May 08, 2010

Market Insights - 8 May 2010

Here is the latest issue of Market Insights.

You can now get the latest from FXIS by following us on Facebook , Twitter , Business Insider , Seeking Alpha and as always, directly via our Blog FXIS Market Insights. 

In case you have questions, comments or suggestions please email: . 

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• A Trading Glitch - Really?
• Is The Glass Half Full Or Half Empty?
• A Wake-up Call From Greece
• A Word On Currency Volatility
• Recommended Read 

Weekly Snapshot
• US unemployment rate edged up to 9.9%, and the labor force increased sharply (BLS)
• US nonfarm payroll employment rose by 290,000 in April (BLS)
• German lawmakers approve Greek bailout (NYTimes)
• Nasdaq plans to cancel trades of 286 securities that fell or rose more than 60% (Bloomberg)
• The SEC and CFTC to review “unusual trading” that contributed to Thursday's market crash (AP)
• The VIX Index (Volatility) jumps more than 50% in one day, closes at 32.80 on Thursday (Yahoo)
• Dow drops nearly 1000 points before recovering to close at 10,520.32 on Thursday (Reuters)
• European Central Bank on Thursday left its benchmark interest rate unchanged at 1% (NY Times)
• Spanish two-year rates are now six times as high as Germany’s (Eurointelligence)
• Australia raises interest rates to 4.5%, the sixth time in 7 months (NY Times)
• US manufacturing activity expanded in April at its fastest rate since June 2004 (FT)
• US personal income in March increased 0.3%,  personal consumption expenditures rose 0.5% (ESA)
• China tightens money supply by raising banks' reserve requirements for the third time this year (NY Times)
• Australian mining firms to pay 40% tax on profits from extraction of renewables starting in 2012 (WSJ)
• Euro-zone and the IMF approved an unprecedented €110B rescue package for Greece (Bloomberg)

Chart Of The Week
This is how Thursday looked like – a sea of red as far as the eye can see...


Weekly Barometers

Stock-2010-0507   FX-2010-0507

A Trading Glitch - Really?
Another roller-coaster week in financial markets.  It brought back some vivid memories of 2008 when many traders were shaking their heads and asked:  What the heck just happened?  At the worst moment on Thursday, the Dow Jones Industrial Index was down nearly 1000 points and plenty of stories were floating around as to why the massive sell off occurred. Reuters reported that Stocks plunge as trading glitch suspected:

The Dow suffered its biggest ever intraday point drop, which may have been caused by an erroneous trade entered by a person at a big Wall Street bank, multiple market sources said.

To get an idea of how close we were to even more hysteria, please consider the current NYSE rules on Trading Halts Due to Extraordinary Market Volatility.


The SEC and the Commodity Futures Trading commission said they were in the process of reviewing the “unusual trading activity” to determine how much of an impact an alleged glitch or trading error had on the market drop. Whether this was a glitch or simply a nervous sell-off, one thing seems certain: the market is telling us “Complacency no more.”  And it was exactly that complacency which caused us to be concerned when we wrote about the make-up of the recent economic data in FXIS Market Insights 24 April 2010:

We also believe that the stock market may have run a fair bit ahead of itself.  The Price/Earnings ratio of the S&P 500 currently has a multiple of 22.04, on a cyclically adjusted basis.  That value is about one third above its long-term historic average of 16.36.  Further, through a combination of near zero interest rates and a general sense of “the worst is over”, risk appetite has returned to the markets.  The volatility index, a.k.a. the fear index, has been back at pre-crisis levels for a few weeks now.  Too much complacency?

Take a look at the VIX index’s massive rise on Thursday to get an idea of how fast fear came back to the market. 


Friday was somewhat tamer, but volatility increased yet again by almost 25% to close the week at 40.95, clearly reminding us of the levels last seen during the credit crisis.  Certainly not a time to be complacent!


Is The Glass Half Full Or Half Empty?
In a number of previous articles, we made the point that any real and sustainable US economic recovery depends to a large extent on the creation of new jobs.  The US Bureau of Labor Statistics employment report for April 2010 finally looked like some form of a real recovery might be on the way:

Nonfarm payroll employment rose by 290,000 in April, the unemployment rate edged up to 9.9 percent, and the labor force increased sharply, the U.S. Bureau of Labor Statistics reported today. Job gains occurred in manufacturing, professional and business services, health care, and leisure and hospitality. Federal government employment also rose, reflecting continued hiring of temporary workers for Census 2010.

In addition to that, the revised numbers for March and February show an additional net gain of 121,000 jobs. That’s all good news.  But let’s look a little closer to see what’s under the hood.

Census 2010 hiring by the NSA was 66,000  in April. This is a temporary measure, courtesy of the US taxpayer and should therefore be excluded from the report.  Hence there were only 224,000 new jobs created.

A growing concern is the number of long-term unemployed which increased to a record 6.7 million about 4.3% of the civilian workforce. 


The unemployment rose to 9.9% but a broader measure of unemployment, the U-6 rate is now back above 17%.

U6-table a15 2010-04

Employment remains the most critical factor for a sustainable recovery of the real economy.  The picture looks better, possibly half full, but we are not quite there yet.

Charts are courtesy of


A Wake-up Call From Greece
The sovereign debt crisis in Greece had a brief respite when Euro-zone member countries and the IMF agreed on a €110bn rescue package last week-end.  However, the financial markets wanted nothing of it, dragged the world stock markets lower and drove the Euro to its lowest level in 14 months. 


Market sentiment is clearly against the Euro right now; rumors of contagion and a possible eviction of Greece from the Euro-zone are increasingly coming to surface.

The scale of the violent protests against the planned austerity measures which include a freeze on government salaries, the elimination of the standard bonuses for government workers (13th and 14th months pay) and an increase in the retirement age to 63 by 2014 seem completely out of whack considering the miserable state of the Greek government’s finances. 

The Greek crisis and the populist backlash are a wake-up call, not just for Greece and Europe but also for the US and most other developed nations.  The current government budget deficits and the overall debt burden may be frightening but they pale in comparison to the scale of unfunded liabilities for pensions and healthcare.  Temporary measures for bailouts and economic stimulus packages are one thing but without drastic measures, ongoing government deficits are simply not sustainable for the simple fact that people live longer and there are not nearly enough young people joining the work force to generate sufficient government revenues and to support the growing unfunded liabilities.

In my view, the root of the problem (in addition to the obvious irresponsible spending habits of most government officials) is demographic in nature; the easiest way to hint at the scale of the predicament is to look at projected population charts.

Greek Population: 2000   Greek Population: 2050
Greece-2000   Greece-2050

If Greece has problems based on current demographics, the projections for 2050 look even more devastating.

US Population: 2000   US Population: 2050
USA-2000   USA-2050

The US projected demographics are not nearly as bad as Greece but the thought of having 13% of men and 17% of women over the age of 70 makes the current US retirement age a near impossible proposition.

Japanese Population: 2000   Japanese Population: 2050
Japan-2000   Japan-2050

A completely untenable development is under way in Japan.  Currently, almost 10% of all men and 14% of all women are 70 and older.  By the year 2050, those figures are forecasted to reach 24% (men) and 33% (women).  If those projections are somewhat close to reality, the current fiscal imbalances are child’s play.

For this very reason, politicians need to address these issues not just with temporary band aids but with real measures to control spending and to put the economy on a path to sustainable economic growth.  Yes, meaningful measures will be painful and there will be much more at stake than seemingly silly programs like 13th and 14th month salaries.  Politically, this may be an extremely risky endeavor as most politicians tend to play to the mood of the latest opinion polls.  Granted, there are no easy answers but something’s go to give if we want to avoid the obvious path towards the bankruptcy of many nations.  Greece must be viewed as an important wake-up call. Mr. Obama, Mr. Brown (Mr. Cameron?), Frau Merkel, Mr. Hatoyama, Mr. Sarkozy et. al, have your phones been ringing lately?

A Word On Currency Volatility
After all the crisis talk about Greece and the impending contagion to other Southern European countries, one could fear for the worst and question the ongoing viability of the Euro.  In terms of price and market risk, one might also get the impression that currency markets are incredibly volatile.  I beg to differ from the perspective of comparing them to other markets.

Oil futures dropped almost $12 or about 13% this week, which in view of the unresolved Oil leak in the Gulf of Mexico and the possibility of an end to further off-shore oil drilling on America’s coastlines, leaves me slightly confused.  In the absence of other economic factors, these types of events would typically boost oil prices.  This feels and smells as if a lot more price volatility, possibly in either direction, is on the horizon.


Stock markets around the world fell over 6% this week, notable exceptions were Hong Kong (-5.6%) and India (-4.5%).  After this sell-off, the major US Indices are now slightly in negative territory for the year – who would have thought...


But the US is holding up better than the rest of the world thus far.  European stocks have been hammered since the Greek crisis.


And emerging markets have not been spared either.  In fact, China’s Shanghai Composite Index is now leading the pack with a 17.6% drop for the year.


How does that compare to currency movements?

The Euro clearly took a beating this year having lost about 11% against the US  Dollar so far.  Other currencies however did not fare too badly versus the US Dollar and also held up well compared with the returns of the S&P500.


Examining a measure of risk as expressed in daily volatility, the major currencies (including the Euro) have generally been far less volatile than the broad stock market index S&P500 during almost every period in the past few years (our comparative data go back to 2007 only). 

2009   2008
FXcompare2009   FXcompare2008
2007   2007 – May 7th 2010
FXcompare2007   FXcompare2007-2010

I do not suggest that investing in currencies would be more profitable than investing in stocks.  But given the same amount of leverage, for instance by using the standard ETFs for the various markets, the major currencies provided a far less bumpy ride than the US stock market in terms of the average daily returns. Given the high correlation of most international stock markets in recent years, the notion of diversification to mitigate risk should be carefully re-assessed.  As Douglas Short of puts it:

Diversification works – Until it doesn’t!


In the above chart and in many asset allocation models, currencies are typically not included.  They are somewhat implied with international equity and bond exposure. I believe however, given appropriate balancing, currencies should be considered a separate asset class and be part of every investor’s portfolio if an inclination to some international diversification is present.  Done correctly, currencies can help mitigate overall risk and generate some balance for your returns.  The sample portfolio below is just one basic example to give you an idea how a simple allocation could be structured.  In the same time frame as above, a basic 40% Bond, 20% Currency and 40% Equity allocation not only provides better returns than the S&P500 but it also results in less than half the volatility and substantially lower risk. 


(Please note that the chart above is just one example of a hypothetical portfolio allocation.  We do not suggest that you should use these exact percentage allocations or any other allocation for that matter.  If you would like more information on how to include currencies within your portfolio, please email: for a more comprehensive assessment of your specific investment objectives.)

Recommended Read
Bill Gross, the Co-CEO of Pimco is not only one of the most successful fund managers, he also has a way with words.  Please consider his entertaining yet quietly sobering Investment Outlook for May 2010.  His remarks about ratings agencies are timely considering our most recent rant: Why Are Ratings Agencies Still Relevant?

Here’s a good tidbit from his letter:

Tramp stamp and hooker heels do not begin to describe the sordid, nonsensical role that the rating services performed in perpetrating and perpetuating the subprime craze, as well as reflecting the general deterioration of investment common sense during the past several decades. Their warnings were more than tardy when it came to the Enrons and the Worldcoms of ten years past, and most recently their blind faith in sovereign solvency has led to egregious excess in Greece and their southern neighbors. The result has been the foisting of AAA ratings on an unsuspecting (and ignorant) investment public who bought the rating service Kool-Aid that housing prices could never really go down or that countries don’t go bankrupt. Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them.

Good luck and good investing!

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