After the Bottom, Then What?

Some day soon, maybe today, maybe in a month, the stock market will find its bottom. Some technicians are predicting 7500, which is the same as the market lows in July 2002 and March 2003. Those form a natural line of resistance for the DJI. Others, like Art Cashin, the CNBC old-timer floor trader, thinks it might be 7000. It is very unlikely the market would crash down to 5000 or 4000. That would require the economic depression scenario, since it will require much lower aggregate corporate earnings to drive stock prices that low. Most think a depression is possible only if the global bankers do not respond with aggressive money creation. So far, the central bankers have responded.

What will be the investment class that does best coming out of the market slump? If you think that all the liquification to unfreeze the financial markets comes with the price of much higher inflation, as I do, then the best place to be will be asset classes that benefit from inflation: hard assets / commodities.

Have you noticed how the global deflationary environment rewards currencies that are doing the most to reinflate their economies, like Japan and the USA? The dollar has soared the past two months from $1.60USD per 1 Euro, to $1.20USD to 1 Euro, a 25% move. The turnaround in Japan is even more dramatic. The yen is now trading at 92Y per $1USD while it was at 120Y per $1USD just a few months ago. The Euro has weakened against the Dollar and the Dollar against the Yen. The Euro has weakend by 40% to the Yen in just a few months. Amazing! And disruptive! How can Japanese export goods compete in Europe after such a currency move? The answer is, they can't. This is why the Japanese Nikkei stock index dropped to a 26 year low today.

This is all about the unwinding of the "Yen Carry Trade" where global investors borrowed the very cheap yen, with interest rates in Japan at only 0.5%, and loaned the same money in other countries at much higher rates, or used the funds to finance commodities futures transactions, which helped drive up commodity prices. With the trade now in full-speed reverse, all that borrowed money is flowing back to the Yen as traders and hedge funds sell their positions and repay their Yen borrowings. As they do so, they convert some / most of their Yen back to US dollars, which strengthens the dollar. Because they are preparing for fund redemptions, they put the funds in very short term, super safe US Treasury bills. This causes competition for Treasury bills causing the interest rates on those instruments to drop to ridiculous low levels of less than 0.25%.

Even the Canadian dollar has gotten into the game, and has gone from parity at $1C per $1USD to $0.78C to $1USD in just a couple months.

On this last point, it has made the performance of the Canroys and other Canadian stocks more dismal when converted to $USD. My Canroy stocks, like Pennwest, Pengrowth, Provident, Canadian National Resources and Daylight Energy, are all down 50% or more the past two months. So is DHG, the closed end high dividend fund that is heavily invested in Canroys. About 1/3 of this decline, though, is the exchange rate. The other 2/3 of the decline can be attributed to the decline in the price of oil, which itself is because of the unwinding of hedge and mutual fund positions. That is a temporary phenomena, so long as I don't have to sell. Since mine are (now) completely unlevered retirement funds, I can hang on till the environment changes. Most of the Emerging Market stocks (Brazil, Mexico, Russia, etc) share with Canada their reliance on commodities for their economy and currency strength. So, emerging markets will also benefit from a global change in sentiment.

What will cause this change? Reflation. Once the markets, and then the economy, bottom, and economic growth reappears here in the USA, but even more dramatically in the emerging markets, global demand will once again increase for all things commodity: energy, grain, metals, chemicals and gold. I do not believe that the global banking system is nimble enough to take all the liquidity back out of the market that has been put in to save the financial system, as fast as will be necessary to avoid inflation. I think inflation, maybe relatively high inflation of over 5%, is a certainty within 24 months. The pain to avoid inflation will politically be just too great, as it will require buying back the financial instruments issued to flood the economy with money. When central banks buy back financial instruments, they raise interest rates in the process and make capital more scarce. It will be hard to take actions that will hurt the economy almost as soon as it starts to get repaired.

So, if you can stomach the volatility, and if you are still invested today, then I guess you have proven you can, hang on to your energy and commodity stocks. If possible, buy more, or at least reinvest dividends to capture more stock at the current low prices. The next couple years will not be much fund. But eventually the sun will shine. And if the 1970s are any precedent, it will shine most brightly on asset classes that benefit from too many dollars chasing too few goods.

Bill Gross, the oft quoted chairman of PIMCO Advisors and global bond guru, agrees with this perspective. Today on CNBC he made took a similar position (I was just happy to be aligned with his perspective, certainly not the other way around). I have posted his appearance for your viewing pleasure (see right hand bar).

www.cnbc.com/id/15840232?video=906626482