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Wednesday February 6, 2008 - 14:12:38 GMT
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Just the Beginning?

FX Trading – Just the beginning?
Not being a stock guy, though I once played one as a broker and money manager, I find it fascinating watching analysts/advisors/cheerleaders cascading across Tout TV to tell us that stocks are looking “really cheap” now.  My knee-jerk response is to use the proverbial cerebral phrase “SAY WHAT?”

I think we’ve shared this chart before in Currency Currents, but if we have, it’s worth revisiting to set the stage for some real cerebral analysis, or a horror story, depending on your perspective:

 [Chart not available in text format]

The point of this chart is to imply that much of the run in stock prices could have something to do with the $400-plus trillion (yes, trillion with a “T”) in nominal derivative value outstanding at year end 2006, representing 789% or total global GDP.  Granted, not all derivatives are bad.  Many are quite good and have helped in creating a financial system that is creative and flexible, supporting the development of real wealth.  But of the $400+ trillion, even if a small percentage of that is of the radioactive variety, it’s not hard to believe we are only at the beginning of a very nasty trend in the stock market.  

The little ditty below is courtesy of Jeremy Grantham.  It comes from his January 2008 GMO letter. [Our emphasis added] 

Warning, if you are a stock market bull, you may want to stop reading immediately!

“Well, the Minsky Meltdown has clearly arrived, and one shoe after another of the market centipede drops onto the floor, and we are waiting for many more. This is the most important U.S. financial crisis since World War II: it is of course far more global than previous crises, with tentacles reaching everywhere, and it coincides with broad overpricing of assets.

“This of course will be a painful process and will be a considerable drag on economic activity. Unfortunately, it is likely to take several years. To house clean completely by the end of 2010 would be a reasonable target. (This would mean that 10 years would have elapsed between the highest overvaluation of U.S. equities ever recorded in early 2000 and a likely low of at least a modest discount to fair value in 2010. Ten years from high to low following a great bull market would be quite normal. For reference the highest overvaluation in the previous U.S. equity bubble was 1965 and the following low point of undervaluation was mid 1982, 17 years later. During these 17 years the S&P 500 index lost over one-third in real terms.) By the end of this credit crisis, perhaps better defined as a sloppy-debt-issuing crisis, we will be lucky if the amount of write-downs does not start with a ‘T.’”

Ten years and a Trillion dollars!  Yikes! 

And Mr. George Soros explains why the stock market is critical when it comes to the health of an economy:

“A decline in stock prices can have a considerable influence on the spending decisions of consumers and the investment decisions of those in business.  Moreover, if there is going to be a recession, it will be brought on by the decline in collateral values, and the stock market is one of the most important repositories of collateral.”

This is precisely why the US has been running an implicit weak dollar policy—the stock market.  Dollars sent out into the global economy provide liquidity for markets everywhere and boosts global demand. 

But it’s starting to boomerang thanks to the credit crunch and an improving US current account!  Is it déjà vu all over again?

  The last two times we saw an improvement on the current account, we saw the following:

1) A stock market crash in 1987 and 2000
2) A recession in 1990 and 2000


So, when the economists, who are so incredibly confused on what the current account really means, thanks to their seeming inability to recognize, or measure the impact of, a world where transactions are more knowledge based and global means more than just selling products overseas, tell us the current account needs to be balanced, just think about the implications of so-called balancing as you can see in the chart below:

 [Chart not available in text format]

Yup!  The current account deficit is now improving.  Dollars are draining off global markets.  Thus, a decline in demand for stuff is already in the system.  It may mean what it usually means:

1) Decline in consumer spending
2) Falling corporate profits
3) Shrinking capital investment
4) And of course, recession
Mr. Grantham’s target of 2010 for what he calls “housing cleaning” is interesting in that two years is usually what it takes for a bear market in stocks to cleanse the excess (or malinvestment for fellow Austrian travelers) built during a very powerful prior bull phase. 

Thus, we may be only at the beginning.  If so, maybe the currency guys start running from the seemingly “overvalued” currencies that are leveraged to growth, such as the euro, pound, and Aussie, at an increasingly rapid pace.

Stay tuned.

Jack Crooks
Black Swan Capital


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