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Wednesday August 15, 2007 - 10:33:41 GMT
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Logical-story-aholic is dangerous to the P&L

Key News

Key Reports Due (WSJ):
7:00a.m. MBA Mortgage Application Survey. Previous: +9.1%.
8:30a.m. July Consumer Price Index. Expected: +0.1%. Previous: +0.2%.
8:30a.m. July CPI, Ex-Food & Energy. Expected: +0.2%. Previous: +0.2%.
8:30a.m. Aug NY Fed Manufacturing Index. Expected: 17.75. Previous: 26.46.
9:00a.m. June Treasury International Capital Flows. Previous: $112.6B.
9:15a.m. July Industrial Production. Expected: +0.2%. Previous: +0.5%.
9:15a.m. July Capacity Utilization. Expected: 81.7%. Previous: 81.7%.
3:00p.m. Aug NAHB Housing Market Index. Previous: 24.


"A black cat crossing your path signifies that the animal is going somewhere.”

      Groucho Marx

FX Trading –  Logical-story-aholic is dangerous to the P&L

Aug. 14 (Bloomberg) -- Brazil's currency tumbled as losses in global credit markets sapped demand for riskier emerging- market assets. The central bank held off from buying dollars in the currency market today for the first time since July 2006, underscoring the extent of capital outflows.

Aug. 15 (Bloomberg) -- Emerging-market shares and currencies slumped, with Indonesian stocks tumbling the most in a year, after widening losses linked to U.S. subprime loans prompted investors to shun riskier assets.

I did it again.  After I left the screens yesterday, very late in the day, I sat in my kitchen sipping a fine glass of California cabernet (purchased for under $10 per bottle, my usual max threshold) as I flipped through the usual cable channels.  And as I got to the queen of all things financial, let’s call her MB, there was another very nice and charming young lady talking about global investing.  She of course was extolling the many virtues of emerging markets.  And of course she was spewing the normal consensus pabulum (i.e. all the good news that is already in the price).  But the best part was when she said, “The sell off in emerging markets is illogical.” 

Why all the fundamentals are so solid in emerging markets and all the problems are in the United States, don’t you know!  This was the lovely lady’s lament.  This is the lament I hear constantly from a bunch of people who aren’t on TV and should know better. 

And when it comes to the dollar, for most people, there isn’t even a doubt.  It “must” go down, they argue.  No matter even in the face of a decent multi-day rally.  It “must” go down after this “little” bounce!  They say it with such confidence.  No doubts. 

If I’ve learned one thing for sure, after getting pummeled many times over during the 25+ years playing in financial markets, it is this: When you meet someone in this business who has supreme confidence, it is time to cover your wallet and head for the door!  Case closed.

Fundamentals matter.  Don’t get me wrong.  They matter a whole lot.  But there are times when fundamentals must take a back seat.  And this could be one of those times.  And if you are open to the idea that this may be one of those times, then you shouldn’t go around saying the decline in emerging markets is “illogical” or the dollar “must go down.” 

For if we cut to the chase and look to the core at how prices move, it is this:

Sentiment (driven by “objective” analysis, or fear, or greed, or any combination of factors) leads people to act.  People act by moving money.  The movement of money changes prices. 

This is supremely logical! 

Thinking about this has led me to what I think is an original discovery of a serious psychological malady—it’s based on flawed logic combined with “falling in love with your own story.”  I have coined it logical-story-aholic. 

It is an insidious malady. I know.  I’ve suffered with it for years.  It’s a daily battle as a recovering logical-story-aholic.  I’m still not sure how many steps to recovery, but I know I’m far from there.  But, of course, at least I have recognized the problem. 

[Editor’s note: Logical-story-aholic has not quite yet slipped into the coveted category of “disease;” so don’t try to claim compensation just yet if you show symptoms.  Just wait a bit longer. If markets keep going south, chances are high it will morph into “disease.”  How else will ex-mortgage quant hedge fund jocks find ways to support themselves?]

I shared with you back on August 7th our story on a pending dollar rally based on a perverse theme.  This was not based on any inherent brilliance flowing from Black Swan Capital, but from a theme articulated from a very brilliant thinker, Mr. George Soros.  We wrote this then, and it’s a logical story we are sticking to now:

Aug 7/07:If our guess is right, than our perverse dollar rally scenario caused by


bad news is still operative.  Money at the periphery will sooner or later come home to roost. 

“By definition, the center is the provider of capital, the periphery the recipient. An abrupt change in the willingness of the center to provide capital to the periphery can cause great disruption in the recipient countries.  The nature of the disruption depends on the form in which capital was provided.  If it was in the form of debt instruments or bank credits, it can cause bankruptcies and a banking crisis…,” writes George Soros.  [our emphasis]

I have discussed the above theme recently with a very smart person I respect.  And you guessed it; he too is afflicted with logical-story-aholic.  How could that possibly be—the dollar must go down because the US economy is in big trouble, he said.  It’s not about economic problems at this stage, I told him.  He moved on to his next argument.  Well, all the foreigners are going to take their money out of the US and that’s going to be bad for the dollar, he shared with confidence.  I told him that US-based fund managers had huge pools of money offshore that will likely come back to the center as risk spreads—that will be good for the dollar.  Show me the numbers that make you believe that, because I don’t believe it, he said.  So show him the numbers I did. This is from Stephen Jen of Morgan Stanley; we have shown them before in Currency Currents:

“US real money accounts consist of four key categories of funds: mutual funds, private pension funds, state and local pension funds and life insurers.  The Fed’s Flow of Funds data track the sizes of these funds.  As of 1Q07, the total assets under management by these four categories reached US$20.7 trillion, up from US$12.6 trillion in 1Q03.  At more than US$20 trillion, real money under management in the US is close to four times the size of the world’s official foreign reserves. Any signs of diversification by these real money accounts would have great implications for the dollar.  [Does not include private equity or hedge funds directly]

“While I don’t have a breakdown of the asset allocation of all four categories, the Boston Fed’s Monthly Mutual Fund Report shows that mutual funds’ allocation to international equities has risen from around 15% in 2003 to 22.5% now.  This trend diversification is gradual but determined….

“Contrary to popular presumption, US real money mangers are the biggest dollar diversifiers, not the Asian central banks.  Controlling assets that are four times the size of the total global official foreign reserves, US real money managers have been steadily diversifying out of the US since 2003.  My calculations show that cumulative outflows may have totaled US$1.16 trillion in the past four years.  This may help explain the downward drift in the dollar in recent years, and why the dollar is so weak now.”

A mind-numbing no response at first, and some uttering of the US economic problems was the best I could get from him.  Hmmm…This I think proves my logical-story-aholic discovery is a psychological problem that cuts across the social and economic strata.  (One sample size is enough when you are trying to make a name for yourself, I’ve learned.  How else do you explain Elaine Garzarelli—worshipped she was at Shearson-Lehman when I was there.)

But then again, I don’t know a darn thing about psychology.  But then again, having little knowledge of a topic hasn’t stopped financial gurus from hawking their discoveries.  A vicious circle it is! 

So, be open to the idea that your story may be completely bogus.  I’m not saying don’t stick with it if it’s working for you, if it gives you comfort and soothes the P&L statement.  But I am saying be careful.  Because most people afflicted logical-story-aholic don’t know it.  The dollar can go up.  And markets with good fundamentals can go down.  That’s the only part of the story we need to understand. 

Jack Crooks


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