Archive for March 3rd, 2007

The Market – A Speculation Induced Sell-off

Though the market has had quite a fall, I don’t think we have even seen a general selling panic and that suggests this recent fall simply reflects the closing of leveraged speculative positions. A tremendous amount of carry-trade speculation may have been built into this market! There is potentially another 40% carry trade speculation built into the Yen, which gained in value from around 121 to 116.7 this week (not to mention Swiss Franc) if you assume the Yen should more likely be priced around 112 given the underlying fundamentals of the Japanese economy. That is a lot of potential liquidity hitting the markets over the next few weeks. Throwing some numbers out there, if speculative carry-trade closing represented 80% of this markets fall, or around 3.5% for the week, more unwinding could represent around a 2.8% fall.

Why do I suggest that speculative unwinding represented so much of this market’s fall? Various commentary talks about how most institutions and average American investors still seem to be holding to their portfolios and “according to a new MSN-Zogby poll, just 5% of Americans said they see a decline like this week’s as an opportunity to buy, and only 1% said the slumping stock market causes them to sell. Thirty-four percent said they either don’t own stocks or are unsure how to react to a downturn.” CNBC writes, “most strategists on Wall Street haven’t made any moves in their portfolios, however, as they believe it is still too early to determine which moves to make, CNBC reported: “Now that the correction is on us, people are trying to decide what to do,” said Jordon Kimmel, a market strategist at National Securities.”

So will this market continue to have an unwinding of leveraged speculative positions? The risks that could force a carry-trade unwinding and closure of speculative market positions include increasing Yen value, fall-out in the sub-prime and thus CDO market causing capital requirements to clean up that mess, a few blow-ups in highly leveraged hedge funds, a broader fall in the market led by the average American investor and institutions not partaking in the carry-trade, and also a blow up in an emerging market like Russia or India. Jim Jubak of MSN Money writes, “India is very dependent on global cash flows. Unlike China, India runs a trade deficit and only showed a total capital account surplus in fiscal 2006 because of that $12.5 billion from overseas investors in stocks, foreign direct investment of $6 billion in 2006 and rising corporate borrowing on international capital markets (about $6 billion in fiscal 2005). India was relatively untouched by the Asian financial crisis of 1997, but it is much more vulnerable to changes in external cash flows today.”

The defining aspect of this market run-up and recent fall was the liquidity explosion driven by cheap credit that took the positive market reaction to a ‘goldilocks’ economy and drove it even higher both here and in emerging markets. Unfortunately, it is extremely difficult to measure how much liquidity in the system is currently priced into the market, as well as the leveraged risk structure of that liquidity. We are able to measure, with some broad assumptions, some of that liquidity risk exposure through the fall of the Yen and Swiss franc and the corresponding fall in the market. Yet overall, too many people know too little about the amount of risk built into current liquidity levels, especially with regard to the derivatives market and CDOs.

A key aspect of this recent market fall is that it didn’t really involve the average American investor and institutions not partaking in the carry-trade. Whether this is dangerous complacency or simply confidence is an important question. Most of the market commentary I read suggests that because the economy is fine, this market should regain its footing and start trending up again. But should we rely on an altar of unbridled confidence when so many bearish tipping points exist? And could seemingly insignificant events, such as the trading scandal, though not in any way a fundamentals changing event, add a smell of rot to this market and increase investor skepticism?

Over the next few weeks, it is going to be very important to watch the effect of the speculative positions on the mentality of the base market support and hope (unless you have a bearish position) that none of the tipping factors described above lead to further speculative unwinding and a bearish domino effect on the broader market support. For instance, the fact that gold fell so much and is now at $644 while silver is at $12.90 is quite interesting. It suggests real concern that China is slowing down. I think it also suggests an unwinding of speculative positions. As mentioned above, the fact that most investors, including the average American investor and institutions not participating in the carry-trade, have not felt the need to reposition their portfolios, ie, buy gold or silver as a defensive hedge, suggests that the fall in these two metals was speculative position closing. I think if these metals start rising in value, and the Yen or Swiss franc do not fall in value suggesting a carry-trade re-strengthening, then consider that a bearish sign that the broader market is buying gold and silver as a hedge against further market deterioration.

On a technical basis, the Nasdaq is suddenly very close to its 50 day weekly moving average around 2,300, only about 70 points or 3% away from Friday’s close! The Dow is also quickly approaching is 50 day weekly support around 11,750. That is about 360 below Friday’s close or 3%, and that could feasibly be reached as Dow lost 533 this last week alone. If either index blows through those supports, we could see some real downside with selling pressure from broad market investors.

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