A Quick One

The objective of this post (whose title is likely to ring a bell with rock enthusiasts) is to provide our readers with a brief update on the markets which we follow and in which we currently hold positions. It is not difficult to surmise that we’re not busy popping bottles of Pétrus to celebrate our winnings. As contrarians, we’re accustomed to coppering the public’s bets and we’re also used to being early and to suffering drawdowns that generally last anywhere from a few weeks to a few months. We rarely have the pleasure of picking exact tops and bottoms. We have however to admit that this time around the stubbornness with which the various markets persist in following their current trends is nothing short of amazing. This can either mean that A) we’re spectacularly wrong on all our major calls so far; B) for once in their lifetime, the herd is being granted by the market’s gods the privilege of being right in spades; C) the degree to which the current trends are being overstretched is going to guarantee equally strong and long-lasting trends in the opposite direction. We’ll let our readers make their own choices re the above.

Precious Metals

Since our analysis of the sector dated the 13th of February and our More-on trades of the 26th of February and the 6th of March, Gold experienced a crash of historical proportions and Silver did its best to keep up Gold’s pace.

As we mentioned we were alert to the possibility of a final washout of weak hands, although we must admit we weren’t expecting such an effective cleansing. However “shit happens” in the markets as well. We aren’t concerned in the slightest that the fundamental, long-term trend is over: we consider this correction to be just part and parcel of a secular bull market and the longer and more severe it is, the better. Those who sell in a panic always have the opportunity to regret it and those claiming that during the ‘70s Gold halved in price and that as such it now has to go below 1.000$/oz. forget the different dynamics of the last bull market and the fact that Gold experienced a much stronger advance in a much shorter timeframe, thanks to the fact that it had just begun to trade freely. As a basis for comparison, please consider that during the same period Silver (which was already trading freely and which of course has a higher beta than Gold) declined roughly the same percentage: a testament to how overbought gold was.

That said there are more than a few facts and factoids that point to the possibility that a major low has just been printed (or that at least a remarkable window of opportunity has opened up). [A retest of said low may or may not occur: we don’t now and, quite honestly, we don’t care. In case it does, it’s guaranteed to scare most people shitless.]

Here are some of them, in no particular order of importance:

• Record-high volume on GLD both on Friday and on Monday;
• Continued outflows from GLD notwithstanding a meaningful price recovery (those claiming that ETF selling is bearish and impacts the market need to remember that the total stock of gold roughly amounts to 170.000 tonnes vs. roughly 2.500 tonnes held by ETFs);
• Record-high volume in the GDX ETF;
• Record-high volume in the Gold futures market as well;
• Record-low readings on the Hulbert Gold Sentiment indicator and very low readings on the Sentimentrader Gold and Silver Public Opinion surveys;
• Extremely good CFTC CoT reports for both metals for the week ending on the 26th of April, with Small Specs in Gold basically erasing their Net Long position. To quote Sentimentrader: “In gold, small speculators have gone from holding a net 60,000 contracts in October of last year, to very nearly being net short now for the first time since 2001. They've reduced their positions over the past two weeks more than any other two-week period since 1988.”;
• A flood of bearish articles, reports and recommendations appearing on a variety of prominent financial sites, newspapers and magazines.

And here are some charts that highlight the severity of the decline and the sheer volume that accompanied it:

 Weekly Gold chart via Stockcharts. Notice the nice long “wick” at the bottom of the last red candle: it usually signals buying pressure and a bottoming process.

 

A daily chart of GDX via Stockcharts: notice the staggering volume.

Daily Chart of GLD via Stockchats: you can observe that just a wee spike in volume took place here as well.

Weekly chart of Silver via Stockcharts: way less inspiring than Gold and yet some support can be detected there as well.

A chart showing the outright collapse in Small Specs’ positioning, via Gotgoldreport.com.

Softs

Both Sugar and Coffee have experienced further declines since our posts dated 14 January, 1 February, 26 February and 13 March. Fundamentals continue to remain decidedly bullish, in particular for Sugar, and sentiment and positioning are extremely favourable to the bullish case as well. An interesting development is the marked reduction in volatility in Sugar, as measured by the width of its Bollinger Bands: our experience is that this usually signals that a powerful trend is the makings.

A slow bleeding accompanied by a marked reduction in volatility: a powerful trend change may be in the offing. Otherwise, hold on to your hat, as we may see a repeat of the Gold near-death experience (extremely unlikely an yet still possible).

The decline of Coffee prices from their 2011 peak now amounts to almost 60%. As Pater Tenebrarum likes to joke, there’s no need to worry, as it exists strong lateral support at 0. More seriously, we have now retraced exactly 100% of the previous advance (you can see the breakout area at the far left of the above chart).

Yen

This is the market where the most interesting changes have occurred. Soon after taking on the role of BoJ Chief, the apparently inebriated Kuroda decided to double Japan’s monetary base on the spot. This may very well turn out to have killed the bullish case. We shall see. We just mention that risks continue to exist and actually abound in various currencies like the CAD and the AUD and that at least a decently-sized correction is likely to occur, to erase the oversold readings and the sentiment excesses. We hold long-dated options that have indeed turned out to prove effective in protecting us from ruinous losses.

Kuroda cheering at the thought of destroying an entire country, right after having smoked some good stuff. He also seems to need a dentist quite badly, a sign that he may very well be addicted to Meth.

A daily chart of the horribly oversold Yen: after a 30% decline in a bit more than 6 months a rally is just par for the course, even if the bear market were to continue. A double bottom may be in place.

Stocks

This is the market that is frustrating us the most. After all, PMs have been great performers for years on end and they’re now experiencing a run-of-the-mill cyclical bear market; Softs are also in the last and hence tricky part of cyclical bear and the Yen is now managed by a band of lunatics. But the stock market is now in the late stages of an extremely powerful cyclical bull market, with money printing that does nothing but create unsustainable bubble activities, with macro data that now obviously point towards a recession (in the U.S.: the rest of the world is already deep in doo-doo), with earnings that are now clearly deteriorating and with sentiment and positioning that have now been signalling for quite some time a speculative frenzy and yet it refuses to beak down. Each and every time it tries to do so, there you have support coming in and, presto, new highs are achieved. Not even the DAX can manage a half-decent decline. The only positive development we’ve seen so far is the recent increase in volatility and in daily ranges, something that usually accompanies the distribution process that takes place at a top.

A chart of the DAX: after tagging the 200-day SMA a bounce occurred and now we’re again above the 50-day SMA. The chart doesn’t look very bullish though.

 Here we have the S&P500: it refuses to break down. Notice however how choppy the recent action has been: generally it is not a good sign when it occurs after long and powerful advances.

Conclusion

We need to exercise patience and wait for our investment theses to play out. The more the various markets keep going in the current direction, the more they’ll need to play catch up once the reversal occurs. The only notable exception may be the Yen, given that there’s now been a catalyst powerful enough to change the secular trend.

Miscellanea

The objective of this post is to provide our readers with a quick update on the markets we have covered thus far, while waiting for our next major post, which will cover the precious metals market.

Stocks

The S&P 500 has advanced less than 4% since our post on the coming bear market, but judging from the bullish noises made by various pundits and commentators you’d tell it has doubled. CNBC has even put on their screens a “countdown window” measuring the distance between the current Dow level and the all time highs.

From a fundamental perspective, the recent data releases have confirmed what we’ve long been thinking: the global economy is at best growing at a very mild pace, but most likely it is in the first phases of a contraction. Europe is undoubtedly in a recession, no matter how desperately talking heads try to positively spin the data: the recent Markit PMIs were supposedly a success, since the pace of contraction eased a little…big deal! Not to mention the fact that France is falling fast into the grave Monsieur Hollande has been so busy digging since coming to power. European retail sales were also disastrous (no surprise here for those who understand the specular concepts of overconsumption during the boom periods and forced savings during the bust). China is showing a lacklustre “recovery” (we’d prefer to call it: “short-lived rebound artificially engineered by means of inflation”), as evidenced by the latest PMI readings. Japan continues to be stuck in a recession, with the only difference being that now companies face additional pressures on their margins, given that a weaker Yen has pushed up their input costs, while their output prices continue to fall amid strong competition and a lack of demand for their products: they can of course thank Shinzo Ape (no, it’s not a typo) for this one. The US economy is also sending more than a few warning signals (and we are not referring to the meaningless GDP) and is in desperate need of a recession to correct and liquidate all the malinvestments engendered by the Mad-Hatter-in-chief Bernanke. It seems likely to us that much of the positive surprises in data recently released are due to the already high and recently accelerating rate of inflation, which furthers the aforementioned malinvestments. Moreover, earnings and revenue growth have at least stalled, but our suspicion is that they’ve started reverting to the mean: after all, many companies have issued negative guidance, either for the year or the quarter.

Technically, the stock market remains very overbought and ripe for a correction. Bullish sentiment and complacency have reached new extremes and many sentiment and positioning measures are now well into their danger zones (e.g. NAAIM Survey, Investor Intelligence, AAII, Rydex Fund flows and positioning, Hulbert Survey etc.). In short: the retail investor is back, eagerly waiting to get fleeced again.

We’re willing to make a wager here: we think that the actual top is less than 5% away (i.e. we think the S&P won’t surpass 1575, much to the chagrin of CNBC). Timing-wise, the prediction is a more difficult one to make: we may be two weeks or two months away from a top. It will all depend on how the stock market behaves: given that it’s already very overbought, if it were to rise fast towards the all-time highs, it’d probably mean a top is in; however, if it were to correct a little and then resume it’s advance, then we’d be looking at a longer topping process that could drag out until March or April. In any case these are just exercises in futility: what really matters is that we are convinced a top is near and we’re committed to the short side, as this is were the best risk/return proposition lies. To all the bulls pressing us to buy we can only say: “After you, my dear Alphonse”.

Yen

This is were things really get interesting! The Yen is as oversold as it has ever been, with e.g. the EURJPY cross stretched more than 22% above it’s 200-day simple moving average, something almost unheard of for a major currency pair like the EURJPY, which only happened before during the 2008 panic, for strong fundamental reasons to boot. But we’ve discovered a little something that might turn the bears dreams into nightmares… We’ve already commented about the usual strategy employed by the BoJ (to say a lot and then do a little) and it appears that this time they’ve really surpassed themselves!

The details are as follows: the BoJ recently announced ¥13 trillion of monthly purchases of JGBs and T-Bills starting in 2014, but what has apparently gone unnoticed to the hordes of excited bears is that these purchases are gross (i.e. they include rollovers, that is purchases made to reinvest the proceeds of redeemed securities). Net purchases (which are made with newly printed money), on the other hand, won’t amount to more than ¥10 trillion per year, that is more than 10 times less than advertised (as a basis for comparison, consider that current monthly purchases amount to ¥3 trillion).

Now this is a remarkable sleight of hand! They’ve fooled pretty much everybody into thinking they’re going kamikaze, when in reality they’re going to print one tenth of what they claimed and one third of what they already print. We think that such an achievement might warrant an entry in the Urban Dictionary: “to pull off a Japanese”. Derren Brown stands in awe.

Of course market participants can continue to ignore reality for longer than it appears humanly possible, nonetheless with sentiment in the dumps, more and more stories pointing to the resurgence of the carry trade and extreme CoT readings we remain convinced that the Yen is going to revert to the mean and then some. It appears increasingly likely, though, that this will happen in concomitance with the decline of the stock market, exactly as in 2007: patience is advised.

Softs

Sugar is behaving in a rather bullish manner: after washing out some more weak hands with a new low on 23/01, it immediately reversed up on huge volume and then proceeded to play a new trick on bulls, staging a high-volume reversal to the downside on 29/01 and then going through a very volatile range on 30/01, before resuming its march higher over the next two days before closing the week on a mixed note. Price now sits right just below the 19c$ level and the 50-day simple moving average and both have acted as strong resistance in the past. We suspect however that an upside breakout is imminent, not least because the recent CoT reports showed commercials going net long for the first time since 2007. Sentiment remains subdued, increasing the likelihood of positive surprises.

Coffee on the other hand is showing weaker behaviour: after an initial follow-through from its break out level, it plunged right back to the 50-day moving average and then after a couple of days moved below it. It now stands again just below this key average, with favourable sentiment and CoT readings. We continue to remain bullish, but this latest development forces us to consider the possibility that the bottoming process is not yet finished and that as such further volatile spikes and corrections could occur.

The Yen: a Contrarian’s Wet Dream

The objective of this post is to clearly delineate the reasons behind our recent Yen bullishness and to explain why we think buying it against the Australian and New Zealand dollars is likely to prove a very profitable and relatively safe speculation. We need however to immediately point out that everything we are going to write below is conditional upon the Bank of Japan continuing to do what it has always done (and what we think is likely to continue to do), namely to say one thing and then do another (or slowly do just a little of that one thing). In case the demented Abe is capable of fully enforcing his delirious inflationary views on the BoJ, then dear readers brace yourselves and prepare for the Misesian “disastrous bull market”… This is the main reason why we advocate implementing the trade with a judicious use of call options on the Yen (or put options on the Aussie and Kiwi), as they both buy us time and protect us from unwanted catastrophic scenarios that, although unlikely, could nonetheless materialize. With the above in mind, let’s begin our analysis.

The Fundamental Backdrop

A) Japan’s Money Supply growth is both modest and lower than that of other major currency blocks

Leaving aside temporary phenomena which might impact it, the long-term value of a currency is mainly determined by its supply and demand dynamics: in the end it will tend towards the level where demand and supply converge. So the main question an investor has to ask himself is: what is the current supply/demand status quo and how it is likely to be impacted by future developments?

We won’t cover here all the factors influencing the demand side, apart from briefly mentioning that during periods of economic turmoil society’s reservation demand for money (see Rothbard, “Man, Economy and State with Power and Markets” - Chap. 11) tends to sharply increase (as a reflection of the increased uncertainty market participants face). Of course such demand will tend to focus on those forms of money which, correctly or not, market participants perceive to be of highest quality. This is the formal explanation behind the safe haven trade and the reason why during the last crisis the Yen and the Dollar benefited handsomely at the expense of other, less trusted, currencies like the Euro. We will instead focus on the supply side.

Japan’s True Austrian Money Supply as calculated by Michael Pollaro at The Contrarian Take.

As can be seen in the chart above, sourced from the highly recommended blog of Michael Pollaro, Japan’s True Austrian Money Supply growth has been muted in recent years (readers interested in learning what this money supply measure contains and why, as well as in which respect it differs from commonly used metrics like M1 and M2, can do so here and here). Even more importantly, given that currencies do not trade in a vacuum but rather against each other, it has been consistently lower than those of other important currency blocks like the U.S., the Euro area and the U.K (not shown in the chart above and yet important to mention is the fact that BoJ’s credit has only recently reached its old 2005 peak, whilst other central banks have tripled, quadrupled or even quintupled their credit since the beginning of the financial crisis).

There are two main reasons as to why this has been (and may well continue to be) the case: on the one hand, the BoJ has been reluctant in injecting large doses of newly created money into the economy, notwithstanding all their posturing; on the other hand Japanese banks have been more than happy to grab the chance to engage in massive deleveraging (a.k.a. credit contraction), thus counterbalancing to a large extent the effect of money printing (it should be noted here that inflation is correctly defined as an increase in the supply of money and money substitutes). Going forward, the second factor is likely to remain unaltered, given that the sorry state of the Japanese economy and the increasing likelihood of a globalized slowdown mean that banks are probably going to be unwilling to extend new credit (please see chart below). So the question becomes whether the BoJ will truly print enough to overcome the deflationary effect of credit contraction and to outdo its competitors in the mindless race to devalue (on this last point please see our paragraph below). We are inclined to think that much of what we’ve heard so far is little more than political manoeuvring and that in the end they won’t seriously alter the status quo lest they may finally wreck the ship, given that Japan’s precarious position does not allow much if any room for “funny money” experiments. The BoJ’s meeting this week will give us some clues as to the likely direction they’ll take, although the actual implementation of their programs is what matters most.

A chart showing first the decline and then the almost non-existent growth of credit in Japan, via http://www.tradingeconomics.com/.

We recommend our readers to have a look at all of Michael Pollaro’s charts on Japan’s True Austrian Money Supply as well as his work on other currency blocks. We also suggest reading this WSJ article, in which the author points out that Abe’s inflationist policies might upset some powerful sectors of the business establishment (not to mention many other innocent people as well as the poor chaps at the bottom of the economic ladder, who always suffer the most from such insanity). Incidentally, this has so far been the only mainstream article we have been able to find which didn’t contain gloomy predictions about the Yen’s imminent demise and which didn’t simply regurgitate some expert’s opinion about why shorting the Yen is going to be the greatest thing since sliced bread…

B) Other Countries are unlikely to let themselves be outprinted by the BoJ

We have already mentioned the fact that so far the BoJ has shown remarkable temperance in its money printing (and that other central banks have not), but should they decidedly change course, what are other countries going to do? Are they going to let themselves be “outprinted” by these latecomers in the inflation game? On this topic we can do no better than pointing our readers to this excellent article written by the always excellent Pater Tenebrarum, which closely mirrors our own views and even includes a nice haiku for the discerning reader. It appears clear to us that the fallacious and highly damaging mercantilist approach is going to be embraced (or has already been embraced) by most nations, thus making any devaluation attempt on the part of the BoJ unlikely to succeed (particularly if half-hearted).

C) The influence of Capital Repatriation (i.e. carry trade and Japanese overseas investments)

This point analyses in more detail one of those temporary phenomena which might impact the value of a currency: the sudden shift of large amounts of capital from one currency block to another. As we have already witnessed during 2008, when a serious, unexpected crisis strikes, massive quantities of money, which previously headed, during the course of many months or even years, in a certain way, are quickly moved back in the opposite direction, thus causing extremely powerful trends in the currency cross involved. This can be likened to the effect that suddenly opening the floodgates of a large dam has on the underlying brook.

In the case of the Japanese Yen, we think there are at least two factors which might contribute to this phenomenon materializing: the infamous carry trade and the repatriation of foreign holdings on the part of Japanese investors.

The former is certainly no longer as large as it once used to be, both because many speculators got badly burned during its 2008 dramatic unwind and because the spread amongst yields has been steadily diminishing. However, the fact that the hunt for yield has become even more desperate and the stable if mild uptrend which many risk currencies (like the AUD or the NZD) enjoyed against the Yen since the post-crisis rebound of 2009 might have induced at least a modest resurgence of this phenomenon. A generally low level of forex volatility that reached its apex during last summer probably also played an encouraging role. It’s important to note that this is only speculation on our part, as we do not have any concrete evidence to back our claims.

The latter factor, on the other hand, has in our opinion the potential to generate the kind of outsized forex move we’re looking forward to. Japanese investors hold a staggering $3.3 trillion of foreign assets, which amounts to roughly 55% of their annual GDP. The Ministry of Finance holds approximately $1.27 trillion in exchange reserves, whilst the remaining $2 trillion are held by the private sector. During a crisis, either out of fear or out of necessity, some of these holdings are liquidated and the proceeds repatriated: this has an obvious boosting effect on the Yen. This is exactly what happened during the spring/summer of 2011: both the massive earthquake that shattered Japan in March and the mini bear market that shook global markets during the summer induced capital flight and thus generated a quite powerful rally in the Yen, which took place notwithstanding a globalized manipulative effort to the contrary on the part of the G-7 (which was capable only of producing a temporary spike in late March of 2011). We expect this to happen again, only on a much larger scale, during the coming bear market.

As to why we chose Australia and New Zealand as the main counterparties to our long Yen campaign (apart from the specific reasons outlined in the paragraph below), please consider the following: roughly 80% of Australian government bonds and 70% of Australian corporate bonds are owned by foreign investors (sources here and here); the situation in New Zealand in not much different, with 62% of government securities now held by foreigners. We suspect this is going to have a huge negative impact on their currencies in case of a global crisis. The icing on the cake is that Japan’s investments in Australia total more than $123 billion and account for 6% of all foreign investments in the country (placing Japan firmly in the third place, behind the U.S. and the U.K.). Almost half of this sum is invested in Aussie bonds, in a desperate hunt for yield. There are signs that this phenomenon is accompanied by dangerously high levels of complacency and euphoria ("If you think there's been a lot of investment from Japan in Australia so far, just you wait and see," Mr Beazley said. "The Australian economy looks and feels extremely secure."). Finally, the traditionally risk-averse Japanese individual investors have recently started to become excited about the U.S. and other foreign equity markets, exactly at a time when caution would be advised.

D) A Brief Introduction to the Australian Bubble

We will now briefly cover the main reasons which stand behind our calling Australia a bubble.

1. Brisk monetary growth, both in absolute terms and when compared to other countries:

The hallmark of all bubbles: monetary growth. M1 in Australia, the U.S. and Japan, indexed at 100 in January 2005.

A long-term chart showing the annual percentage changes in M1 for the same three countries. Australia has often led the way.

It appears clear from the charts above that there has been remarkable inflation going on in Australia for at least two full decades and we know that with inflation malinvestments and capital consumption inevitably occur. Japan on the other hand has certainly been the least bad of the group, something which we already remarked above [Ed. Note: since we do not have True Money Supply statistics for Australia, we are using M1, which acts as a decent proxy.].

2. Large amounts of debt, mainly concentrated in the household sector:

Household debt as a percentage of GDP: higher than in the U.S.

Australian households are buried in debt: if the economy barely sneezes, they’ll get pneumonia. In this context, it’s worth nothing that the latest PMI reading (December 2012) came in at 44.3, marking the 10th consecutive month of contraction, and that the overall picture painted by the report is rather bleak: interested readers can find more info here.

3. The always-present real estate bubble:

House prices in Australia, U.K., Canada, Spain, Japan and the U.S. via The Economist.

Year over Year % change in real estate prices in Australia, via Global Property Guide.

It’s quite obvious that there’s a massive property bubble in Australia. Other indicators looking at affordability (namely price to income and price to rent ratios) also signal massive overvaluation. Mortgages account for a large part of the astronomically high household debt [Ed. Note: readers can find some interesting info here. We also think that the whole blog is worth keeping an eye on.]. When will this bubble pop, as they all inevitably do? We wouldn’t rule out it’s already in the process of deflating, given that we’ve had two years in a row of declining prices (recall how in the U.S. prices topped in 2005, roughly two to three years prior to the actual bust) accompanied by declining sales in both the residential [Ed. Note: forget the mindless babbling of the article’s author and instead just focus on the chart at the top of the page.] and commercial sectors. Moreover, point 4 below might prove to be the prick that this floating balloon needs so badly.

4. Australia’s fate is highly dependent on China:

Exports to China constitute roughly 29% of all Australian exports, with Iron Ore accounting for more than half of the total, with Coal, Gold and Oil distant followers (all data sourced here). It’s not difficult to envision what would happened in case the much-talked-about Chinese hard landing materialized. As a side note, we’re highly sceptical of the Chinese boom as well, given that it’s built on the shaky foundations of money and credit inflation, coupled with massive state intervention in the economy (which all result in malinvestments and capital consumption). Curious readers could embark on their own research on the topic: we’ll just mention that ghost cities are amongst our favourite manifestations of the massive misallocations and imbalances currently plaguing China, mercantilist extraordinaire.

Technicals, Sentiment and Positioning

From a technical perspective, the Yen is severely oversold and incredibly stretched below its long-term moving averages (like e.g. the 200-day simple moving average):

A chart showing the Japanese Yen Index, via http://stockcharts.com/.

It’s important to note that the index above tracks the movements of the Yen against a basket of currencies and that the levels reached against certain currencies (like e.g. the Euro, the AUD, the MXN and the NZD) are even more extreme.

Yapanese Yen Futures Positioning, via http://www.cotpricecharts.com/.

Positioning in the futures market is also remarkably elevated, with small speculators holding a record amount of shorts and large speculators’ shorts at a multi-year high (significantly higher levels were recorded during the summer of 2007, right at the peak of an egregious bubble and at a time when the carry trade was still buoyant). It’s worth mentioning that this is accompanied by opposite extremes in AUD and MXN positioning, thus showing a propensity toward risk-taking and generalized complacency. We briefly mention here that record CoT readings in risk-on and risk-off currencies usually provide very reliable contrary signals on the stock market as well.

Finally, sentiment on the Yen lies at multi-year (possibly all-time) lows, with Sentimentrader’s Public Opinion Survey showing only 16.5% of bulls, after having spent quite some time in the below-neutrality zone. Moreover, the Yen is universally hated: we have yet to see somebody who is not bearish on it. Pundits and talking-heads as well as many self-appointed experts have all been quick to point out how the currency is doomed, how shorting it is going to be the best trade of 2013 (when in fact it most likely was one of the best trades of 2012...), how the BoJ will inflate ad infinitum etc. As the heading of one of our favourite blogs reads: "When it's obvious to the public, it's obviously wrong."

The conclusion is clear: rarely have we seen such extremes and they have never proved to be the hallmark of a sustainable trend.
Moreover, an investor has always to ask himself: what is the market already discounting? It appears to us that in this specific case the market has already priced in many negative developments, some real some most likely not, leaving ample space for positive surprises.

Conclusion

We are very bullish on the Yen and we are convinced that the best way to position ourselves is to buy it against fundamentally weak currencies like the Aussie Dollar. The important caveat is that the mental Abe could really wreak havoc on the country and consequently on its currency, given that Japan truly is just a little inflation away from total disaster. We always prompt our readers to engage in their own research. In our next post, we’ll discuss how secular bull markets generally end and which common traits they tend to share at such a juncture: as you’ll see, the Yen currently displays none of them.

Addendum

The BoJ set a 2% inflation target and embraced open-ended asset purchases: we have to confess that we are rather pleased to see this outcome, given that on the one hand it deprives the hallucinated Abe of the possibility to attack the Bank and on the other it gives the Bank itself the flexibility to decide how much and when to print (whereas a fixed monetary goal would have forced them to act and would have always elicited calls to "do more"). Moreover, there wouldn't be any additional money printing until 2014. We'll now have to watch like hawks how this new program is implemented (and whether the appointment of the new BoJ governor in April will change the landscape significantly), as this is what really matters: should the BoJ really print ad infinitum, then it would be game over; should they decide to continue to deliver only a modicum of money printing now and then, as they've always done, then the secular Yen bull market should resume its advance. So far the market's reaction gives us cause for optimism: at least a short to medium term rebound is likely in the cards, as too many jumped too quickly on the short yen boat.

A Brief Note on the Yen

We’re currently busy writing our second post, which will focus on the Japanese Yen. We can by no means be certain that the recent bout of selling has exhausted itself, but as we’ve stated we like to establish a position when we think that the long term potential of the trade trumps its short-term risks. Hence we’re buyers here. As to why this is the case, please find below a brief summary of the salient points, on which we’ll elaborate further during the course of our next post, which we expect to go live early next week.

Interesting Fundamentals

Inflation as properly defined (an increase in the supply of money and money substitutes) has been relatively tame in Japan, particularly when compared to the rates of growth achieved by the Federal Reserve and the ECB. This gives our bullishness a solid basis, at least until the Bank of Japan continues to refrain from implementing the “bold” (read reckless and ruinous) policies invoked by Abe (our contention, backed by actual facts, is that so far nothing meaningful has really happened: traders just think it has). When it comes to the next BoJ Monetary Policy Meeting, it seems to us that the market has likely discounted at least both an increase in the size of the asset-purchase program and the adoption of a 2% “inflation” (we use the term here in its common fallacious meaning) target. Imagine what could happen if they were going to disappoint… Even if the BoJ were to implement both, we think we could still witness a “sell the news” event. As for the long-term soundness of the trade, it’d need to be re-evaluated in light of the Meeting’s decisions, keeping in mind that one thing is to “adopt a 2% inflation target”  and another one is to actively print money at a high enough rate to achieve the Yen’s devaluation (keep in mind that it’s not so easy to outprint Bernanke). Moreover, we harbour more than a few doubts about the desirability of a weakening Yen (and the accompanying rising interest rates) and we suspect that these are shared by quite a few Japanese, including some powerful business leaders who could make their voices heard at the LDP’s headquarters (the fact is, if Abe is not a complete fool, like for example Hollande is, he’ll quickly reach the same conclusion without the need for any outside help).

Two different and somewhat interrelated catalysts

We suspect that in recent times there has been a resurgence of the infamous carry-trade, particularly in favour of what we like to call bubble currencies (the Aussie dollar is chief amongst them). This has likely been driven by the desperate and very risky hunt for yield, which has also produced the already mentioned collapse in the spread of risky bonds vs. treasuries [Ed. Note: we can personally attest to this fact, as we’ve witnessed many European banks peddle Aussie bonds of questionable quality to unsuspecting customers. This is moreover confirmed by the worryingly high 80% of Australian government bonds and 70% of corporate bonds currently owned by foreigners.].

The Japanese hold a massive 3.3 trillion $ in net overseas assets (of which roughly 1.3 trillion $ are foreign exchange reserves, whilst the rest is in the hands of the private sector), more than 50% of their annual GDP. What if they suddenly repatriate some of them (maybe because of a scary bear market in equities or a resurgence of the European debt crisis or a deepening recession at home)? We mention here en passant that Japanese holdings of Australian and New Zealand bonds are rather large in both absolute and relative terms. This, coupled with the very real possibility of a sudden bursting of the Australian bubble and a few other considerations, makes us think that the best way to play the Yen is via the AUD/JPY and NZD/JPY crosses. A careful accumulation of long-dated put options might prove to be a savvy speculation, as they could allow the owner to withstand any further upside there might be left in these crosses whilst at the same time limiting his losses to a predetermined amount in case the BoJ really goes nuclear.

Extremely oversold readings and one-sided Sentiment

The USD/JPY cross has not been so stretched above its 200-day simple moving average since at least 2005. This combines with many other measures and indicators into an extreme technical picture rarely seen and almost always destined to revert spectacularly. Countless pundits and self-appointed experts with a dubious track-record have been all over the news predicting nothing less than the total collapse of the Yen. Sentiment on the currency lies at multi-year (probably all-time) lows. There are also signs that Japanese investors have recently increased their exposure to foreign equities (mainly American ones): as they tend to be rather risk-averse, this may indicate an extreme degree of complacency in the markets and act as a contrary signal for stocks (reference our post on equities as well), which could in turn activate on of our hypothesized catalysts.

How Bull Markets end

We will also go through a brief list of the phenomena that usually accompany the end of secular bull runs, with the purpose of showing that none of them are currently present in this case. We’ll use Apple as a recent example of how such moves tend to end (although it’s important to note that not all of them reach the same mind-boggling extremes).

Conclusion

We are bullish on the Yen and we’re actively buying it. We cannot rule out further weakness (and in particular a test of the 90 zone against the USD), but we consider the risk/reward proposition to be good enough for us. Readers should always remember the importance of doing their own analysis and of proper position sizing and risk management strategies.