Many analysts have speculated for months that a sharp rally in the U.S. dollar could create a quick and dramatic sell-off in equities around the world (as well as in the U.S.), as global currency speculators move to close out short-term debt positions in the U.S.  As a result of last year’s financial market meltdown, the U.S. government took extreme measures to stabilize the economy and stave off economic disaster.  One of these measures included keeping short-term interest rate targets at historically low levels–well below one percent.  Concomitantly, worries about the U.S.’s exploding debt levels caused the dollar to sink throughout a good portion of 2009.  This made the U.S. debt market one of the cheapest sources of funds for global speculators who wish to use the “carry trade” to their advantage.  The “carry” in carry trade refers to the cost of holding an asset.  When it is positive, this is known as “return” and return is what all investors are looking for in an investment.  A negative carry is cost and is obviously something most would seek to avoid.

By definition, the whole concept of “carry trade”, as it has come to be known, entails the heavy use of leverage.  Ideally, speculators seek to borrow money from a nation whose short-term interest rates are comparatively low and whose currency is in decline relative to others.  The speculator can then re-invest that borrowed money in whatever asset class offers the best prospect for appreciation.  When U.S. equities hit their nadir in early March, there is no doubt that speculators saw opportunity and began channeling money into U.S. (as well as foreign) stocks.  It is logical to assume that a good portion of that inflow was borrowed money from investors using the carry trade.

However, leverage removes patience from the investment equation.  Investors who purchase securities without the use of leverage can weather down markets far better than those who borrow to buy.  Add the volatility and unpredictability of currency movements into the equation and you have a recipe for one hell of a wild ride.

While many commentators predicted that there would eventually be a rally in the dollar—even if it were nothing more than a “dead cat bounce”—that rally, which began in mid-November, intensified this week.  On Tuesday, there was a much-publicized Senate race in Massachusetts in which the Republican, Scott Brown, defeated Democrat Martha Coakley to complete the term of the late Senator Ted Kennedy.  This stunning upset was considered a repudiation of some of the largest pieces of legislation pending in Congress (health care reform, “cap and trade”, financial regulatory reform, etc.)  Some market commentators (Jim Cramer comes to mind) even went so far as to predict that a Brown victory would spark a strong stock market rally.  Indeed, on Tuesday, there was a strong rally in equities, but it was short-lived.  The theory undergirding such prognostications was that this election signaled a return to divided government, and would force a move the center by the Obama administration and perhaps demand a greater focus on spending restraint throughout our government.  This should normally be good news for stocks.

It would appear to us that these conclusions may also have been reached by currency traders and those who utilize the carry trade to find alpha.  For much of the last year, the dollar declined as our spending went through the roof and legislation being crafted promised to further balloon U.S. deficits in the years ahead.  Countless articles were written predicting an eventual U.S. credit downgrade or even default.  Yet now that concerns about runaway government spending have risen to the forefront of the national political debate with Scott Brown’s win, it appears that the dollar is finding some fans around the world again.  This is only logical since, despite our enormous problems, the economies of the EU, Japan, China and developing nations all face significant issues which in many cases are greater than our own.

Stock selling volume accelerated yesterday and U.S. Treasury debt reversed its recent decline.  This coupled with an accelerating dollar rally leads us to conclude that the sudden end of complacency and even a whiff of fear in the U.S. equity market may be as much a result of an unwinding global carry trade as anything.  The volatility indicator or VIX has risen quickly recently, and is on pace for 32% rise just this week.  Clearly, earnings season has not provided the kind of disappointment that would account for this recent sell-off.  The President’s proposed attack on big banks, while certainly a negative for this crucial (and still wounded) sector of our economy, seems to have little chance of becoming law post-Scott Brown.

If carry trade speculators are indeed unwinding their positions, then the equity sell off could be deeper than fundamentals might warrant.  We have said for some time that equities were not cheap and advised caution on adding new positions.  However, we did not—and still do not—foresee a major pullback.  However, an unwind of the carry trade could intensify and prolong any pull-back.  Thus, equity investors may want to be especially cautious at the present time.

“What do you make of overall car market? By the way, we’ve got Ford’s auto sales down 5.1% in the month of September. That’s not a very good showing. Overall the American car market is going to shrink to below 10 million vehicles this year.

I think we have some quick revisionist history happening on the cash for clunkers plan. It was not the successful stimulus program. It was a quick way to spend $3 billion but there’s no lasting effect. The market’s back where it was in August. I got a preliminary number from Chrysler. I’ve got to go through this more thoroughly but the preliminary number is they were down 42% in that’s compared to a very weak September of last year. What do you make of that?

Not a surprise at all. Exactly where they were before cash for clunkers and back there again. Nobody’s buying Chryslers.”– Fox Business Network 10/1/2009

The government’s Cash for Clunkers rebate program was generally very well received as the program ignited demand for vehicles in late July and August.  However, many were skeptical that the program would in fact boost sales or simply pull these sales from the future.  The temporary nature of the CARS Program was well known to manufacturers, dealers and consumers, so everyone wanted to take full advantage of the rebates while they were available.  Anyone who was in the market for a car and qualified for the program would have considered buying their car during the program.

Now, we are seeing the post-clunker slowdown as the major auto-manufacturers are reporting September sales results that are below expectations.  Ford (F) was slightly worse than expected falling 5.1% (5.8% if you exclude Volvo).  Nissan saw their sales drop 7%.  Chrysler looked the worst of the slowdown, with sales falling 42% and more than 61% for the Chrysler brand.  But in Chrysler’s case, the comparison is to pre-bankruptcy filing, which certainly skews the results.(Note: General Motors (GM) had not yet reported their results at the time of writing, but they are expected to be far worse than a year ago.)

These comparisons are versus sluggish sales one year ago, not against the rebate fueled sales totals of last month.  The seasonally adjusted annual sales rate slid to 9.3 million vehicles, this important metric stood at over 10 million vehicles the past two months.  However, the annual sales rate was better than Edmunds.com analysts had predicted mid-month at 8.8 million vehicles.  This improvement reflects an up-tick in sales in the second half of the month.

In addition to the lack of demand after Cash for Clunkers, auto dealers were dealing with the industry’s lowest inventory levels in 24 years.  This only exacerbated the problem as consumers were left with fewer options and dealerships had less incentive to make deals.  However, this data was well known to industry analysts and sales results still fell short of their projections.

This outcome was not a surprise to many who were critical of the Cash for Clunkers program, but time will tell how long this lack of buyers will persist.  If this was simply a one month hiccup, then it would be hard to say that the program was a failure.  Of course, the trend in the second half of the month is somewhat encouraging.  However, should auto sales continue to disappoint through the end of the year, the program would have been a complete waste of money.

Nouriel Roubini has seen his star rise faster than almost anyone after predicting a deep recession during what was hailed by some as the “goldilocks” economy of 2006-2007.  The so-called “Dr. Doom” is now a legitimate superstar and his words carry a lot of weight.  We noted back in July (A Week of Superstar Bears Moving the Market) that Roubini’s remarks were regarded as a change in direction and the stock market rode a wave of positive sentiment much higher.  It was surprising to us that such a event that has absolutely nothing to do with market fundamentals would be met with such ebullience from the market.  Well, according to Bloomberg.com on Friday, Roubini has started to come around to the idea of recovery.

New York University Professor Nouriel Roubini said that action by governments and central banks has led to a “bottoming out” of the global recession and that there is “light at the end of the tunnel.”

In the U.S., “there are signs right now that the recession might be close to over,” Roubini, who gained notoriety for predicting the global financial crisis, said today in Istanbul. While he sees a U-shaped recovery, there remains a “a risk” of “a double-dip recession.”

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“Right now, the main issue is the question” of reversing policies implemented to bolster economies from the crisis, Roubini said. Exiting from fiscal and monetary stimulus programs globally “is going to be a very difficult thing” and the timing of this is one of the factors that could lead to a double-dip recession. — Bloomberg.com 10/2/2009

He made these comments while in Istanbul for the annual meeting of the International Monetary Fund.  This time the market is not soaring higher on his statements, but this is markedly improved over his view of just a few months ago.  He still warns that risks remain and that optimism in the market “is excessive”, but he will find no argument here on those points.  Also, he notes that the very same measures taken by world leaders to stimulate the world economy out of recession could potentially create trouble down the road.

While we would not consider this capitulation, Roubini’s language is softening.  He must at least recognize the possibility that the stock market could continue to rise, and his shooting star would lose some of its luster.  Investors who have followed his lead, would likely have missed out on the market’s rally over the past 7-months (nor would they have had their money in the market prior to Lehman’s collapse).  In his defense, he is an economist and not an equity analyst.  The recent performance of the market has been driven much more by improved sentiment than by improved fundamentals.  We will continue to monitor Roubini because he remains one of the brightest economists in the world, and he has a tendency to see what many others cannot.

According to Bloomberg.com, many investment managers are becoming optimistic about the future of the market because there is still a ton of cash not yet invested in the market.  This money has been termed “cash on the sidelines” because it is really not earning a return, and people have stashed it away for a rainy day.  As the bulls theory goes, there are two reasons that this will help drive the market higher.  First, economic improvement and a return to growth will make investors less risk averse.  At the same time, these cash-heavy portfolios will start allocating those safe assets into more risky investments in order to reap better potential returns.

Saving Money

Investors placed $1.45 trillion in U.S. money-market funds in 2007 and 2008during the worst financial crisis since the Great Depression, based on data from Washington-based ICI. The amount has dropped $439.5 billion since reaching a record $3.92 trillion in the week ended Jan. 14.

A broader measure of reserves that includes cash, bank deposits and money-market funds has climbed to $9.55 trillion this month, based on data compiled by the Fed. That’s enough to buy all of the companies in the S&P 500, which have a combined market value of $9.37 trillion, Bloomberg data show. Since 1999, so-called money at zero maturity has on average accounted for 62 percent of the stock index’s worth.

“There is a wall of cash,” said Yves Carpentier, a Paris- based manager at Cap West, who oversees $118 million in three U.S. stock funds that have gained more than 32 percent this year, beating at least 87 percent of their competitors. “Stocks will be the investment of choice in the coming months.”

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Stock Inflows

Investors are returning to stocks faster than in the last bull market. They’ve added $15.8 billion to domestic-equity funds since March, compared with outflows of $18.6 billion during the first five months of the bull market that began in October 2002, data from ICI shows.

Should inflation exceed returns on money-market accounts, that may cause more investors to buy equities. The 100 largest taxable U.S. funds returned an annualized 0.12 percent during the past week, according to data compiled by Westborough, Massachusetts-based Crane Data LLC.

The Fed said on Sept. 23 that it anticipates keeping the benchmark interest rate “exceptionally low” for an “extended time.” Labor Department reports this month showed prices of goods imported into the U.S. tumbled 15 percent in August from a year earlier and consumer prices dropped 1.5 percent.

“Many of the fund managers I talk to that have missed this rally or underplayed this rally are sitting with way too much cash,” said Jeffrey Saut, chief investment strategist at Raymond James & Associates in St. Petersburg, Florida, which manages $214 billion. — Bloomberg.com 9/28/2009

So, the fact that there is a net inflow into stocks is an encouraging sign coming out of the worst financial crisis since the Great Depression.  It shows that investors are willing to take on more risk, as most cash heavy portfolios have greatly underperformed the benchmarks over the past six months.  The cash well still runs deep, and this could provide an added boost to the market in the coming weeks.  Furthermore, with continued quantitative easing and economic growth on the horizon, there is sure to be growing concern over inflation.  This fear over inflation will likely drive many to diversify out of cash and into inflation hedges like precious metals and basic materials.

However, we would have to caution against reading too much into these figures.  In our experience, chasing performance can be disastrous for a portfolio because you may end up buying at a peak, instead at more attractive prices.  We would have to think that at least some money managers are starting to become more defensive in light of the S&P 500 being up nearly 60% since the bottom.  The advisors that had been invested at the bottom would be wise to take some profits and allocate them to cash and other less risky investments.

The hordes of cash on the sidelines, which are far greater than historical norms, will likely draw down in the near future as investor sentiment is mostly bullish right now and inflation has not materialized as feared.  It will be interesting to see how the interplay of inflation concerns, investment advisors bullishness/bearishness, and other factors play into this trend.