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“Every civilization has understood the dualistic interplay between changes and permanence, between male and female principles, between the yang and yin of creativity and preservation. And this creative tension is as much a driving force in politics and economics as it is in every other aspect of human psychology.

“Yet this all-important dualism of life and society is rarely mentioned in economic discussions. Instead of trying to understand the interplay between repetition and progress, economists and financiers are typically divided into two mutually hostile camps. Some declare that the lessons of previous experience are irrelevant because of the Internet or globalization or the credit-crunch has changed everything. Technology shares will rise to infinity; all goods in the world will be made in China; credit will contract or expand forever. Others insist that all cycles are the same. The boom-bust cycle in housing was essentially the same as the speculation in technology stocks in the 1990s, the Japanese bubble in the 1980s, and Tulipmania in seventeenth-century Holland. By why should we adopt either of these extreme views?”
                                          Anatole Kaletsky, Capitalism 4.0

Commentary & Analysis
Maybe it’s time for Mr. Market to do some Darwinian Winnowing!

I got call yesterday afternoon from a very seasoned player in the world of finance. He is a man that has seen it all, many of these cycles again and again. He knows, or has worked, or has rubbed elbows, with the biggest names in the industry. This is a man I respect. He is a man I believe it can be argued he is one of the best technical analysts in this game–ever.

He called to say he was enjoying my very “edgy” commentary of late. I told him I guess being a bit ticked off helps my writing…LOL. After chatting about the markets a bit, he said this to me: “I’m not sure what it is, but something very nasty could be on the way. From what I see in this market (stocks) and some of the international markets I’m watching, and from what I’m picking up in pieces from various sources, maybe it comes from China and is part of the slowdown theme you’ve been talking about.”

Maybe yesterday was the beginning of something nasty and not just another opportunity to “buy dips.” None of us know now, but don’t worry, we will all soon be enlightened to precisely what it was, or was not, and why it was or was not, by the plethora of analysts trotted out on the shows after the fact.

This morning I was also contacted by a friend in Thailand, via email. He liked the sound of the “‘running for the exit of ephemeral fundamental expectations” that I penned yesterday, and shared a poem he penned with that as the lead. I won’t share that poem with you, it is brilliant, but not meant for prime time or likely palatable to many. And Lord knows I create enough trouble for myself without friends helping. 

Anyway, I tell you that because I want to share a quote from Stephen Gould he sent to me:

The human mind seems to work as a categorizing device (perhaps even, as many French structuralists argue, as a dichotomizing machine, constantly partitioning the world into dualities of raw and cooked [nature vs. culture], male and female, material and spiritual, and so forth).

This deeply (perhaps innately) ingrained habit of thought causes us particular trouble when we need to analyze the many continua that form so conspicuous a part of our surrounding world.

Continua are rarely so smooth and gradual in their flux that we cannot specify certain points or episodes as decidedly more, interesting, or more tumultuous in their rates of change, than the vast majority of moments along the sequence. We therefore falsely choose these crucial episodes as boundaries for fixed categories, and we veil nature’s continuity in the wrappings of our mental habits.

Now granted, that is some weighty stuff. But notice how it dovetails so well with the quotable from Anatole Kaletsky?

We all seemed conditioned to choose between the extremes it seems. These two quotes are particularly relevant for me, as I often get stuck on a story–bull or bear–and when I do it hurts my trading performance tremendously.

Remaining open to “our surrounding world” is easy to say, but not so easy to do. By jabbing at the market machine of thought consensus each day, as I try to do in these pages, I think helps me avoid losing control of my brain to the market thought police, and hopefully does a bit of that for you.

Thus, in thinking of the call I received yesterday, I have tried to develop a scenario whereby all those who go to bed safe and secure in the inherent certainty of commodity prices growing as the dollar falls may want to pull those covers over your head if this scenario starts to play out.

Those of you who believe in the inevitable march higher in resource prices and fall in the US dollar have to admit this trade was becoming, and may still be, too easy. Though not perfectly analogous, to me this trade is looking very much like the dart throwing that went on during the Nasdaq E-bubble. It was easy. Then, as now, dumb people (usually easily spotted because they are the loudest) have been right for a very long time. Maybe it’s time for Mr. Market to do some Darwinian Winnowing.

There is no magic here. I have tried to create some very plausible rationales to explain why the game could be changing. What’s interesting, the reason for a big change in trend, in my little scenario, is precisely a big part of the reason why the current trend is expected to continue…let me explain…

  1. The vast amount of money flowing into emerging markets, plus real demand and some shortages, has pushed resource prices higher; creating what we define as inflation.
  2. This of course has sparked the massive spec interest in commodities; and of course Ben and Co. have egged it all on by implicitly devaluing the rocket fuel, or otherwise known as the mirror image of this trade–the US dollar.
  3. Now from an emerging/developing world central bank perspective, this massive amount of money rolling in has made it very difficult on them, as they do not want their currencies to appreciate nor do they want inflation to roar, as it destabilizes. Keep in mind destabilization is the last thing your average Chi-com politburo member or local autocrat (many of which dominate the governments of EM markets) wants to see because this can ultimately threaten that nice flow of wealth into said personal Cypress bank accounts. This has led to the concern about currency wars, as defined more by the active imagination of headline writers than reality–though there is some merit as depiction of the differing needs of the major players.
  4. As all the liquidity has rushed into the EMs, central banks have to invest somewhere, much of it has gone back into the dollar (US Treasuries), but much has also gone into commodity currencies that are rising against the dollar–helping to drive a self-feeding trend. All this in an attempt to keep their own currencies from rising against the dollar.
  5. And of course, thanks to Ben, this dollar selling is magnified by both cause and effect. Let’s use oil as the example, because it is a good one given the global need for oil. As the dollar falls, the dollar price of oil rises. Middle-eastern central banks then play the same game as their Asian friends, reallocating out of dollars with all those surpluses and into other currencies as a hedge. But also, those countries that don’t have a natural supply of oil get into the dollar trading game–by borrowing dollars to pay for oil–and then placing those unused funds i.e. saved because they borrowed dollars, into other currencies that are of course rising against the dollar. Thus it’s a win-win for them as the dollar gets cheaper their oil cost effectively is muted by this trade.
  6. But what-if the burden of rising prices, coupled with a dawning reality that global demand flowing from the US ain’t what it used to be, despite the fact Mr. US Consumer is still the big dog, leads EM central banks to realize:
    1. We must finally let our currencies appreciate against the US dollar because
      1. It will go a long way to muting imported inflation and enhancing stability
      2. It will go a long way to creating more growth from our own consumers, as their purchasing power rises
  7. If that what-if scenario plays out, the upshot could be:
    1. The oil-dollar carry trade reverses (oil getting crushed recently as you know) and countries pay back those dollar borrowings, which could help the dollar.
    2. The European currencies, which have been caught in the middle and squeezed higher as EM currencies were effectively suppressed will likely fall against the dollar.
    3. Commodity currencies, which I think already have a massive spec-premium built into them, will lose a bunch of air.

All a complete fantasy I have developed to satisfy my need for an alternative scenario? Maybe! But stranger things have happened in markets.

Happy Jobs Report Friday