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Jeff Saut Presents: Unwinding the Carry Trade, the 1998 Analogue


...the markets have a tendency to do whatever it takes to confound the majority of participants.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"The market clearly shows the footprints of carry traders running for the doors. Whether you look at the yen, the Swiss franc, corporate spreads, swap spreads, EMD spreads or mortgage spreads, you see the prices of high yielders falling in relation to low yielders. When a move like this begins with such a fury, the tendency is to call it 'over' too soon and to underestimate its follow-on magnitude. There is a lot of money on one side of these carry trades and most of that money needs to unwind and will try to unwind at the same time. This is how six standard deviation events happen. In fact, when you look at the five biggest daily, weekly, or monthly moves in the yen over the past ten years, the average size of the fat-tailed event is about six standard deviations.

Another way to think about the potential magnitude of the reversal is to look at the 1998 carry trade as an analogue. Our guess is that the money riding on this one is a lot larger than the money riding in the 1998 carry trades, given the explosive growth of hedge funds and new instruments that target carry trades for the naive investors (e.g. an ETF that buys high-yielding currencies or Japanese retail investment products).

...Bridgewater Associates, Inc.

So said the good folks at Bridgewater Associates last week and not to be outdone, none other than legendary hedge-fund maven George Soros likewise blamed the recent market machinations on the carry trade. Obviously, I agree, given my strategy reports of the past few months. Indeed, despite the naive nabobs that minimize the "carry trade's" impact, or that the carry trade even exists, I view the carry trade's impact on the markets as significant both on the upside and the downside. Most recently, said impact has obviously been on the downside, yet in the very short-term scheme of things, the impact of the "carry trade" seemed to abate last week as the envisioned Monday/Tuesday trading "low" played in spades.

Recall that in last Monday's report I suggested a Monday/Tuesday trading "low" should be at hand, leading to a three- to five-session rally. Well, last Monday's low of roughly 1374 on the S&P 500 proved to be that "low," leading to a multi-session "spurt" that left the S&P at 1402.85 as of Friday's close. Indeed, the perfunctory "throwback" rally of three to five sessions that my firm wrote about from our perch at Raymond James' 28th Annual Institutional Investors Conference in Orlando last Monday came pretty much on cue, begging the question what happens from here?

As previously stated, the typical pattern now calls for a successful downside retest of the recent "lows" at best and at worst a breakdown below those lows, extending the decline into a full 10%+ affair. Scarily, over the weekend many publications noted that what was going to happen was indeed a retest of the recent lows and then a resumption of the "bull market." This ebullient sentiment was reflected in's figures, which showed a "jump" in equity exposure last week, from middling levels to new highs. To quote Barron's savvy Michael Santoli, "Lots of technically oriented analysts are invoking the usual pattern of 'retest' of the former lows after this kind of bounce, which raises the pretzel-logic question of whether this is too widely expected to actually happen."

I like the term "pretzel logic" because the markets have a tendency to do whatever it takes to confound the majority of participants. Using that logic infers that the equity markets are unlikely to resume their eight-month bull-run, or that the downside retest of the recent lows will be successful, which is why my firm remains cautious. Plainly, we have been cautious for months as we have attempted to ascertain if the economy was going to descend into recession, slow to a muddle, or actually reaccelerate. While over that timeframe many of the economic reports continued in their Fox Trot skein (fast/fast followed by slow/slow figures), the slowing statistics of the past few weeks have been concerning.

For example, the Chicago Purchasing Managers' (CPM) report remains below 50 (read: weak), the prices paid component of the CPM report rose sharply (to 63.2 from 54.9), construction spending is down sharply, factory orders are sliding (-5.6%) with non-defense capital goods orders (ex-aircraft) off a shocking 6.6%, productivity growth is slipping (+1.6% vs. +3.0% estimates), unit labor costs are increasing dramatically (+6.6%), consumer sentiment is declining, gasoline prices are rising, nominal retail sales have declined at an alarming rate, and the list goes on. Yet it is not just the recent economic figures that give me cause for pause, but a number of inferential observations as well.

To wit, I didn't like the failure of the NASDAQ 100 (NDX) and the Securities Broker/Dealer Index (XBD) to confirm February's new highs by most of the major indices. Further, it is troubling that the interest sensitive S&P Homebuilders Index (XHB) and the XBD indexes have collapsed despite the 10-year T-Note's recent decline to a yield of 4.48%. Also troubling is the flameout of the sub-prime mortgage market that appears to be spreading not only to Alt-A mortgage loans, but to prime home equity loan portfolios as reflected in Countrywide's (CFC) prime portfolio, whose delinquency rate has doubled. Meanwhile, the costs per unit are rising at the production level without a concurrent increase in prices for the final product. This trend suggests that the long-awaited reduction in corporate profit margins I have often discussed may have finally arrived with negative implication for capital spending, corporate share repurchases, and many other things.

Still, the thing that worries me the most is the sense that investors' "risk appetite" may be decreasing. I have long argued that while at the margin "liquidity" is certainly a driver of asset classes, the ultimate driver is investors' risk appetite. Verily, if participants have no risk appetite you can push all the liquidity at them you want and they will just take that cash and deposit it in a money market fund. In past missives I have highlighted Merrill Lynch's Financial Stress Index, which does a pretty good job of measuring investors' "risk appetites." We have further noted that emboldened by the straight-up July 2006 to January 2007 "unnatural" rally, investors have embraced ever increasing risk appetites. Recently it feels like that trend has reversed. If that sense is correct, in a mean-reverting world a reversion to the mean in risk appetites implies a fairly stiff headwind for stocks.

Given these concerns, I once again quote my astute friends at Knott Capital Management who opine:

"Our risk-adverse and conservative nature forces us to maintain a 'predominantly defensive' investment stance. Investors shouldn't have a highly optimistic or hardened pessimistic mindset. Proper sector-selection is the best tactic to achieve above-average investment results. We favor those industry groups where valuations are reasonable, pricing power is formidable and earnings growth seems assured. We continue to sell on strength and buy-on-weakness. This defensive tactic is flexible and adjusts to the market's volatility. It also allows gains to accrue as 'money is taken off the table.'"

Along these lines, some of the company presentations that piqued our interest at last week's conference included: Covanta Holding Corp. (CVA); Petrohawk Energy (HAWK); Kodiak Oil & Gas (KOG); Tessera Technologies (TSRA); Tetra Technologies (TTI); Helix Energy Solutions (HLX); Harris Corp. (HRS); Agnico Eagle Mines (AEM); Tutogen Medical (TTG); Sprint Nextel (S); and L-1 Identity Solutions (ID).

This week I will be attending, and speaking, at another conference here in San Diego and will hopefully be able to glean some additional risk-adjusted investment ideas.

The call for this week: ALL of the indexes my firm follows have broken below their respective rising trendlines that have been intact since the July/August lows of 2006. Historically when this event has occurred it has taken time for the markets to convalesce. I don't think it will be any different this time.

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