Monday when the Dow continued to languish," he added.

Wall Street is expected to give up some of those gains when it opens later with futures markets predicting signaling a weaker opening for the two main U.S. indices in Wednesday trade. Dow and Standard & Poor's index futures were both down about 2 percent.

"After such huge gains yesterday a degree of profit taking at the open on Wall Street would pose few surprises," said Matt Buckland, a dealer at CMC Markets.

Elsewhere in Asia, the regional rally fizzled by the afternoon as traders cashed in profits amid fresh worries about company earnings.

Hong Kong's Hang Seng Index, up nearly 5 percent in early trading, trimmed its gain to just under 0.9 percent in volatile trade after a spectacular 14.4 percent rise the day before. Australia's S&P/ASX200 climbed 1.3 percent, helped by higher commodity prices.

South Korea's index pared its morning gains and dropped 3 percent as bank stocks pulled back on fears they may cut dividends after the government guaranteed their foreign currency loans.

Japan's stocks were helped by another fall in the value of the yen, which prompted investors to buy exporters like Toyota Motor Corp., which shot up 10.4 percent. Honda Motor Co. jumped 18 percent even though on Tuesday it reported a 41 percent drop in quarterly profit and lowered its forecast for the full year.

The yen has softened since jumping to about 91 to the dollar Friday. On Wednesday, the dollar was trading at about 97 yen after surging above 98 yen Tuesday, but up sharply from 94 yen late Monday.

Keep an eye on that yen. If it starts softening more, it could be a sign that this rally has a lot more room to run. If, however, it starts surging again, you know that pesky unwinding of the carry trade will continue to hamper financial markets.

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