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.

Sunday, September 03, 2006

Post Labor Day Breakdown?

I've observed over the years that holidays often mark major turning points in the market. According to my theory, families and friends get together over the holidays and talk often turns to how great their portfolios have been doing (or how poorly they've been doing). Coming out of the holiday, the greatest fools try to jump on the bandwagon just as the market reverses course.

The current situation bears some remarkable similarities to the market situation in 2000. Six years ago, the tech bubble had already burst, but the broader market still struggled through the summer and appeared to be rallying into Labor Day. After falling from an all time intraday high of 1552.87 on March 23rd, the S&P 500 rose from a low close of 1419.89 on July 28th to a high of 1520.77 on Friday September 1st. Buy-the-Dippers were celebrating their success at family barbeques. By Christmas, the market was down to 1305.95.

This year is similar in that the housing bubble has clearly burst. The S&P500 peaked around 1326 in May. Then they took a dive to 1234.28 on July 17th but have since bounced back up to 1311.01 on Friday September 1st. This year's group of buy-the-dippers are probably congratulating themselves this weekend.

With the S&P500 and Dow30 doing much better than smaller stocks over the last three and a half months, and the big permanent and temporary injections of last week, it smells like a possible top. Of course these rallies usually go on longer than I expect them too.

Even with the major market indices rallying during the month of August, the short portion of my portfolio had its best month of the year. Retail, Builders and Sub-Prime have been taking an early dive as they should be given the macro-economic climate. Consider this updated chart:

That account, based on the principals of the rebalancing trade, is up 62.8% since the end of April, after being down 26.7% over the first 4 months of the year. The short positions in that account are typically the individual companies I think are most vulnerable to an economic slowdown in the sectors that I think will be hardest hit by the rebalancing process.

(So here it is, Labor Day Weekend, and I'm talking about how great the short half of my portfolio is doing, and expecting it to do even better if the broader market starts to slide. It'll serve me right if the market rallies and takes the garbage stocks with it.)

In my view, fuel for the market prop job has probably been coming from hedge funds borrowing yen, buying dollars, then sinking them into treasuries and large cap stocks. While the RMB continues to strengthen against the dollar, the Yen has remained weak. This chart shows a fairly strong correlation between the Dollar vs. the Yen and the performance of stocks and five year bonds:

Carry traders picked up the slack when the Bank of Japan began reducing their treasury holdings. The BoJ is probably willing to let carry traders continue to pile on the risk for now before they start a long, slow squeezing process that bleeds all the profit and money out of the hedgies. Japan wouldn't want a rapid unwinding because that would cause a shock to their own money supply.

All this leaves me torn between expecting a change of direction over the labor day weekend, leading to a broader market decline, and a continuing prop job to get Wall Street through one last Christmas bonus cycle before things break down in January. The fact that Mauldin also noticed the similarities with 2000 and broadcast his thoughts to a wide audience, tends to make me lean toward a continued prop job through the end of the year. Time will tell.

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