Friday, February 4, 2011

Inflation (Currency Depreciation) Looms Large: Investors Seeking Protection For Their Wealth

Equity stock market is afloat on two-year high during a period of consolidation. External events such as the turmoil in Egypt caused temporary swing but did not drag down the market. Investors appeared to hold very tight for their positions to embrace potential paper loss temporarily but to benefit from the longer term asset appreciation. Hedge funds and individual investors previously attempted to move away from equity stock market to the sideline. The former dared not to short against market in the beginning of year after initial attempt and then switched to accumulation instead. The latter quickly felt uncomfortable holding cash on the sideline and promptly jumped back to the market. Those reaction supports market to buoy at current level.

Market participant sentiments are diversified. There are both buyers and sellers among institutional investors, individual investors, as well as hedge funds. The common anticipation is a possible short term correction which causes speculative day trading activities. However nearly all market participants anticipate a rising market trend in the year ahead. Wealth effect and greed encourages investors to take risk on possible short term temporary loss during market correction, rather than to miss a pop on market momentum. Therefore, any market dip quickly attracts speculative buyers and reverts movement direction. On the other hand, investor confidence are fragile and extended rally causes anxiety as short term overshoot for profit taking. During this market consolidation period, this scenario provides opportunity for risk-taking speculative traders. Despite anticipation from the majority of market participants, a sizable market correction is unlikely due to increasing risk appetite of investors, unless for "black swan" event that creates investor fear running for exit door.






As mentioned in earlier post dated back on October last year, it is observed that individual investors begin to return back to equity stock market after long waiting period with cash on the sideline. The flow of capital into equity stock market continues while investors begin to exit from treasuries and bond market at the same time. The article "Big Returns on Bonds Have Come and Gone" has similar interpretation on market observation as the speculative investment portfolio trading philosophy.

A. It will be difficult for fixed-income investors to make any reasonable rates of return this year (and perhaps for the foreseeable future) if rates begin a secular trend toward higher yields;

B. "Pick your poison" -- credit risk; currency risk; interest rate risk; or switch to equities to achieve a positive rate of return on your nominal dollars (before adjusting for inflation) -- the "easy ride" in bonds is over;

C. This makes life for investors difficult trying to find "safe" returns (ask anyone who has held a municipal bond since November how "safe" they feel), and it effectively forces all investors to embrace some type of risk if they hope to achieve a rate of return from what used to be considered their "safety net";

D. Ben Bernanke and the Fed have achieved one of their goals (creating a positive wealth effect) by driving money market rates and fixed-income yields so low that, inevitably, investors have no choice but to look for returns by gravitating away from bonds and toward equities (and commodities, of course); and

E. To be clear, this perspective could be wrong, and interest rates may not head higher (or they may rise very slowly over time). Take a look at David Rosenberg's commentaries at Gluskin Sheff for a very different perspective on the direction of interest rates versus the view espoused by Gross.


Although the perception on market trend has been correct since last October, the speculative trading portfolio performance is not impressive despite a moderate gain better than broad market index. In consideration of leveraging and active management, the performance is below reasonable expectation. One of the major shortfall is in the timing of market cycle. For short term timing of intra-day trading, it is not easy to predict a trend out of the random nature of market movement driven by market participants instantaneous reaction. However, for longer period of time spanning overnight or days, the picture may be clearer from observation of market participants activity. The entry and exit point of most tradings are mostly far from the optimal time for maximum profit. Some trades incur a loss which can be avoided if the timing of trade execution for position opening or closing is advanced or postponed for a few hours or less.


The trading skills of day traders may not be easily acquired. However, with longer time span between trading transactions, the confidence can be improved with more data analysis of market participants activity. Therefore the speculative trading strategy is adjusted accordingly to accommodate overnight equity holding which is previously suggested to avoid to reduce risk exposure. For risk mitigation, overnight holdings should have less leveraging than day trading positions and adequate borrowing margin buffer should be provided. Previous experience during financial crisis serves as a painful reminder on the destructive power of over leveraging in an environment of extended unfavorable market movement.

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