Today's comment is by Jack Crooks, The Sovereign Society's Currency Director and Editor of The Money Trader and Crooks Currency Options.
Dear A-Letter Reader,
I'm writing this commentary from 30,000 feet, on my way to Phoenix, Arizona for an investment conference.
I'm looking forward to speaking at the conference and talking about my favorite topic: currencies. But I still get a bit antsy when I am away from my currency trading screens. Years of conditioning have taught to me keep my eyes glued to my computer, watching each tick in the forex market, both up and down.
So plane rides, as uncomfortable as they may be for me at times, also offer a few hours to get away from it all, and think about the markets in uninterrupted solitude for awhile. On this particular flight, I'm meditating on the question that's on every trader's mind lately: Is this correction over?
Have we seen enough of a shakeout in financial markets so that we can now jump back in with confidence? My gut instincts - honed over years of trading these markets tells me: "not just yet!" That's because I've seen all this before - just in a different form. It's called contagion . The experts were fooled in the past-and I have a sneaky suspicion they will be again. So my message to you, and to those attending the Arizona conference, is this: Don't Get Fooled Again!
On Tuesday this week, we had another "incident" of risk rearing its ugly head. And to many it was a surprise, as they were told by the experts, just the week before, that yes indeed, its time to buy again. Jump in with both feet.
The yen has been a kind of a barometer for global risk taking-it soared on Tuesday. And dutifully, the currencies that represent the risk-taking side of the yen carry-trade, meaning the Australian dollar and the New Zealand dollar got whacked. These currencies are on the flipside of the carry-trade because speculators are borrowing yen to invest in these other higher yielding currencies. They are in effect willing to take a risk that the "global Goldilocks" scenario continues - higher asset prices and little risk. So on days like Tuesday, when the yen moves higher, the carry-trade players lose money. And nothing makes you question your risk exposure like taking losses!
The so-called experts are already saying that the worst of the sub-prime lending debacle is behind us. Once again, "don't worry, be happy" - Goldilocks rules the roost! According to these experts, there will be no contagion into other markets - no spillover of selling, no carry-trade unwind that threatens to send global assets into a tailspin of selling.
So where have we heard the term "Contagion" before....As I said earlier: I've seen all this before. Contagion was a term coined in 1997 when a little global market plague called the Asian Financial Crisis hammered markets around the world. That includes both emerging and non-emerging markets. It was a storm that got an extra boost from the so-called experts - who got it all wrong - at Long Term Capital Management.
Contagion Sneaks Up and Infects You... That's Why It's Called Contagion
I remember it vividly. I was working as a research analyst for a global investment firm at the time. Our firm had recommended Malaysian stock investments about a year earlier, and had been doing so. But this trade started to bother me. Things simply looked too easy in Malaysia. Markets were going on a credit induced rocket ride. The problem was international investors were providing most of the credit. This made the trade more risky than usual.
I won't go into the nitty-gritty details, but for more on the Asian Contagion of 1987 - and some eerie parallels that are showing up in emerging markets today, see my colleague Mike Burnick's BLOG from today: Suffice it to say, Malaysia effectively had a huge mismatch between its borrowing and its investing. This relationship could work well as long as the Malaysian currency remained strong. (If a country's currency is relatively strong, its borrowings can appear cheap.)
I could sense there was trouble brewing. I didn't expect it to morph into what it did...but I was afraid of contagion across the other Asian Tigers.
It was my focus on risk first, that allowed me to see what many analysts overlooked. It wasn't magic. By focusing your attention on risk, instead of reward, you can gain much needed perspective. When you focus on risk, you are less likely to be caught up in the euphoria and notice that the punch bowl is near empty. Malaysia, Thailand and the rest of the Asian Tiger countries, represented a virtuous investment circle that was about to turn very ugly.
They Said the Asian Crisis Would Never Happen Either
"Don't worry, Malaysia's a small country. There is no chance of contagion," said the experts back in 1987. I can remember big time analyst Barton Biggs, of Morgan Stanley, touting Thai stocks at the time. He saw the negative impact in Thailand, flowing from Malaysia, as just temporary . Thai stocks were "fundamentally undervalued."
And of course Barton Biggs wasn't the only one fooled. The Nobel Laureates - Long Term Capital Management, a team of Wall Street's best and brightest with more brainpower per square foot of office space than the world has probably ever seen - went bankrupt in about a week during 1998.
Their rational expectations didn't seem to hold up. Yes, their models were elegant and back tested and stress tested, but no one at the firm, or any place else expected Russian government bond prices to "disappear off the trading screens." Poof! Gone! They couldn't unload positions at any price. This added to the Asian contagion, and every market in the world got hammered. And one hedge fund, small in comparison to today, almost brought down the entire financial system -- just another victim of the global contagion focused too much on reward and not enough on risk.
This is a good time for you to reflect a little on that history lesson and think about what the so-called experts are saying before you decide to jump back into this game:
"The yen carry-trade is back on, the yen will weaken again. The sub-prime mortgage meltdown won't lead to contagion..."
So apparently...risk is still on holiday. But just the same I say: be careful out there over the next few weeks.
JACK CROOKS, Currency Director
EDITOR'S NOTE : As risk returns to the markets, certain currencies like the Japanese yen are rallying hard. That might be bad news for the carry-trade crowd, but it's great news for currency investors who are racking up big gains on the Japanese yen. Just two weeks ago, Jack's Crooks Currency Options subscribers banked 100% on Japanese call options. And this rally isn't done yet, get in now before the next big move.