Saturday, June 15, 2013

Craftiness into crapiness...

Here's an explanation of how stock market volatility can be caused by factors other than the factors you and I consider when buying stocks for the long-term. And yet another reason to never ever attempt to time the market:

The new Japanese prime minister has vowed to manipulate the yen into the cellar to promote an export-driven economic boom (somehow that's criminal when China allegedly does it, but a-okay when Japan and the U.S. do it). Believing he just might pull it off, let's say you---the ever-crafty trader---decide to exploit an "obvious" opportunity: So you borrow, say, a million yen from a Japanese bank, convert that to ten thousand U.S. dollars (I'm rounding) and buy an S&P 500 index fund.

Here's what you're BETTING on:

For starters, let's say the dividend on the index fund amounts to 2.0%, while the interest rate on the Japanese bank loan is 0.15%---you're thus making nice money right from the get-go. In fact---given that you're investing borrowed money (your cost is just the interest on the loan)---you're making an absolute killing!

And if the U.S. stock market advances while you're in this trade you could be making a killing of a killing.

Example: You hold the trade for a year, the S&P fund nets you a 10% return, your fund is now worth $11,000. You pay back the yen-denominated loan which, in U.S. dollars, amounts to $10,015. That's a cool $985 profit, piece a cake! A huge piece a cake!

Now the real kicker: This is where your craftiness comes in. Remember, the Japanese have vowed to devalue the yen, so let's pretend they succeed to the tune of 20% over the course of a year. Which means that it would no longer take 100 yen to make a dollar, it would take 120. Which means that you only need $8,333 to pay off your million yen loan. Which means there's an extra cool $1,667 added to your $985. Now we're talking an utterly monster rate of return.

Now the BIG BUT! But, if, as has been the case of late, the yen, for whatever reasons (rising interest rates perhaps), defies the central planners and actually appreciates against the U.S. dollar, your craftiness soon turns into utter crapiness. You don't make a killing, you get killed.

Example: You're in the above-referenced trade, the yen spikes, say, 20% against the dollar (to 80/dollar). It now takes $12,500, plus the pittance in interest, to pay off the million yen loan. But you only have $10,000 (or so you thought) in your index fund, which means you're out a (relative to the size of your scheme) big chunk of money. Oh, but it's much worse than you thought; you, alas, weren't the only big-betting-bloke out there. Carry trades are the addiction of hedge fund geniuses, and, I assure you, they carried out that scheme to the tune of billions. And they're much quicker, and much more resourceful, than you. They stormed the gates (out of the dollar [denominated stocks] and back to the yen) when it gained only 5%, which of course exacerbated the rise in the yen, and---UH OH!---a decline in U.S. stocks. Now you're really screwed; your $10,000 is worth $8,000 and you owe $12,500, and you're not Long Term Capital Management and there's no Alan Greenspan to (despicably) come bail you out (which is a whole other discussion on moral hazard): Read Don't Worry My Child, I'll Buy You a New One...

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