One World, One Market

Dec 5 2007 | 6:48am ET

By John R. Taylor, Chief Investment Officer, FX Concepts

Managing an institutional portfolio in today’s world has become a 24-hour-a-day and five-days-a-week job, even if your portfolio is a domestic one. The European equity markets as a group are correlated with the US market and the Japanese market at better than 0.7, which means that over 50% of the movement in Europe can be explained by movement in Tokyo and New York, and vice versa. Even if my day job were on the Paseo de la Castellana managing a portfolio of Spanish equities, my night job would take me around the world, watching all the other markets to glean information about the next day’s move. It sounds like fun, as I now know more about places than I ever dreamed possible, and I never have any boring slow moments when I am supposed to be at home with my family. But, the tight relationships between global markets have a more serious downside, as it is no longer possible to construct a low risk portfolio, made up of many uncorrelated or slightly correlated investment markets. This means that all the investors in all the various markets are watching each other and are forced to move at roughly the same time to make sure that their performance is not destroyed by a synchronized shift across all parts of their portfolios. All portfolios are riskier than they used to be.

Why has this happened? Even while this inter-market correlation has grown so dramatically in equities, interest rates and foreign exchange in the last 20 years, the correlation among the economic and political fundamentals, within the nation states in which these markets reside, that should control prices in these markets have remained very independent and have continued to show their peculiarly local and national characteristics. The economies are as unconnected as ever, but their markets are tied to a global grid that seems to be tightening each year. Although the market realities do not seem to support this move, the growth of global portfolios, and especially hedge funds, have pushed the whole world into the same box. Long only funds hug the benchmarks, buying some of all the markets and trying to find the bits that are undervalued. As hedge funds can both buy and go short, almost all of their strategies can be summed up easily: buy cheap things and sell expensive things. The nails that stick up too high are hammered down and the holes in the flat terrain are filled in. Global investors smooth the markets, cut volatilities within markets and among them, and minimize outliers everywhere.

Academic studies have shown volatilities declining around the world, and as the trading algorithms get more sophisticated the internal market jigglings will become more and more suppressed. This results in markets that have very low volatilities, but are leptokurtic, so they have a pinched distribution around the mean with long, fat tails. Markets that are leptokurtic are very steady and lull you to sleep and then explode in unexplained violence as all the managers have the same position and must get out. These markets have a six or seven standard deviation event every year or so, and this is getting to be an every day occurrence. This trend will continue until the “low risk” relative value managers perform poorly enough to be balanced by directional traders, buying stocks or currencies because they are going up, not because they are cheap. Trend followers and old style macro traders should be ready for a rebirth.

Cyclical Perspective

The major financial event of the past five months has been the widening of credit spreads and the increasing breakdown in the short-term market for liquidity. Historically these periods of deteriorating banking indicators are short-lived as the Fed either jumps in to provide support or is overwhelmed by events that it has not been able to control. In either case the move is usually completed within a year, and a new period of economic expansion begins. Because of that history, we would say that even though we don’t know whether the Fed will manage to control this situation or will watch it spin out of control, the recent crisis should be over by the end of February. As our cycles expect the dollar to form an important bottom at about the same time, there is a good chance that we will see a major reversal in the financial outlook by the start of March. The US and the world should shake of the trauma of the past year and begin a new expansion.

However, there is a very good chance that the US financial stew that has been bubbling away will not disappear because the real estate and construction markets will not recover until the end of 2009 at the earliest – or so the cycles argue. This would mean that US interest rates will be low until that time, and our interest rate picture confirms that view. As there are further cyclical highs expected in late 2008 for yen and in late 2009 for gold, our outlook for the dollar is bleak. Low interest rates and strong commodity prices imply a weak dollar so the dollar low that we expect in February – no matter how dramatic it is – should not be the final one for the currency.

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