Today's comment is by Jack Crooks, Currency Director and editor of Crooks on Currencies and Crooks Currency Options.
Dear A-Letter Reader,
Pavlov's dogs could salivate on cue to the sound of a bell. Well, guess what, portfolio managers and investors can, too. I'll call them Pavlov's Investors!
And because markets go through cycles, these bells ring at many different points along the way. The problem is, because there are no bells ringing at the top, I think this time Pavlov's Investors might be salivating for the WRONG reason - a dip in the markets.
This concerns me. In fact, I grow weary when I hear about friends urging friends to jump back into the stock market to scoop up those so-called "bargains." Rather, I prefer taking a different approach using my handy global thermometer to take the market's temperature and see how healthy it is to invest.
This lead headline dropped onto the pages of Bloomberg on Sunday afternoon:
Cheapest Stocks in 16 Years Entice Investors Amid Market Rout
Here's how the story started:
"Investors are preparing to snap up shares of telephone, healthcare and computer companies after last week's US$2.1 trillion global stock market rout left U.S. equities the cheapest in 16 years."
The article went on with quotes from a sample of Pavlov's Investors saying things like 
: "The opportunities for buying are opening up"..."The fundamentals are strong..."The stability of financial markets is not at risk."
It's easy to argue that buying during the dips in a bull market works. It's the stimuli that conditions investors. Just as Pavlov's dogs learned food was near by the sound of a bell, investors have learned that profits are near when a bull market dips (though the dip is a unit of measure fairly difficult to quantify).
The problem is Pavlov's Investors seem to be treating this dip as automatic and, more importantly, they're failing to open their eyes to the implications of rising risk levels. It's just a matter of time before they start feeling the heat.
The Global Market Risk Thermometer is Heating Up!
Pavlov's Investors aren't confined to equity markets. They exist in foreign exchange markets as well. And in this currency arena, I see Pavlov's conditioning process embodied in the Japanese yen.
Buying on the dips between the Japanese yen and the U.S. dollar has offered huge gains for investors for a very long time because the carry-trade has worked for a very long time. (The carry-trade is borrowing low-yielding Japanese yen, and then using it to invest in other higher-yielding assets.)
This arrangement has driven the yen to extreme lows versus the buck. The carry-trade exemplifies investors' growing appetite for risk (i.e. taking on risky investments thanks to ample liquidity).
As far as I'm concerned, the break in this carry-trade isn't far off. It will have little to do with Japanese fundamentals and everything to do with global risk. That's why I've coined the yen my "global temperature gauge. "
The Land of the Rising Yen
Credit risk is still spreading, no doubt about it. Funds (big yen borrowers among them) are under pressure. This is the best test yet in this cycle of the "things are different this time" theory because credit has been manufactured 24/7 in every sausage shop in town.
The Japanese yen is starting to reflect this feeling. The yen's value has risen quickly from a four-year low with every new warning signal out of the U.S. sub-prime mortgage debacle
. Loans are becoming more expensive and higher borrowing costs are reducing the appeal of some risky assets. These risky assets have become huge beneficiaries of speculative money funded by borrowing Japanese yen.
I'm convinced this carry-trade unwind has a lot further to run. Should the existing concerns encompassing the markets subside, the yen's appreciation may slow. But I don't imagine Pavlov's Investors will be able to hold off a large scale unraveling of risk-taking for much longer.
If you think you perhaps could be a "Pavlov Investor," I caution you not to run too hastily into "bargain shopping mode." The writing is on the wall. At some point these bargains will become awful rip-offs. Be careful not to get stuck on the wrong side of the deal.
JACK CROOKS, Currency Director
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