The Business Times, Wednesday 01 Aug, 2007

Deciphering the message of the markets

By JOSEPH CHONG

ABOUT seven months ago we made some key predictions in the Business Times of Jan 10. We predicted a continuation of the bull market in global equities (still up about 6 per cent in USD terms despite the recent pullback). We also predicted a further surge in Singapore residential prices (up 13 per cent), and we were the first to publicly analyse and point out the supply crunch in 2008.

We did not arrive at these pronouncements through guess work or pure gut feel. Gut feel is used but it is never the starting point. It is resorted to only when analysis can go no further. Indeed, as professional investors, we spend most of our time discerning the message of the markets.

Digesting data releases and correlating with market action is the first crucial step in the investment decision process. It is important to understand as fully as possible (but 100 per cent is never possible) the prevailing situation. The military strategist would call this 'situational awareness'. As in warfare, one's resources could be badly mauled if decisions are made without the appropriate situational awareness.

Very often, market events are followed by all sorts of commentaries from all angles in the media. Unfortunately, there is no one market guru who will stand up and say: 'This is how you should see and exploit it.' The highly global (and secretive) nature of professional investing today now makes situational awareness far more complex then in the past because of the global nature of trades straddling multiple asset classes. Here are some recent interesting examples:

• End-February 2007: Global stock markets pulled back sharply and suddenly after remarks about yen weakness were made by the G7. Investing textbooks will tell you that there is no fundamental correlation. However, when we plotted the downward movement of global stock markets with the strength of the yen over that bruising week, we found an almost perfect correlation. Large global investors that had borrowed in yen at low interest rates to invest in higher yielding instruments elsewhere (yen carry trade) were taking profit or unwinding these trades.

• Mid-May 2007: The sudden global sell-off in government bonds. Not only US treasuries and German Bunds but Japanese government bonds (JGB) were sold. Indeed, 10-year JGBs were sold off most sharply on the day that weak economic data was released - it makes no fundamental sense! Our own analysis indicated that it was precipitated by a major asset re-allocation trade carried out by large institutions. This was because after the initial sympathetic drop in global stock markets, equities recovered to new highs despite bond yields staying high. We also found out that around the same time, large pension funds like the mammoth US$500 billion Norwegian Pension Fund (previously called the Norwegian Petroleum Fund) had increased their allocations to global equities at the expense of global bonds.

• Mid-July 2007: The sell-off in global equities and high-yield corporate bonds. Much of the noise in the media revolves around the agonising platitude 're-pricing of risk'. Our own analysis shows that this sell-off in equities could be traced back to July 10 when one of the major rating agencies decided to downgrade the entire spectrum of bonds backed by sub-prime debt. Although this appeared belated as the bonds were already trading at levels reflecting downgraded creditworthiness, an official downgrade would force investors with minimum credit rating mandates to sell. The need to rebalance portfolios when a portion of one's portfolio has gone junk, would mean that treasuries need to be bought while poor quality corporate bonds are sold - which is what has happened. This event has (un)fortunately struck global leveraged investors playing the yen carry trade.

Japanese Yen versus US Dollar (source: Reuters)

FTSE300 (source: Reuters)

Again we see a good correlation between sudden yen strength and falling European markets in the week of July 23. Gold, which normally rises in market turmoil, fell instead. This makes sense if we understand that gold is often used as collateral in yen carry trades. Now, is this a money-making opportunity?

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions