Just a pitstop on the road to prosperity?

Rather than simply repeat what’s happened this week, I’d prefer to try and figure out if it actually means anything or whether it’s just another pitstop on the road to prosperity.

Personally I don’t buy the broker-spin peddled in some news outlets about it being a “healthy correction”. I think it’s a warning sign that things in the ‘hood aren’t going to quieten down in a hurry. After all, something of an overreaction don’t you think? An over-inflated market has a rumour-driven sell off yet investors from New York to Sydney start having kittens. I believe the problems are deeper than the toasting of some Chinese retail investors and the ubiquitous hedge funds. Several aspects of it are troubling and I’m still organising my thinking but here’s where I’m at:

• The yen carry trade is a big source of liquidity for global markets. Yen-denominated borrowings are invested in securities of higher yielding currencies (AUD, USD, NZD for example)
• The US sub-prime residential mortgage backed securities (RMBS) market is in trouble. HSBC has taken a huge write down on its portfolio ($US10bn!), defaults are increasing and lenders are getting into trouble. Read this opinion piece for more information, it’s a good article and even if you’re not familiar with all the jargon you’ll still get the picture. Locally, arrears on non-conforming RMBS are also creeping up (as reported by S&P)
• Asset backed securities have been a destination of choice for carry-trade proceeds so when those same securities start losing their value quickly thanks to defaults, how will the yen borrowings be repaid? By selling other securities, that’s how
• The yen has had a bit of a rally lately, reflecting many of these factors. If it gains momentum it will simply exacerbate some of the problems
• And because so many investors, funds and banks have put on this trade, if there are forced sales then it will get nasty

The key point is that if risk increases, valuations for many securities decrease even when business fundamentals don’t change. In a leveraged environment that often means margin calls.

I’ll be interested to hear from anyone who thinks none of the above is a big deal.

Meanwhile I’ll continue mulling this over to try and organise my thoughts a bit better. Until then, some of my observations from this week:

Firstly, who looked at their small cap stocks? Spreads ballooned from maybe 3-5 cents out to 30 cents+ as liquidity just vanished. A few of mine were down dramatically on miniscule volume thanks to what must have been a panicky retail investor selling everything that moves. I kind of hope we get some more of this because there will be some great little companies available for good prices, provided you can be patient.

Secondly, the enormous gaping flaw of using online brokers was again exposed: when things are bad, you haven’t got a hope of getting reliable service from their website. E*trade was having problems and I gather Commsec was too. More upgrades I guess. Anyone know exactly when E*trade’s new new website will finally be launched?

Most people I spoke to didn’t seem too fussed about it all, repeating what they’ve heard on the news and thinking about buying opportunities (not just stocks, jetskis, plasma TVs, whatever). They all seem to think that it’s all onward 7,000. If ever you needed a larger, yellower more fluorescent warning device then what you really need is a white stick and a Labrador.

No doubt the party will continue for a while, I’m sure there will be a sucker rally and we’ll once again crest the 6,000 mark quite happily. But there’s a pretty good chance it won’t stay there.

Tired of the doom and gloom? Here’s an alternative point of view, this Reuters columnist thinks now will prove to be a good buying opportunity.

On that note, enjoy the weekend.