October 4, 2013 Update

DJIA:14,996 S&P 500:1,679 NASDAQ:3,774 Gold:$1,316 Oil:$103.69 EURO:$1.36 YEN:97.20

Investing on Overextending

The global economy is facing a unique combination of exogenous pressures. The markets have become reliant on central’s bank ability to provide liquidity and manipulate interest rates, the old  financial and political problems are beginning to resurface throughout the Eurozone, and the source of growth in the global economy over the past decade is beginning to slow down as the emerging markets face a credit crunch and see an increase in NPL. Since the Fed has depressed yields, the search for return in this market environment is real. No one is being properly compensated for the risks they’re taking, which has consequently caused investors to increase their appetites for risk and alter their perceptions of appropriate return. It seems to me that the best opportunities in this market environment would be to invest around the central bank’s ability to encourage borrowing and inflate the asset market. The financial sector, for instance, are reaping all the benefits of the central bank’s dishonesty. Because of the Fed’s ability to skew risk premiums, the banks can pay low interest rates to their depositors and then lend those deposits to borrowers multiple times and receive a higher interest rate than they’re incentivizing savers with. By nature, banks are highly leveraged institutions and the forward guidance brings the cost of leverage to zero. The incentive to use financial leverage to bolster returns is strong, which creates temptation to increase and overextend exposures. Forward guidance has make leveraging free by eliminating roll-over risk on short-term funding positions. Since banks borrow short and lend long, they’re positioned well as long as quantitative easing continues. Credit expansion accelerates economic growth. The low incentive to save and temptation to borrow could temporarily relieve some exogenous pressures and points to signs of recovery in the economy. If this is true, then cyclical sectors should outperform this quarter and ride tails of an stronger economy. The recent speculation and concern over when the Fed will begin to scale back the asset purchasing program has placed downward volatile pressures on the market, which could provide a solid opportunity to get enter the market. In addition to cyclicals, higher returns could also be seen in consumer durable and technology companies that have a large presence in the emerging markets. As the demand for commodities from developing countries begins to weaken, I think it could be time to focus on how the emerging markets are developing. A rise in per capita income could shift spending trends, and cause an increased demand in durables and technological goods as the countries continue to modernize. Since a weak dollar is good for international equities, EEM could also be an investment that could continue to lift as central bank’s dishonesty continues. Buying the VIX would be a good hedge against these bets, as it trades inversely and will spike when the Fed tapers (and both financials and EEM are extremely sensitive to tapering speculations). The market is currently experiencing the largest manipulation of interest rates in history, and as long as it continues to expand credit the printing presses remain hot the economy and market will show signs of improvement. Betting on financials and spending shifts in the emerging markets (despite their credit crunch), and using VIX as a hedge could be an investment that overextends returns without having to adjust risk appetites.The economy is facing pressures that have no precedent, investing on the incentive for consumers and corporation to overextend their positions and increase leverage could provide the return investors are hungry for. 

Domestic News

• Market Update Futures are trading up as investors wait for speeches from the Federal Reserve. 
• Due to the shutdown, the government will not be releasing data on nonfarm-payrolls. I always thought the data came in earlier than the release date, not releasing employment figures is fishy. 

International Updates

Asia

• Market Update Markets traded up from yesterday’s upbeat economic data, despite the continues shutdown of the US government. 

Europe

• MMarket Update Markets are up despite the US political contagion.