Hercule Poirot and the market for investment assets

by admin on March 5, 2013

It is good to be back in Japan, where the plum blossoms have started their thing already, and the cherry blossoms will soon.* Compared to London, Warsaw, and Moscow, the climate is perfect (but still no grilled chicken street food).

What I am worried about recently:

The USD is rising (and JPY, GBP, and EUR falling), but…

US stocks are also rising.


*It just occurred to me that this is a classic opening to an old-school formal Japanese letter. Plum blossoms start flowering around a month before sakura.


This should be indicative of expectations of a strong economy, but …

we know that the economy is probably getting worse, and…

although this would not necessarily matter, because earnings and share prices can rise in a deteriorating economy, margins are already high, and things which lead to increased revenues (such as consumer sentiment and hence spending) are not doing very well.


At the same time…

gold is falling

which would normally indicate increased expectations of either monetary tightness or better uses for money (a.k.a. a better economy), but…

copper is not doing so well, and expectations of rates are still low. The yield curve (2yr/10yr) was 0.24%/1.58% in mid-Nov, 0.27%/1.86% at the beginning of this year, and is 0.24%/1.88% now. If this tiny steepening is supposed to be due to increased growth expectations, what is going on with copper?

So, this is like one of those sessions at the end of a Hercule Poirot film – someone is lying, either gold, the USD, interest rates, copper, or stocks. Practical psychologists will also find this interesting.

Hercule & the stock market Hercule & the stock market Copper prices Copper prices

Here is a summary of my view of whether recent moves in certain assets are consistent with those in others:

Asset consistency?

Asset consistency Asset consistency

Of course, gold does not need to move in that same direction as stocks, and actually moves in the opposite direction quite a lot. However, the above is the distillation of my view on the current movement, in which stocks could be moving up at least partly on belief in an improving economy and artificially low interest rates, but that would clearly lead to increased inflation expectations and demand for gold, and therefore the movements in those two series seem to be conflicting, and my reading above is likely flawed. The same point on my added interpretation applies to other pairs, and items in red are the most significant pairs, in my view.

The reason why I put “no” for gold versus copper is that copper should fall with declining economic activity, which should involve increasing allocation of funds to “safety” and increasing bets on further central bank craziness, and thus higher gold prices (with the caveat that a 2008-style dash for liquidity will put a temporary downer on gold, but that is not likely in the current situation).

The reason for the “no*” for bond rates versus the US dollar is that the dollar is going up much faster than intermediate and long government bonds since early February.

Stocks vs dollar and bonds divergence Stocks vs dollar and bonds divergence

This implies that there is net buying of dollars but only putting that money in the short end of the curve, and there has been fairly normal steepening overall with the recent rally. So it is possible that the rise in the US dollar is primarily being driven by action in the Japanese yen and the British pound (and now the Euro), whereby there is selling of the dog currencies to buy the apparently less-ugly US dollar as a macro trade, which will involve purchasing bonds with the US dollars (you obviously need to park the USD you get in the transaction in something very liquid but with a bit of yield, and, probably more importantly for the people responsible, rising in the short term). And, if this is the case, then it explains all the other moves (hence the asterisk), even though it still is quite strange.

So, what to do now?

I have already said that I have been significantly selling Japanese shares. I am not yet down to neutral, but perhaps I will be soon. In the meantime, if this thesis is correct, then it appears you need to take the opposite side of the trade which is apparently in vogue, and the best way to do that, it seems to me anyway, is to buy gold with the currency you get from coming out of your risk assets. The reason for this is that, first of all, gold should be performing well under general current conditions (more money printing/”liquidity operations” = more paper dollars per ounce), but is not. Secondly, the fundamental drivers specific to gold are all good anyway (loose monetary policies, competitive devaluations, terrible supply outlook, increasing marginal cost per ounce produced, etc.)

Thirdly, even if we enter a period of declining risk appetite AND IF the above thesis is incorrect, then you still have a “kicker option” whereby whatever mechanism is going on at present will likely unwind, as the current appreciating dollar trend is incompatible with a rising stock market with a weak economy (although it can work with a strong economy, as per Soros’ “Imperial Circle”), and the reverse of that mechanism should involve a rising gold price, even if we has misdiagnosed the exact mechanism.  Fourthly and lastly, increased economic activity should only bring down gold if interest rates rise significantly (i.e. in real terms).


Of course, I can hear you muttering, this analysis has more air holes than a bag of popcorn, chief of which are that the economy might actually be doing better (copper is lying), and that the status quo can continue for a while.


Regarding copper: I don’t know. My modest reply to the status quo point is that yes, this kind of dynamic can continue, but is self-limiting. Within certain boundaries, this kind of coupling can be self-reinforcing, as more participants identify and join a trend. However, beyond a certain boundary zone it becomes self-limiting, as a high dollar will damage the outlook for US earnings (amongst other corrective factors), pouring some cold water over currently high levels of excitement. To see how this relates to my short-term view on Japanese stocks, please see the last post.

Where will it end?

Not where I say it will. The answer is “I don’t know”. All I can see is a dynamic I believe to be self-limiting. Sorry for this Japanese-style anti-climax. All I have really said here is “this too shall pass”. Finally, this all could be an overly complex justification for my own biases, and outrage at the high prices that are out there.


PS: Another reason to be bearish: lowest short sales since 2007, very high insider selling, and now even “shorting vol” is in vogue. If that does not scare you then you are either very brave or …

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