Dalio on market views provides good review of major themes

"Currency devaluations are good for stocks, good for commodities and good for gold. They are not good for bonds." Ray Dalio, Bridgewater in a Barron's Interview

The Barron's Dalio interview focuses on the recurring theme that there are two global economies. There is the emerging markets which have recovered to beyond their pre-crisis levels and the developed world which is stuck in a malaise. The emerging market world is showing continued upward movement with inflation while the developed world is flat. Real rates are still negative in most of the world, so there is no constraint on funding for most businesses.

The dollar is down and stocks and commodities are gaining. Still, we do not have strong job creation.

Trading disaster events - buy on dips?

“Buy when there is blood in the streets.” “Be greedy when others are fearful.”

The question of what should be done on negative events has been the focus of finance research for years. The impact of news or announcement effects has been the bread and butter of empirical finance for years. Clearly the adage from Wall Street is to be a buyer when others are in panic.

Behavioral finance research has suggested that being a buyer on bad news will provide positive gains because buyers must be compensated with a higher risk premium to entice the purchase of an asset. There is a risk premium with negative news uncertainty. Hence, there will an price over-reaction on the downside when there is bad news. When there is good news, there is no added risk premium needed in the market. The data suggests that there is under-reaction to good news and suggests that there will be carry-over with good information.

Under both cases there will be increases in uncertainty which will affect market prices and volatility. However, selling require overt action while holding existing assets is a passive activity. Recent research on airline crashes and stock reaction shows that the loss of market value is much greater than the ultimate settlement and cost of a crash. Hence, there is a market over-reaction.

How does this relate to the Japanese earthquake? The initial reaction was a strong sell-off and then a rally to reverse some of the losses. The theory concerning negative news would say that this is consistent with past research on bad news events. We would agree, but would like to add a slightly different twist to the story. It was not so much that bad news was the main cause of the stock decline but uncertainty concerning the news. Since it was not clear what was the extent of the bad news, it is important to be a seller until there was clarity concerning the size of loses.

Still, employing a trading strategy of buying bad news dips is dangerous. When do you buy? Does the market have to be down 2%, 5%, 10%? It is not clear. In hindsight, the answer is easy. The market reversed, so the over-reaction was realized. It is unclear that after negative news there is subsequent good news to reverse the move.

Yes, the buy dips strategy work, but it takes courage to employ capital when there is blood in the streets.

Dollar declines to three year low

With all of the geopolitical and earthquake events, the dollar has not been the focus of many investors, yet it has now reached a three year low. We are at pre-crash levels and little expectation of turn around. The only dollar gains come when there is a crisis in another country like the Greece or Ireland events.

There are strong dolalr headewinds. There is less flight to quality into the dollar. There is no yield advnatage with holding dollars. The US is energy dependent and we are facing a oil price shock. The deficit problems are real and there has been no leadership on this issue. The rest of the world, especially emerging markets, still looks like good long-term bet even if there is higher inflation and a slowdown in growth momentum.

There is not a strong dollar story to be presented at this time.

What happened to capital adequacy

The Federal Reserve on Friday announced it has completed the Comprehensive Capital Analysis and Review (CCAR), its cross-institution study of the capital plans of the 19 largest U.S. bank holding companies.

As a result of the CCAR, some firms are expected to increase or restart dividend payments, buy back shares, or repay government capital. The Federal Reserve on Friday will discuss the reviews and its decisions with firms that requested a capital action. All 19 firms will receive more detailed assessments of their capital planning processes next month.

So what happened to capital adequacy and the need to protect the banking system. If there is a need for more capital in banks, and/or less leverage, you are not going to be able to have this happen if funds are paid out in dividends. Similarly, a stock buyback reduces the amount of capital that is held in the market. Under normal times, a buyback or a dividend would make sense if there less opportunities in the banking sector. That may be the case now, but there is the larger policy of capital adequacy.This review seems all the odder given that deposit insurance is provided by the government, there is a too big to fail issue, and the Fed is supposed to look at macroprudential systemic risk issues. We should also not forget that the policy of lowering rates to zero has the intent of making banks more profitable to offset loses. It would seem that the first issue would be to have banks retain more cpaital until a global policy can be determined.

Bnaks are preparing to announce buybacks and dividend increases. This is is the new Washington consensus of cooperation between the government and large financial instiutitions. The public and economists should not be happy with this direction.

G7 currency intervention - saving the yen from itself

G7 joint intervention occurred in the yen today. The market reaction was swift with a reversal of over 3 percent. This is the first time coordination has occurred in over a decade. The last time the G7 took coordinated action was in September 2000.

The whole yen affair since the earthquake has been out of the ordinary. A combination of a economic shock with strong central bank intervention should have pushed the yen lower without any intervention help. The BOJ has increased their asset purchase program to 1 trillion yen after the earthquake. In reality, the yen has rallied. The talk is that any companies, especially in insurance, have been bringing back capital to prepare for the rebuild.

It is supportive for the Japanese economy to have a stable yen, but the intervention should not have been necessary. The new question is whether further coordination will be necessary. Once the markets know that intervention is possible, there will be less threat to push the yen higher. Still exchange rates will react to the fundamentals and money will be needed to move back to Japan to help the economy.

Risk as a choice

"The word risk derives from the early Italian risicare, meaning to dare, with the strong implication that risk is a choice, not a fate. In this sense, risk conveys a notion of freedom of choice; it is up to the individual, or organization, to choose how to proceed - whether to dare (go ahead) with something, or not."

- Peter Bernstein, Against the Gods: The Remarkable story of Risk

This is always a great quote to remember when we are in uncertain times. There have to be choices made, whether to buy or sell. To keep existing positions or move to cash. Unfortunately the news from Japan was never clear and constantly in a state of flux. You needed to look at time stamps for news stories to determine their freshness. Nevertheless, risks have to faced and acted upon.

China news - "Inflation is like a tiger"

Chinese Premier Wen Jiabao states that inflation is caused by the flood of cheap money from some countries. (My guess would be the US.) He uses the analogy, "Inflation is like a tiger, once set free, it will be very difficult to get the tiger back in its cage." Inflation is up 4.9 percent and 11 percent for food.

Of course, Chinese M2 growth is almost 4 times as large as the US. Even adjusted for growth, Chinese money is expanding faster. If you want to look at the inflation tiger, you do not have to go far from China. What is also clear is that if China does not want to import foreign inflation, it has to allow its exchange rate to appreciate. The Chinese do not want this to occur at any fast rate, so inflation will be domestic problem.

The US is a clear driver with global inflation; however, the inflation tiger is out there but a number of countries have allowed this animal to roam the globe.

The power of words

The ISM index came out today with levels at 61.40, the highest since May 2004 and match the highest levels since 1983. The employment index is above 60 for only the third time in the last decade, yet the market is lower.

The problem for markets has been the power of words by central banks. Whether the Fed or the ECB, comments from central bankers have been driving the markets as much as any good news report with hard data. Currently, policy comments make the difference in market direction. The focus on news conferences is obvious. Markets react to the Q and A.

A question is whether this makes sense. Should policy be the driver of growth or should it be in the background? For central banks, the policy issue is not solely price stability, but whether central banks can bail-out governments and spur economic growth. In this environment, words will play a greater role.

The ECB is commenting that they may start to raise rates in the face of higher inflation. In itself, this should not cause a strong market reaction. The reason for the extra impact is that the ECB has been involved in many other issues concerning sovereign debt and fiscal balance; consequently, a rise in rates will not just have an impact on price stability but on the real economy.

We should be in an environment where words do not matter.