What Now?



Donald Trump will be the next president of the United States. Needless to say, that took a lot of people by surprise.

As I’m writing this Tuesday night, Dow futures are down 800, and the dollar is tanking. People are panicking. It’s the end of America… the end of democracy itself!

My advice? Wait a couple days for the dust to settle, and then buy the dips.

Seriously. We’ve had terrible presidents in the past. Lyndon Baines Johnson, Richard Nixon, George W. Bush… we’ve had plenty of terrible presidents, and yet the country finds a way to march on. The world doesn’t end.

You have to remember that the American president is one of the weakest executives in the world. In their respective countries, the British prime minister and French president are vastly more powerful than the American president. None of the more questionable aspects of Trump’s platform can happen without the consent of Congress, the Supreme Court and a good chunk of the states.

Still, the market hates uncertainty. So this is how I see this playing out. Stocks will fall like a rock on Wednesday and will probably drift lower for a couple days. But then, investors will figure out tha not much has actually changed. Just as with the Brexit, the market will shrug this off, and life will get back to normal.

Take a deep breath. It will be fine.

Not With A Bang But a Whimper


Jeremy Grantham had some good comments in GMO’s third-quarter letter to investors.

I have come to believe, however, very reluctantly, that we bubble historians have, together with much of the market, been a bit brainwashed by our exposure in the last 30 years to 4 of the perhaps 6 or 8 great investment bubbles in history: Japanese land and Japanese equities in 1989, US tech in 2000, and more or less everything in 2007. For bubble historians eager to see pins used on bubbles and spoiled by the prevalence of bubbles in the last 30 years, it is tempting to see them too often. Well, the US market today is not a classic bubble, not even close. The market is unlikely to go “bang” in the way those bubbles did. It is far more likely that the mean reversion will be slow and incomplete. The consequences are dismal for investors: we are likely to limp into the setting sun with very low returns. For bubble historians, though, it is heartbreaking for there will be no histrionics, no chance of being a real hero. Not this time.

I’ve had a similar view for a while now. Stocks are expensive based on any criteria you want to use — the traditional P/E, median company P/E, P/S, cyclically-adjusted price/earnings ratio… Find any traditional value metric, and the market is expensive.

Yet you don’t have the irrational optimism or generally good fundamentals that you see during a bubble… what Grantham calls “excellent fundamentals irrationally extrapolated.”

Think back to 2005. Expectations for home prices were ridiculous and completely divorced of economic reality. Yet you did have a booming economy, falling bond yields and an overall strong macro environment. The same was true in 2000. Tech stock prices had gotten ludicrously overvalued based on ridiculous growth assumptions, yet the late 1990s economy was also one of the biggest booms in U.S. history. It’s hard to say those conditions are in place today. The economy is growing at a tepid rate, and investor sentiment is downright horrid. Fear is far more prevalent than greed.

So, we’re unlikely to get that bubble burst “reset” that we got in 2000 or 2008… yet stocks are too expensive to generate acceptable returns going forward. So, what does this mean, and how do we allocate capital?

I’ve argued for years that stock returns will likely be flattish for the next decade, which is why I’ve focused my attention on income strategies and alternative investments. Grantham would agree, and his team is forecasting returns on U.S. large caps of -3.1% to 0.3% over the next 7 years.

We’ll see how it shakes out. But a larger-than-usual allocation to alternatives seems like the sensible move, all things considered.

Charles Lewis Sizemore, CFA is the principal of the investments firm Sizemore Capital.

What’s Next for the Euro?

A year ago, European Central Bank chief Mario Draghi promised to “do whatever it takes” to save the euro.  The reality is that he hasn’t done much of anything.  He hasn’t had to.

The Outright Monetary Transactions bond-buying scheme—which was designed to calm the bond markets by buying potentially unlimited amounts of Eurozone periphery-country bonds in the secondary market—was put together after Draghi’s comments but has yet to be implemented.    Its mere existence—and Draghi’s perceived eagerness to use it—were enough to put the bond market as ease.

In the year that has passed, the Spanish 10-year bond yield—which has become a de facto measure of investor sentiment towards the Eurozone—has collapsed from 7.8% to 4.6% at time of writing.  It had fallen to as low as 4.0% in May, until Fed Chairman Ben Bernanke’s QE “tapering” comments caused a general world-wide hike in bond yields.

Italy’s bonds have fared even better.  Despite a political crisis brewing in Italy that could see former prime minister Silvio Berlusconi jailed and barred from office—and bring down Italy’s coalition government in the process—Italy bond market remains healthy, and the 10-year yield sits at a manageable 4.4%.


As fears that the Eurozone would implode continued to build throughout late 2011 and the first half of 2012, the euro lost nearly 20% of its value relative to the dollar.  But as fears of a meltdown receded, the euro rallied, notching up gains of about 13% vs. the dollar before settling into a trading range that has lasted for most of 2013.

So, where does the euro go from here?

There are a lot of moving parts, but let’s look at some of the most critical drivers one by one.

1.All else equal, an improving Eurozone economy should  give investors faith that the worst is over for Europe.  Improving sentiment means new money flowing into Europe…which should point to a stronger euro.  On this count, we see what could be the first green shoots of recover.  European oil consumption is rising for the first time in two years, and the Spanish unemployment rate—though still shockingly high at 26.3%–ticked down for the first time in two years last quarter.

2. The “carry trade” is a major determinant of currency moves.  All else equal, higher-yielding currencies tend to rise relative to lower-yielding currencies.  Currency traders short the lower-yielding currency and buy the higher-yielding currency, hoping to profit both from the spread between the two interest rates and from appreciation in their long currency.  Right now, the Fed Funds rate is effectively zero (it’s official target is 0.00% – 0.25%).  Bernanke has indicated that rates will remain close to these levels for “the foreseeable future,” which is taken to mean through at least the end of 2014.

The ECB’s target rate is slightly higher, at 0.50%, but not high enough for the spread to be much of a factor.  At best, the euro is slightly less likely to be used as a funding currency than the dollar or yen.  Overall, I consider the carry trade to be neutral for the euro.

3. Lower inflation generally leads to an appreciating currency, all else equal.  And on this count, I see a mild positive for the euro.  Inflation in the Eurozone can in at 1.6% last month, and core inflation was just 1.2%.  In the U.S., the numbers were 1.8 and 1.6, respectively.  I expect inflation to remain tame in both the U.S. and Europe, though when inflation does eventually start to trend upward again I expect it to happen in the U.S. first.

4. A positive trade balance is good for a currency, all else equal, and this metric favors the euro.  While five years of economic malaise have brought the American current account deficit down to just 2.7% of GDP,  the Eurozone has a current account surplus of about 2% of GDP.

The numbers suggest that the euro should enjoy modest gains against the dollar over the next year, or at the very least continue to trade near the upper end of its recent trading range.  Of course, all of this could go out the window in an instant if Italy or Spain slide into political crisis again or if the bond markets revolt as they did early last year.

Trading “near the upper end of its recent trading range” is not a ringing endorsement of a long-euro trade.  But given the likelihood of relative stability in the euro, a strong case can be made for European equities.  Taken as a group, European stocks are substantially cheaper than their American counterparts and tend to pay higher dividends.

This article fist appeared on MarketWatch.

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Still Waiting for Japan’s Day of Reckoning

The “Abe Trade” is back on…for now.

The “Great Bernanke Scare” of May and June hit Japanese equities hard, forcing the Nikkei into “official” bear market territory (a loss of 20 percent or more is considered a technical bear market by most analysts).  But in the six weeks that have followed, Japanese stocks have recouped virtually all of their losses.

The yen—which tends to rise during times of crisis as traders cover their short positions—has resumed its gentle decline, and calm has returned to the Japanese bond market.  After more than doubling from  0.45% to 0.93%, the Japanese 10-year yield has drifted back to 0.78%.

What conclusions can we glean from this?

To start, Japan is indeed “back” as a risk asset class.  This is not to say that the Japanese economy is on the mend or that Japan’s long-term prognosis is anything but grim.  But after years of indifference, it shows that traders see the Japanese market as being worth trading.

Secondly, Japan’s day of reckoning—which will eventually come—is not here yet.  The bond market is calm—even complacent—and investors are unwilling to challenge the Bank of Japan.

So, what now?  Is it too late to jump on the Abe Trade?

In my view, yes—or at least for the first half of the trade, going long Japanese equities.  After roughly doubling in less than a year, Japanese stocks are no longer cheap.  By Financial Times estimates, Japanese stocks trade for 19 times earnings and yield only 1.6% in dividends, making them downright expensive by world standards.  As a point of reference, the U.S. S&P 500 trades for just 16 times earnings and sports a dividend yield of 2.5%.  German stocks trade for less than 13 times earnings and pay out 3.5% in dividends.

But what about the second half of the Abe Trade—shorting the yen?

This would seem like a low-risk proposition. Barring another jolt of “risk off” volatility that led to short covering, it’s hard to see a scenario whereby the yen appreciates from here.  The Japanese government is determined to push down its value, and the near-zero yields across the yield curve offer little in the way of resistance.

In a benign environment, shorting the yen should produce modest, albeit positive returns.  But if I am correct about Japan eventually having a capital markets meltdown, then those modest returns could get eye-popping in a hurry.

The key here is the bond market.  If the bond vigilantes finally awaken from their slumber and push Japan’s borrowing cost to something that actually reflects the underlying risk, Japan will be effectively locked out of the international bond market.  It will be forced to commit that cardinal sin of turning to the Bank of Japan for financing…which will turn the yen’s orderly decline into a rout.

If you want short exposure to the yen, consider shorting the CurrencyShares Japanese Yen Trust ($FXY).  And put the PowerShares DB 3x Inver Jap Gov Bond ETN ($JGBD) on your watch list.  When Japanese yields start to rise again, JGBD will put you in position to profit.

Charles Sizemore has no position in any security mentioned.  This post first appeared on MarketWatch.

Is the ‘Abe Trade’ Still in Play?

The votes have been counted.  Japan’s Liberal Democrats—the party of Prime Minister Shinzo Abe—won a landslide victory over the weekend, securing control of both houses of parliament.

The implications here are huge.  Abe is as close as you can get in modern Japan to a militant nationalist, and the win will only encourage him to escalate his war of words with China.  Abe is pushing for a re-write of Japan’s constitution that would scrap some of the pacifist language written in by the United States after Japan’s surrender in World War II.

All of that is fine and good, but the question on most investors’s minds is far more focused: what does this mean for Abenomics and the “Abe Trade” of going long Japanese equities and short the yen?

Japanese stocks were mostly flat after the news, suggesting that there were no real surprises.


Looking over the past few months, we get a more interesting story.  The Japanese Nikkei Index (orange line above) took a tumble in May and early June, falling into bear market territory.  Yet taking a lot of investors by surprise, the Nikkei has since rallied and gained back most of its losses.

The yen (green line), which has moved the opposite direction, rallied over the period before giving most of the gains back.

So, it would appear that the Abe Trade is back on…at least for the time being.

If you are a short-term trader or trend follower, then there may be a little money left to be made in this trade.  By all means, go for it. But be careful, and make sure you have some kind of risk management in place.

If you are a longer-term investor or if you are less-inclined to monitor your positions closely, stay out of Japan.  Being long Japan is comparable to picking up nickels in front of the proverbial steam roller.  If you linger too long, you will get crushed.

While I try to stay objective and avoid looking at the markets through biased eyes, I admit fully that I have become something of a Japan permabear.  When I look at the country’s macro environment, I do not see any set of circumstances whereby this doesn’t end poorly.  At 240% of GDP, Japan’s sovereign debts are the highest in the developed world, and by a wide margin.  Its population is aging and shrinking (see Jeff Reeves’ recent article about the Japanese boom in adult diaper sales) meaning its tax base to support its debts gets smaller every year.  And it adds to this mountain of debt with a budget deficit of nearly 10% of GDP.

All it would take for Japan to descend into a financial meltdown would be for its bond yields to rise by a couple percentage points…which is a virtual inevitability given the country’s borrowing needs.

And topping it off, after their torrid run, Japanese shares are no longer cheap.  The Nikkei trades for 16 times expected 2014 earnings.

When will Japan’s day of reckoning come?  Frankly, I have no idea.  It will come when investor sentiment shifts and investors suddenly perceive the risk that has been there all along.  It could happen tomorrow…or it could happen in a few years’ time.  But happen it will.

If you want to continue to play the Abe trade, the second half—shorting the yen—is the less risky option.  If I am correct about Japan eventually blowing up, then the yen will fall to zero…or close to it.

If you decide to play the first half—going long Japanese equities—do so with the mentality of a short-term trader and use proper risk management.  Japan is not a long-term buy because Japan has no long-term future.  If you need a reminder, print off Jeff’s article on Japanese adult diapers and tape it to your wall.

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