Well, as I said in last week’s update, volatility has returned. It was another wild week in global markets with politicians, central bankers and even some actual economic data providing the fireworks. Japan barely kept the JGB/Nikkei roller coaster on the tracks with a wild week that ended with the Nikkei in what some are calling a bear market since it has dropped 20% from the high. Frankly, I think that is ridiculous since the  Japanese stock market is still up 50% since mid-November. Get some perspective people. Anyway, Japan looked like it might be stabilizing and then Abe had to open his mouth and provide some detail about the third leg of his reform program. Unfortunately, it wasn’t detailed enough or it wasn’t bold enough or something and the Nikkei managed to trade in a 700 point range – on Wednesday.

In a stark illustration of how interconnected global markets have become, the Japanese volatility bled over to other markets through the Yen carry trade. As the Yen rallied, emerging market and European periphery bonds sold off along with US stocks, junk bonds and assorted other risk assets. Mario Draghi supposedly goosed the unwinding of the European leg of the carry trade as the ECB refused again to join the QE party. Or at least that’s what I read last week. I’ve been in this business over 20 years and I’ve never actually met anyone who has done, is doing or is contemplating doing the Yen carry trade and neither have most of the folks pontificating on it. It is sort of like a financial market Yeti with alleged sightings but few if any credible first hand accounts of its existence. I actually have no doubt that there are some highly leveraged funds or bank trading desks out there doing this trade – borrowing in a devaluing Yen and buying assets in other currencies with a higher yield – but as for quantifying it, well good luck with that. Anyway, suffice it to say, most of last week was highly volatile for some good reasons and possibly due to some unwinding of the Yeti trade.

Japan’s correction or whatever you want to call it is not something I’m particularly worried about. Japan will either follow through with some real structural reforms in which case I think the economy can perform better than most anyone expects right now. Or they won’t and this rally will end like all the other ones of the last 2 decades. Our bet from the beginning of our investment last summer was that Japan was out of options and that a combination of Yen devaluation and real structural reforms was inevitable. If we’re right about that – and so far we’ve only gotten the Yen devaluation part right – we think the upside is much greater than the 50% we’ve made so far. But it won’t happen overnight and there will be bumps along the way.

As for the US markets’ volatility last week, I suppose it could have had something to do with Japan but frankly the weak economic data early in the week was certainly sufficient to cause some angst among the longs. The ISM report Monday showed the manufacturing sector contracting with a reading of 49. Obviously, that is moving in the wrong direction but it should be noted that the 50 level has been breached many times in the past without a recession being the end result. The ISM was followed by a string of weaker than expected reports from construction spending to factory orders to a weak employment component in the ISM Non Manufacturing survey to a weaker than expected ADP employment report. We also got another drop in mortgage applications and a trade report showing a weak rebound that wasn’t enough to reverse the recent downtrend in global trade.

Of course the string of weak data was nothing new. We’ve been highlighting the weakening trend of the economy for several months now. But the market hasn’t cared, preferring instead to focus on some hoped for improvement at some undefined but always in the future date. Over the course of this rally, fear has been in retreat. First gold, the ultimate fear trade, had an ugly selloff culminating nearly 18 months of steady downtrend. Then over the last month we’ve some something similar in the Treasury market. Treasury notes and bonds sold off and TIPS sold off even harder as inflation has become more scarce than privacy. On top of that the US dollar has been rising and contrary to what has become conventional wisdom the last decade, that isn’t bad for stocks. If you put all that together – falling inflation expectations, rising stocks, rising bond yields, rising dollar and falling gold – about the only conclusion you can draw is that the market – or more accurately the people who have been buying it – has been anticipating better real economic growth. Despite the weakening of the actual data. Despite a gridlocked Congress and executive branch that can’t seem to do anything positive. Despite falling incomes. Despite the Fed’s QE having almost no noticeable effect on the real economy.

But finally, it seemed at the beginning of last week that the message of the weak economic data was starting to get through and fear was starting to get a little lead on greed. Then Friday came the employment report and while it was the same muddle through type report we’ve been getting for almost two years, it was enough to inspire the optimists sufficiently to wipe out all the losses in the stock market from earlier in the week. It wan’t enough to completely reverse some of the damage, particularly in the currency markets where the US dollar took a beating against almost everything, but overall I have to say the week was a win for the glass half full crowd.

From whence this optimism springs is a mystery to me. The problems facing the US and global economy are not ones that can easily be repaired and in my opinion can’t be solved at all by monetary policy alone. Quantitative easing is at best a palliative and is probably more accurately described as a placebo. The US economy needs major supply side reforms and until that happens the best we can hope for is the occasional cyclical upturn and potentially another round of bubbles and malinvestment from monetary policy. The Fed is doing what it thinks it needs to and is required to, but it is overmatched by an economy suffering from too much debt, too little savings and investment, overly complicated regulations, an out of control tax system (and IRS apparently) and a financial sector that has become the tail wagging this dog of an economy.

For now it appears the bulls will succeed in pushing the market higher until either the growth they hope for magically appears (and economies do that sometimes so it isn’t completely out of the question) or something happens to finally crush their hopes and dreams of better earnings growth. Fundamentally, stocks are, at best, fairly valued and unless profit margins are never coming down ever again, pretty obviously and significantly overvalued. But in the eternal market battle of fear versus greed, greed is winning in a romp right now. For long term investors, the best stance is to not get too emotional either way. When greed is winning, like it is now, be fearful. When fear is winning, be greedy. Needless to say, we remain firmly on the side of fear right now with our portfolios positioned conservatively (although we did lift some small hedges Friday).

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.