Last Week's Volatility: A Shot Across the Bow

Dear Investor,

If I had told you five years ago that the success of your 401(k) might be linked to Chinese government rhetoric surrounding Shanghai Shares, would you have blinked?

Clearly, the recent 9% drop in the Shanghai Composite Index was the catalyst for the sell off felt around the world the last week in February, but was it the cause? If we look at it from the perspective that this Index had doubled in 19 months, a 9% correction seems to me to be reasonable, maybe even expected.

The Real Surprise

So to me, the surprise certainly isn't the correction in China. After all, what goes up fast can fall even faster. The real surprise to many was the subsequent global correction in almost every asset class that followed. From Brazil, to Europe, to the US, every major Stock Index corrected violently. In addition to global equities, most commodity prices were down, including crude oil (which is generally good for equities). Even the supposed "safe harbor" of gold fell more than $20 in a single day, as the investors' flight to quality marched right past gold and instead embraced the US bond market.

Source: International Traders Research, Inc.

So What Happened?

What was the true cause of this violent market action? There are several "post" correction theories.

First, there has been acceleration in the collapse of the sub-prime mortgage markets. The last I checked, over 20 sub-prime market participants have been closed or forced to seek buyers since the start of 2006¹, and the collapse really picked up steam and revealed itself in February.

Many blame this on the slowdown in the US housing market, coupled with the recent rate hikes. As mortgage payments go up, and the value of an owner's home goes down, there is a monetary and psychological tipping point that triggers defaults and a much more cautious investment outlook.

In addition, the Yen Carry Trade has come under increasing pressure and is unwinding (more on that below). This trade has historically been a big liquidity provider, but, as they say, there is no free lunch. Japan has recently raised rates, the Yen has rallied, and borrowers are asking for their lunch money back. Although this may be temporary, the Yen rallied aggressively during the correction.

Inflated asset prices, Carry Trades, sub-primes, home prices, Chinese officials, a global liquidity glut…which is it? Or is it all of the above?

The Story Under the Surface

The real story here is not the cause. Any investor, in retrospect, can wax and wane about the cause of this or that. Give me any financial event and there will always be a talking head on CNBC explaining the cause. We had a multitude of experts explaining the "cause" after the tech wreck, but where were they just prior? The real concern from where I'm sitting is the correlation.

Source: International Traders Research, Inc.

I've been pointing out for a while that the correlations across major asset classes have been on an upward trend. Rising correlations across asset classes AND rising prices across asset classes has been the rule of thumb for the last several years around the globe. This won't be a surprise to the savvy investor. But why is it happening? There are several obvious reasons, many of which have made headlines.

Global liquidity and rising consumer consumption have pushed asset prices up substantially. The liquidity has come in the form of Central Bank fiscal policy—low borrowing costs have allowed massive borrowing, refinancing of government and consumer debt, and leverage. How many Hummers in La Jolla have been financed by home equity lines?

Additional liquidity has come in the form of the now famous "Carry Trades," which I earlier mentioned. An example of a Carry Trade is the ability to borrow Yen at, say, 1% and invest it in the US or elsewhere at, say, 5%. Those who entered into such a trade while watching the Yen drop were treated to as darn near a free lunch as an investor could get. And for those who were a little more risk tolerant, why not borrow the Yen at 1% and invest it in equities or real estate?

Additional liquidity has come from Current Account surpluses. China's Current Account surpluses recently exceeded 1 trillion dollars. The US has been the primary benefactor of China's success—China's appetite to invest in our treasuries is no secret. How long that can last is the subject of much debate. Couple that with the surplus savings of other countries that are commodity producers (e.g. petro dollars, metals) and you have a lot of cash to spend on assets.

Consumption Keeps Chugging Along

Now add to this recipe the massive consumption trends led by US consumers (flush with borrowed money) and the emerging market consumers (flush with cash). The way people all over the world consume has been scrubbed and channeled by our marvelously successful capitalist system. Twenty years ago, an emerging market consumer may have defined his success by owning an additional cow or by purchasing a new roof. Now that same consumer wants Levis, a Rolex, an iPod and a car.

From the US to China, the story is the same. Everyone wants more. It is human nature. These demands are typically reflected in rising commodity prices and share prices. How many emerging market consumers does it take to push up the share price of Qualcomm or Motorola, or the spot price of crude or copper?

Yield Chasing

This flood of liquidity and consumption has fueled massive asset price appreciation and a global hunt for yield. Over the past four years, any investment with a yield above US T-bills has been gobbled up. If an investment yielding 9% popped its head up anywhere, investors rushed to it until the yield was no longer 9%. This has dramatically narrowed credit spreads between US government bonds and riskier US corporate bonds, and between emerging market government bonds and riskier emerging market corporate bonds. In an ever-increasing appetite for higher yields, US investors have been chasing the lure of international stocks. During 2006 an amazing 92% of all US equity mutual fund inflows went into international stocks...over $148 billion!² (Forbes, March 2007).The US and global equities markets, as well as commodities, have enjoyed a tremendous tailwind.

Liquidity + Higher Asset Prices + Consumption + Linkage = DANGER

Finally, there is what I call "the Linkage Effect." We are all linked. Take the investment community as an example. Global trading desks can freely trade sub-prime mortgages in the US, Microsoft shares, Hang Sang shares, Asian REITS and the Swiss Franc, in between water cooler breaks. And the media, through the Internet, print and radio, is everywhere. The overnight drop in the Asian markets was on your local news channel between the weather and sports. Central Banks are linked—like it or not, China and the US are in bed. This linkage affects how we think, how we consume, and how we invest, and even how we characterize our own beliefs.

Maybe some readers will think that I've just stated the obvious: Liquidity + Consumption + Linkage = Danger. So what's the point? The point is simple: anything can trigger a market meltdown...a bird flu epidemic, a US recession, a dirty bomb...the list goes on. But regardless of the trigger, what is ultimately important for an investor's portfolio is what melts down. The Liquidity + Consumption + Linkage danger makes "Mass-Correlation" more likely—a phenomenon that happens when everyone runs for the door in the investment world and the prices of all assets act the same. This can happen over three days, three quarters or three years.

Correlation and an Investor's Portfolio

Mass correlation can be particularly damaging for an investor's portfolio. The extent of damage will depend on how the portfolio components will move together in situations of periodic crisis or longer periods of time where everything is going sideways or down. Where can investors find true diversification to help survive periods of significant market stress, like the one we just experienced? Or even in more likely scenarios such as a gradual decline or sideways action in global asset prices, how does an investor maintain his wealth? Here is my ultimate question: How does an investor structure their portfolio in this kind of environment?

First of all, I'm not suggesting investors sell all their long equities exposure and run to cash (although some may argue for this). Indeed, many investors and advisors believe global equity markets are still favorably priced. The global growth story is compelling and not participating in any part of it may be foolish. What I am suggesting is that correlation seems to be rising, and traditional investments may be more linked than ever before. Most traditional money managers don't have a mechanism to hedge their bets, or can't employ tools that may help them thrive in turbulent or sideways market environments.

But some hedge funds can use those types of tools. Many sophisticated investors understand that today the use of the term "hedge fund" can mean just about any type of trading strategy. They can't all be lumped together as a group of investments that are speculative or highly leveraged (although some certainly are). Depending on the type of hedge fund, and the type of strategy its managers are employing, market environments like the one we are experiencing now may produce opportunity, and may allow some managers' risk management techniques to work. While the markets were getting whacked, I know for a fact that there were some managers that actually made money. How about the ability to short sub-prime mortgages? Or the ability to play widening credit spreads? Or to buy options as a hedge? Or to aggressively short overvalued pockets of stocks while at the same time being long reasonably priced stocks. The ability to hedge against a decline in stock or commodity prices is a valuable tool for skilled managers. While there are no guarantees that any one strategy will be effective in any particular market environment, for investors willing to do the proper amount of homework and drill down, it is possible to find managers with the potential to thrive in the type of environment we're experiencing now.

Deep Thoughts

In the end, what I'd really encourage investors to spend some quality time thinking about is whether their portfolio is truly diversified, and whether they have components that may serve to avoid correlation in times of market stress or prolonged sideways action. Do they have a portfolio of long-only managers, who clearly got hurt in last month's correction, or do they have managers and strategies designed to counteract the effects of this environment?

Although the markets may proceed to march to new highs after the February correction, at the very least, thoughtful investors should consider this as a shot fired across the bow. We'll see just how many will take notice.

Best regards,

Jon Sundt
President
Altegris Investments, Inc.
(858) 459-7040

¹ Bloomberg.com, "New Century Leads to Rebound of Mortgage Company Shares (Update 1)", Bradley Keoun, March 6, 2007.
² Forbes.com, "Volatility in Emergind Markets: A Warning Sign", Drobny Global Advisors, March 3, 2007.