Economic Rebalancing

The global economy is horribly out of balance, with the United States going deeper into debt each year as a result of a huge trade gap. This blog describes the process of global economic rebalancing. If you have any comments or questions about the posts here, please don't hesitate to use the comments section.

Wednesday, August 02, 2006

The Rebalancing Trade

For over a year, I've been structuring my portfolio around what I think of as "the rebalancing trade." Most hedging strategies involve some type of trade where the goal is to profit on differences between two types of asset classes. In merger arbitrage, one company will be shorted and another held long as a way to bet on whether or not a merger will go through. In the carry trade, short term bonds are shorted (or money borrowed at short term rates) while long term bonds are purchased as a bet that interest rates will stay constant or go down. In the rebalancing trade, I short US companies that depend on excessive US consumption and go long on foreign companies that are likely to profit from increased consumption overseas, especially in China. My bet is that US consumption must decline relative to international (and especially Chinese) consumption.

With most hedging strategies, there is very strong correlation between the components of the trade. While one might expect a high correlation between foreign and domestic consumer cyclicals, I've found that the correlation hasn't been very strong and that there have been days and periods where the trade has either worked very well or very poorly. I suspect there is a large amount of hedge fund activity in the rebalancing trade in one form or another, and that many funds play somewhat related trades, hedging inflation (foreign currencies, gold and other commodities) against US stocks. Many hedge fund managers do understand the inevitability of global rebalancing, even if the mainstream economic news totally misses the issue. I suspect the activity of momentum oriented and leveraged players in the trade are largely responsible for the low correlation between certain classes of foreign and domestic stocks in recent months.

Recently the rebalancing trade has been working very well. Builders have been trending down for about 9 months, but mortgage lenders and retail joined the fall the last couple of months. On the other side, China has been outperforming most other global equities markets.

The gold bug websites tend to focus on total market liquidity, usually ranting against the excessive use of liquidity. I don't worry about that as much, but I see the world's central banks trying to make the global rebalancing process go as slowly and painlessly as possible. The air is being taken out of the US economy slowly now, which is why the rebalancing trade has begun to work well. I see the rebalancing trade working successfully for a long time, with traders piling in out in front of the central banks, forcing them along a little faster than they'd like to go.

I do not encourage others to try the rebalancing trade for themselves. For one thing, I believe the markets are rigged to take advantage of people's natural tendencies. If you can't trade objectively and cautiously, you'll likely get taken to the cleaners. For another, when too many people are shorting stocks they can be manipulated to take advantage of those shorts. I'd rather not invite manipulation in the stocks I trade or have to compete with others in searching for shares to borrow and short.

I think that most people should try to stay out of the market entirely. It is much better to pay down your debt than to carry a large mortgage along with exposure to the markets. Nothing is really safe in today's markets. As I've mentioned elsewhere, there is a potential for massive defaults in the banking sector because of extreme risks taken through the derivatives markets. Short term treasuries will probably avoid default for a few years, but the US government will not be able to make good on all of its promises in the future. Even money market funds are vulnerable to default if enough of the underlying short term bonds end up being worthless.

It's probably best to keep your debts low and enough cash available in savings accounts to get your through a few months of hard times if the job market suddenly heads south. If things really get shaky in the financial markets, then it could pay to move a large chunk of cash our of the bank and into your mattress.

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