Last week, I wrote that the Wall Street consensus idea — that markets would just keep trading in a range — was a “crock of you-know-what.” I also said, “I believe the market could be on the verge of a very large break … and my suspicion is that it’ll be to the downside.”
Boy did that ever pan out! Exactly one trading day later, the Dow Industrials plunged almost 1,100 points before recovering somewhat. Then it dropped again amid a volatility explosion, before trying to launch a deeply oversold bounce.
Many traditional analysts and CNBC pundits are running around trying to grasp for explanations. They’re blaming everything from computer trading algorithms to investors who just don’t understand their worldview that everything is peachy.
Hogwash! This crisis is completely understandable. It’s the result of all the forces I’ve been discussing with you for months on end — weakening economic growth at home, massive turmoil in China and other emerging markets, breakdowns in multiple U.S. market sectors, and huge warning flags coming from the bond market.
But one factor I haven’t talked about YET — but need to share with you now — is the implosion of massive, global “carry trades.” In simple terms, a carry trade is when you borrow money from one cheap, low-rate source of funds and invest that money in a more expensive, higher-rate asset. Your profit is the difference in what your funds cost to borrow and what you earn from your investment.
The $5.3 trillion currency market is famous for this. Investors worldwide are constantly borrowing in the cheapest currencies they can find, and investing those funds in higher-yielding ones. They use massive amounts of leverage to increase their returns. And they count on making money from both moves in underlying currencies, and the increasing value of the assets they buy with their borrowed money.
But those trades are now, to put it in layman’s terms, “blowing up!”
The non-stop devaluation in carry trade currencies like the Japanese yen, Swiss franc, and euro is starting to reverse. That’s causing losses on the borrowing end of the carry trade. Plus, the currencies, stocks, and bonds they invested in — oftentimes higher-yielding emerging market assets — are all plunging. That’s causing losses on the investing leg of the carry trade.
In other words, they’re losing money coming and going. Just look at this long-term chart from a Bloomberg story earlier this week. It shows the performance of a Deutsche Bank index that tracks carry trade profitability …
You can see that imploding carry trades helped cause the market meltdown in 2007-08. And you can see that this carry trade index is now rapidly falling, dropping back toward the levels we hit during the depths of that meltdown.
That is yet another reason — as if we needed one — that stocks could be living on borrowed time. After all, the Dow Jones Industrial Average was trading for around 10,000 the last time this index was trading at these levels.
Bottom line: If you haven’t already cut your stock exposure, raised cash, grabbed gains and cut losers, please don’t wait much longer. Take advantage of oversold rallies to lighten up.
I also urge you to start looking at strategies that haven’t really worked for the last six-and-a-half-years, but that are starting to crank now. I’m talking about using inverse and leveraged ETFs, put options, and other plays on increased volatility, falling asset prices, and declines in vulnerable, lousy-rated or risky stocks. They are all vehicles that can help you profit as global carry trades implode.
Indeed, my Interest Rate Speculator service has already been hitting the ball out of the park. And I think we could be just getting started given this latest carry trade catalyst.
Until next time,