Beyond Newton's Cradle: Looking Deeper Into Market Analysis

Last weekend, we took a big picture view of the world by putting into a very simple perspective: "yield on vs. yield off." It showed that we are currently in an environment which is a "rush for yield," where assets also known as risk assets have been bid up and bought with fury as investors around the world look for some sort of income to add to their portfolio.

This has created an environment where junk bonds are now yielding the same price as risk free bonds were only a few years ago. While this is occurring in many of the developed countries, the following shows the current mania in United States junk bonds as yields continue to plunge to record lows (creating record high prices for the bonds).

I mentioned last week that while people spend all their time, attention, and capital focused on finding the best possible risk assets to add to their portfolio, I would prefer to spend my time where no one is looking: assets that yield close to nothing. This is the world of cash or currencies.

This weekend, I'll take it a step further and show how I monitor specific opportunities within the global world of cash, while we wait for this current "reach for yield" mania to subside. I will discuss "shopping list" cash options I believe have fundamental strength, and specific currencies I believe have fundamental weakness.

I will, of course, not spend my entire life investing in non-yielding assets. The pendulum will switch direction at some point in the future and the herd, crowd, or whatever you like to them, will coming rushing out of these higher yielding assets as their value bursts.

Before we begin, to give you a primer on how we got to this general over-valuation in yielding assets and how it will impact the financial world when this coming "shift" occurs, I suggest you review:

The Complete 2013 Outlook

For a review of how this general shift works in terms of capital movement and psychological behavior from the market participants involved, as well as how I personally prepare today to buy as many higher yielding assets tomorrow, I would review:

Newton's Cradle: Visualizing Asset Prices Through Capital Movements

We'll now move deeper into where that conversation left off, and we'll find that the world of cash is not all that boring, especially when you are the only one at the party.

Up Next: The Markets Are Global: How Cash Can Take Many Forms

The Markets Are Global: How Cash Can Take Many Forms

You've heard that hedge funds, pension funds, mutual funds, or your next door neighbor are holding X percentage of their holdings in cash. Usually this number is extremely low and only rises after prices fall and people become afraid (see 2008). Then, over time, the fear slowly leaves the market and investors become more and more convinced that it is safe to tread back out into the ocean.

If you think about holding cash in your portfolio you have more options than just holding X amount of dollars down at your local bank in your local currency. We live in a global financial world today and cash can take the form of numerous currencies, many of which we will talk about today. 

What follows is a simple thought experiment that I do on a daily basis to figure out where capital will perform best within the world of none yielding cash alternatives. This thought process can be extrapolated out to any asset class you believe is attractive. For example:

If I thought stocks were undervalued and under-loved, I would spend my time deciding on the best sectors within the stock market, then the best stocks within those sectors. For example, people that recommend buying stocks today may say that American technology stocks are an attractive sector of the total market. Within that group there may be a few specific stocks they expect to be the best performers, such as Google or Facebook.

If I thought real estate was an undervalued and under-loved asset class, I would spend my time deciding on the sector within the real estate market, then the best location to purchase that type of asset. For example, people that recommend buying real estate today may say that retail property is an attractive sector. Within that group they may believe that markets such as San Francisco or Phoenix will be the best performers for the retail market.

At some point, after capital and sentiment begin to move away from stocks, bonds, and real estate (higher yielding assets), we will be having in depth conversations on the best opportunities in that area.

A normal financial adviser will recommend that you have a portfolio that consists of X amount of stocks, X amount of real estate, and X amount of bonds to give you a total of 100%. The type of thought experiment we are moving through today cannot be found in a world where your adviser only makes money if you purchase from the three above.

Today's discussion is not a recommendation that someone should own (or not own) any of the asset classes discussed. It is just another way I can try to explain how my mind works when I view the financial markets, which will hopefully open your mind to the complex layers that are involved in any portfolio decision. 

Up Next: How Capital Flows Impact Currency Movement

How Capital Flows Impact Currency Movement

We live in a bizarro world today that differs greatly from the investment landscape of the 1970's and 1980's. Today, an increase in central bank printing (supply) can be met with a large rise in the currency strength (see Europe's recent movement). A large supply of new government debt can also be met with open arms (see the U.S. dollar's recent movement). In the long term, real fundamentals have the advantage, but in the short term, that is not always the case.

The currency of a country strengthens or weakens for one simple reason: there are more buyers of that currency than there are sellers. If more people are selling their yen in exchange for another form of currency such as the US dollar or the Euro (which has been occurring over the last 6 months), then you will see the value of the yen drop in the open market vs. the dollar.

This means that the dollar now buys more yen. It also means that the dollar now buys more goods that are manufactured in yen. Imagine that you make toy boats on the beaches of Japan. After you complete your toy boat you get on a real boat and travel across the sea to the United States to sell it to an American waiting to buy it on their shores.

If the Japanese yen is valued at par with the US dollar, meaning that 1 Japanese yen = 1 US dollar, then the boat costs $1 and the American can purchase 1 boat. What happens if the Japanese yen falls to 0.5 USD in the currency exchange market? The person in America converts their 1 American dollar into Japanese yen and they find that they now have 2 Japanese yen. They can now afford to purchase two boats when the seller arrives at the port.

This simple walk through is the foundation for what is taking place around the world today called "currency wars." Countries are in the process, in some cases completely open about it (see Japan), in devaluing their currency to boost their exports.

What causes a currency to be devalued?

The first and most simple to understand is an increase of the total units of that currency in existence  We know that if 10 people live on an island and there are 1,000 shells that they use as money and someone finds a secret location holding another 1,000 shells, the total value of each individual shell on the island will fall in value. Scarcity is a key component to value, not just in currencies, but in every good on the planet.

The second part is a bit more complex. When capital enters a country, it needs to find a home. As money pours in it will likely end up in the form of real estate, stocks, or bonds (looking for a "return" on the money). The largest liquid investment opportunity in a country is usually in government bonds. If an investor believes that the government is very likely to pay back the money they lend them and they are receiving a strong return (interest rate) then it becomes more attractive to buy bonds.

A Japanese citizen may take 100 yen and get back on a boat toward the shores of Australia. They arrive and go to the local Australian currency office to exchange their 100 yen for Australian dollars (the number of Australian dollars they receive is based on the exchange rate in the open market that day). They now take their Australian dollars and invest in Australian government bonds because they are a trust worthy government who provides a strong interest return.

This process lowers the value of the yen (yen is sold), raises the value of the Australian dollar (Aussie dollar is bought) and raises the price of Australian government bonds (bonds were bought).

This does not happen today with someone taking a boat to Australia. It occurs electronically, with trillions of dollars moving around the world at the speed of light.

So, what would reverse this process? If sentiment toward Australian government bonds were to fall, which could occur because investors lost faith in the government's ability to return their money in full or they expected the underlying currency that they purchased the bonds in to fall in value.

Then the process would reverse. Aussie government bonds would be sold, Australian dollars would be sold, and the yen would be purchased (or some other currency).

This is only a fraction of what is involved when looking at why a currency should fundamentally move up or down in value, but it is enough to provide a full discussion on how each currency's financial statement looks around the world.

Up Next: The Fundamentals Behind Currency Strength & Weakness

The Fundamentals Behind Currency Strength & Weakness

The thought process that I move through when deciding when to purchase an asset is a relatively simple one. I spend time deciding on a "shopping list" within a specific asset class that I feel is attractive. The second part of the process is easy: wait for an asset on the shopping list to go on sale and sentiment to become low, then accumulate.

For this discussion, we are going to talk about currencies, or options for where/how to hold cash. There are three major components that I use to determine whether I believe a currency is a long term, fundamentally strong buy:

1. The current price and sentiment of the currency on the open exchange

2. The government debt to GDP within that country

3. Interest rates within that country

There are numerous other factors involved, but these three will provide us with a foundation for the scope of the discussion. Based on the insane nature of the currency wars taking place around the world, if you only use these three benchmarks to make your decision you will do better than almost all other investors in the long term.

We'll begin first with the currencies that are currently on my personal shopping list. I would suggest you do your own research to develop your own:

1. Canadian Dollar

2. Australian Dollar

3. New Zealand Dollar

4. South African Rand

5. Swedish Krona

6. Norwegian Krona

7. Malaysian Ringgit

8. Mexican Peso

After discussing the big three characteristics above for these 8 currencies, we will move on to the group of currencies I believe are fundamentally weak:

1. U.S. Dollar

2. Euro

3. British Pound

4. Japanese Yen

Over the next decade, I believe money will be moving from developed (bankrupt) to developing (healthy balance sheet) countries. This will not occur in a straight line process due to the fact that markets tend to act irrational for long periods then make major shifts to re-adjust. 

I like the eight currencies discussed above. I also like others. Do I recommend that someone move 100% of their cash position into those currencies today? NO! Again, this is just my shopping list, not the only currencies I own. Many of these currencies have performed well since they bottomed in 2009. This makes them less attractive at the moment. Others have not, making them stronger buys. We'll discuss the price movements for all of them.

I think the majority of a cash position today should be held in "safe cash," or pre-crisis cash, which I have discussed numerous times over the past few years. This represents ultra-short U.S. treasury T-bills. Why? The U.S. dollar, for all its flaws, is still the world's reserve currency and if there is a liquidation moment in markets there will be a scramble for liquid U.S. dollars.

This is the moment you can trade in your fundamentally flawed U.S. dollars for the items on your shopping list that are (hopefully) selling at a discount. 

I think we have one more "great" liquidation in front of us before you can feel comfortable moving 100% of your portfolio out of U.S. dollars. In the meantime the process is easy. You make your shopping list and raise safe cash. Then all you have to do is wait for the sale light to go on. We'll now review the markets discussed above and you can decide if they represent attractive assets for your personal list.

Up Next: The Canadian Dollar

The Canadian Dollar: Price, Government Debt, & Interest Rates

The following charts come from the team at Trading Economics. Their site is an incredible resource for all sorts of charts and information.

The Canadian dollar fell to a low of 80 cents against the U.S. dollar during the panic of 2008 and has since rebounded to parity and has hovered at that level for years.

Since 2000, the 10-year government bond has fallen from the 6% range in almost a straight line decline to today's 2% range.

The Canadian debt to GDP has moved from 66.5% in 2008 up to 84.6% today.

Up Next: The Australian Dollar

The Australian Dollar: Price, Government Debt, & Interest Rates

The following charts come from the team at Trading Economics.

The Australian dollar has risen from 0.50 U.S. dollars in 2002 up to over 1.0 U.S. dollars in recent months. The currency fell to as low as 60 cents during the financial crisis and hit 80 cents in mid 2010. It has the ability to plunge quickly then recover rapidly making it an excellent "shopping list" currency.

The Australian 10 year government bond hovered between 5% and 6% for 13 years before falling to the 3% level seen today.

The Australian government debt to GDP rose from 9.7% in 2008 to 22.9% in 2012. 

Up Next: New Zealand Dollar

New Zealand Dollar: Price, Government Debt, & Interest Rates

The following charts come from the team at Trading Economics.

The New Zealand Dollar rose from 0.39 U.S. dollars in 2000 to 0.83 U.S. dollars today.

The 10 year New Zealand government bond fell from a consistent 6% over the last 13 years to 3% after a recent sharp decline.

Government debt to GDP rose from 17.4% in 2008 up to 37% in 2012.

Up Next: South African Rand

South African Rand: Price, Government Debt, & Interest Rates

The following charts come from the team at Trading Economics.

 The South African Rand fell to 0.09 U.S. dollar's during the financial crisis, then rose up to 0.15, and has now fallen back to .11.

South Africa's debt to GDP rose from 28.3% in 2008 to 38.8% in 2012.

South Africa's 10 year government bond has fallen in a steady decline from 14% in 2000 to 6% today.

Up Next: Part 2: The remaining strong currencies. The weak currencies. Plus a discussion on gold and silver.

Jeffrey Gundlach Discussion On The Global Financial Markets

The following is an excellent interview from Reuters with Jeffrey Gundlach of Doubleline, not only due to the quality of the questions but the clear responses from one of the best minds in finance today.

The interview covers asset classes around the world, both where they are today and where he sees them heading moving forward.

His fund, DoubleLine, currently has over $60 billion under management. He became a household name during the middle of last year when he was one of the very few (perhaps the only) voices who recommended shorting Apple stock just a few months before it peaked and collapsed.

Japan's Government Bond & Currency Markets Begin To Tremor

The Japanese financial markets are beginning to get exciting. I have discussed many times over the last 18 months that the announcement of the ECB to do "whatever it takes" marked the entry into the second phase of the sovereign debt crisis.

During this phase of the crisis, you will see the perverse economic consequences for what has now become gospel for economic recovery: unlimited government spending combined with unlimited central bank printing. It is now widely believed that the only mistake policy makers can make is not doing enough of either one.

During these many discussions on this second phase of the sovereign debt crisis I mentioned that I believed Japan would be the first country to implode. It could just as easily begin in Europe, the United States, or the U.K. (and it will eventually arrive at all three), but for countless reasons discussed Japan is simply a powder keg waiting for a match.

The match was lit upon the announcement of their most recent quantitative easing program discussed in detail here: Japan Steps Into The Abyss: Begins The Largest Money Printing Experiment In History. Now it is just a question of how long the fuse will burn before it ignites.

Back in late 2012, when it became clear that the new leadership at the Bank of Japan (their version of the Federal Reserve) would do "whatever it takes" to take the lead in the currency war, meaning devalue their currency through money printing, the Japanese Yen has been in a straight line decline. It crossed below the 100 mark against the US dollar this past week.

The central bank has the ability to control the price of the Japanese government bonds, due to their ability to print enough money to purchase every bond in existence. However, if the markets chose to protect themselves against the promised currency devaluation it is impossible for them to simultaneously keep control of the value of the yen and protect the yields on bonds. At some point they are going to lose control of one.

It is likely that they will eventually lose control of both markets simultaneously as more and more investors in Japan and around the world begin to understand what is taking place. An interesting thing began to happen in the long term Japanese bond market 4 days ago, which people have said for years now would never occur.

Prices began to plunge.

The following chart shows the incredible move in 10 year government bond yields from the 60 basis point range to the 90 basis point range in only a few short days. Bond prices move down as yields move up.

The central bank is currently purchasing over 70 percent of all government bond issuance, which makes the current move even more incredible. If yields keep moving higher, they will be forced to buy more. They cannot allow yields to rise because the cost to finance the debt would instantly overwhelm the entire government annual tax receipts. Is this the moment that the central bank finally loses control?

Stay tuned.

For details on how the individual investor can participate in this trade see:

How To Short Japanese Yen & Government Bonds Through ETFs

h/t Sober Look