March 4, 2007 – It’s funny how I continuously see articles originating out of the U.S. financial media that slam foreign markets as being dangerously risky, a crap shoot, and so on, yet never speak about the weaknesses of the U.S. markets. When foreign markets correct, it’s always due to their “greater risk” but when U.S. markets correct, it’s just a blip not to worry about. I guess it’s ignorance and part nationalistic pride. Sure, Chinese markets are not as transparent as the U.S. or U.K. markets and accounting standards may not be what we desire, but this doesn’t mean that investing in Chinese markets has to be a crapshoot. It may take a little bit of care to find the right stocks and it might take discipline to take profits off the table when you have them (but this is a rule that you should employ in developed markets as well).
When I hear American financial analysts tout unreliable foreign company’s financials as the reason they avoid them, I only have to look at the past several years to find a whole boatload of American companies that had been embroiled in scandals for cooking the books. Among these companies were Adelphia, AOL Time Warner, Arthur Anderson, Bristol-Meyers, Squibb, Freddie Mac, ImClone, Citigroup, General Electric, JP Morgan, Lucent, Duke Energy, Dynergy, Enron, and Global Crossing. Want more? K Mart, Merck, General Motors, Qwest Communications, Reliant Energy, Tyco, Worldcom and Xerox all admitted cooking the books to promote share price in the past as well. And most recently, the U.S. Securities Exchange Commission is investigating Apple and over 100 other American companies for backdating options, which is just a polite way of saying that company executives stole money from shareholders.
So my point is that corruption exists in every country, developed or emerging. I have always maintained that financial analysts that spread fear of the risk of foreign markets only do so to cover up their lack of knowledge about foreign markets and their inability to invest wisely in such markets. It’s much easier to stick to what you know (domestic markets) by spreading fear to your clients about the risk of foreign markets.
Secondly, the many articles I’ve seen regarding the risk of foreign markets (which predominantly originate out of the American press) seems to ignore the role that U.S. companies play in increasing the volatility in emerging markets and in certain asset classes. Many hedge funds in the past made a relatively safe killing in the markets by playing the spread between what was basically interest free Japanese yen and 5%-6% interest-paying U.S. Treasury bonds. When you consider that many hedge funds are leveraged 10 to 1, you can see how profitable playing the spread has been in the past.
Although I haven’t seen statistics on this yet, with the rise in commodities and emerging stock markets as of late, I believe it is safe to assume that hedge funds had recently been borrowing yen to buy many assets much more risky than U.S. Treasury bonds. With hedge funds typically charging 2% of assets under a management in addition to taking 20% of all profits, I’m sure that many hedge fund managers had dreams of borrowing dirt cheap yen and chasing hot assets to earn enough money in one year to fund a retirement.
Say for example, that hedge fund managers had borrowed yen to buy long positions in Chinese stocks. Remember that many hedge funds are leveraged at ratios around 10 to 1, and use margined positions to accomplish this leverage. With a 9% one day drop, surely many hedge funds had to sell out of their long positions even if they desired to stay in to cover margin calls. Or perhaps with hedge fund manager Brian Hunter’s couple week loss of more than $6 billion still fresh in their minds, such a large one day drop in the Shanghai markets caused immediate selling by hedge fund managers as no one wants to become the next Brian Hunter.
Secondly, the Bank of Japan recently raised interest rates to 0.25% and then to 0.5%. Consider if the Bank of Japan raises their interest rates again, which I think will happen sooner than most people believe. All of a sudden, hedge fund’s (those that leverage the Yen) profit margins will be squeezed (if they aren’t being squeezed already), and those that are highly leveraged, will see the profit margins severely squeezed. In order to limit potential losses, not only will hedge funds will then be forced to buy yen to pay the borrowed yen back, but they will also be forced to unwind and sell off assets bought with the borrowed yen.
Last year, I blogged about hating the fact that silver and gold ETFs were introduced to the market and that the introduction of precious metal ETFs on the U.S. markets (even though they had existed for years in overseas markets) would introduce a lot more volatility to these markets as hedge funds would pump and dump them in search of the ever quick profit. The fact that they yen reached a 3-month high against the U.S. dollar the other day is further contributing to volatility in emerging stock markets and in precious metals. Many hedge funds used yen to buy long gold futures. As they were forced to unwind these carry trades as the yen continued to rise, they were forced to close out their positions in gold futures. As many hedge funds closed out their positions, they forced gold even lower as I surmise a mass exodus was created by the strengthening of the yen. It is important to note that this has nothing to do with the long-term outlook on gold but more to do with they risky behaviour of hedge funds and their detrimental contribution to the financial markets.
So by now it should be obvious how hedge funds contribute to increased volatility and instability in emerging markets and in certain asset classes. For some analysts to claim, as I have read this week, that foreign markets like China are risky because “Elderly people hang around in stockbrokers’ offices and play the Shanghai slot-machine because those offices are air-conditioned” is incredibly short-sighted and a superficial assessment of a very complex financial machine.
I’m not saying that my analysis here of the volatility of emerging markets is comprehensive by any means. However, I am saying that there are many more factors that influence the volatility of say, the emerging Chinese markets, than just Asians that view the stock market as another trip to Macau or Las Vegas. Most hedge fund managers seek to enter and exit markets as soon as profits are made, as I would too if I managed a hedge fund. If I had been as heavily leveraged as hedge funds typically are in many of my long positions in stocks I would have made several hundred percent profits on many of my positions. Certainly at this point, if I’m taking 20% of all profits as my fee, I’m going to cash out whether fundamentally speaking or not, this is the proper thing to do. Again, decisions driven by such considerations will introduce more volatility to markets.
However sometimes dips created in asset classes and markets create buying opportunities. If you understand the underlying fundamentals behind certain markets and asset classes, you’ll know whether such dips are a signal to take profits and sit back for a while and wait for the volatility to settle, or if they present a prime opportunity to pick up what are now undervalued assets. So the next time you hear a financial analyst tell you that it’s not possible to safely invest in emerging markets, you’ll know it’s just another excuse to conceal his or her inability to adequately evaluate and invest in foreign markets.
[tags]investment strategies, yen, gold ETF, silver ETF,wealth literacy[/tags]
J.S. Kim is the founder and Managing Director of maalamalama, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to yield 25% or greater annual returns.