Forward Looking Statements

watch the yen

We all saw the china sell-off ripple through the world today, shaving 3.5% of the S&P500.

As everyone knows, there's been a lot of money sloshing around.  Many know that a lot of that liquidity was provided by the carry trade, with funds borrowing in yen to make purchases elsewhere, including in the US.  Those activities pushed the yen even lower, and roughly speaking, made it seemingly more attractive for the next fund to borrow in yen, to buy in dollars. 

The Economist is looking very smart today, having run this article on Feb 8, 2007, with the title:

"Japan's currency, Carry on living dangerously.  Speculators and low interest rates have helped cheapen the yen, putting the world economy at risk." 

The Economist thinks the yen may be undervalued by 40% and notes in the article that according to "record net “short” positions in yen futures on the Chicago Mercantile Exchange...estimates of the total size of the carry trade range as high as $1 trillion."  that's a lot of money that's relying on an un-appreciating yen.

I think there were two very important news items today.

1) No one has identified the reason behind the sell off, which simply says that we don't know what might be next and how people might react.  The unknown unknowns just increased, and the risk premium just went up.

2)  But the most important news item isn't the 3.5% drop in the S&P 500.  It's the the fact that we saw yen based trades were being unwound - people were buying Yen to cover the carry trade.  As far as I can tell, the yen appreciated less than 2.5% on tuesday, and opened weaker Wed Feb 28th - looks like we dodged a bullet today because the Japanese government reports showed a drop in industrial production and retail sales - if those reports had been different..

What happens over the next week will be very telling.  If some good news about Japan's economy comes out, you could see the yen appreciate.  And if bad news happens in the US, then certain funds might have to unwind their yen borrowings, which would also drive up the yen.  And either of these could drive the yen to rise significantly, like a stock when the shorts need to cover.  In 1998, the yen appreciated 13% in a very short period of time, the carry trade was hurt, and it wasn't pretty.  A repeat could dry up a ton of liquidity, and that could lessen demand for shares around the world.  And a few funds that were reliant on the carry trade could blow up, triggering more supply.  That would be bad for equity prices everywhere. 

Watch the yen, to find out what's going to happen to the US stock market.

Google: cheap at a 27x forward PE?

Rick Munarriz at The Motley Fool has this to say about Google's valuation.

It's one of the most intelligently thought through articles on Google's valuation I've read.   

Nice one - thanks go to Rick for making the discussion about purchasing expected future cashflow - many articles these days are arguments about the company, not the investment.

Decades of Growth?

Thought this was a good article worth reading - which suggests that a slow down of the US economy is not imminent.

The global economy, it asserts, is on the threshold of a decades-long deflationary boom that will lift America and much of the world to unprecedented prosperity. Its optimism stems from a theory that profound economic changes have and are taking place that have been ignored by most commentators -- specifically a business model it calls the "platform company."

Read more about the platform companies at Seeking Alpha and citing such "platform companies" such as Apple, Motorola, HP, Dell, and Danaher, among others.

My view is that the author is bang on the money for platform companies but that he extrapolates into hyperbole on two points:  1) specific companies vs. the economy and 2) the time horizon.

1) I don't see a compelling argument that platform companies constitute a large enough portion of GDP to create a systematic decades long deflationary boom.  GM?, McDonalds? there are many, many non platform companies in the S&P 500 and the broader market indexes.

2) Decades?  Maybe if you're a stock picker (I'm not) - then perhaps you can get quarters (maybe years) of good alpha from factoring in platform companies, but decades? 
puhlease.  these platform companies are predominantly growth companies and therefore trading at high multiples - NOT the 17x PE of the S&P500.  Example, Apple, a platform company, trades at a 36x PE - the implied growth and cash flow implied cannot reasonable be expected for decades. There is such a thing as competition, business cycles and reversion to the mean.

That said, there are some very good points raised in the article.  I think we've got another good year in 2007 and then absolute returns are going to get harder to come by. Maybe, just maybe, I'll rethink my bias toward index funds (or not).