Safe Haven: Could U.S. Markets Rally in a Global Decoupling?   (May 29, 2012)

The primary purpose of "safe havens" for "big money" is to preserve capital in relatively low-risk, highly liquid markets. There are few markets that offer both.

Experienced investors try to avoid the "confirmation bias" trap by asking what supports the other side of the trade. Confirmation bias is our instinct to find data to support our position once it is taken. To counter this bias, we must attempt to build a plausible case against our position. If the effort is sincere, we gain a fuller understanding of the market we are playing (or perhaps avoiding).

That the global economy is going to heck in a handbasket is self-evident. If you over-weight anecdotal "on the ground" evidence and fade the ginned-up official statistics, it is obvious the global slowdown is picking up speed in Europe and China, two of the world's largest "linchpin" economies. For example: China's once-hot economy is turning cold.

On the face of it, "growth"-related sectors such as commodities, stocks and high-risk bonds should decline across the globe as the recessionary reality sinks in, while relatively safe assets such as government bonds in Japan, Germany and the U.S. (the global economies perceived as more stable and thus less at risk) should see inflows.

And indeed, bond yields are falling as money flows into these safe-haven bonds.

Since "big money" tends to move markets, let's put ourselves in the shoes of someone tasked with managing $100 billion. If we understand the world's investment options from this point of view, we might gain some insight into the direction and dynamics of where "big money" will be flowing.

Our prime directive is not to make a lot of money with the $100 billion--it's to preserve this precious capital and keep it liquid so opportunities that arise can be exploited.

The traditional "safe havens" of gold and real estate have served the wealthy well for thousands of years, and they remain attractive capital-preservation safe havens. Moving capital out of inherently risky financial instruments into real assets is a time-honored risk-management strategy ("make it on Wall Street, bury it on Main Street"). We can discern this strategy at work in stories of Beverly Hills, Calif. houses drawing multiple bids for the first time in years and the long-term bull market in gold.

But gold and real estate have their downsides: first, they are relatively illiquid, that is, it's not that easy to "park" $10 billion in either sector and then sell it quickly to move the capital elsewhere. Second, each market has its own risks: the gold market is relatively small and volatile, and it's simply not big enough to move $100 billion in and out. Its role in risk management and capital preservation is important but limited.

Real estate is highly local, and its liquidity and return on investment subject to many dynamics. Various macro-conditions can turn a "hot" market into a cold one, and a "safe" investment can become dead-money or even a losing investment if rising property taxes eat away at the net return from rental income.

As an example of these limitations, Warren Buffett recently observed that he would buy thousands of single-family homes in the U.S. if it were possible to do so on a wholesale basis. Eevn if we discount this sentiment as propaganda aimed at supporting the housing market, it highlights real estate's fundamental limitations as a place to park $100 billion or more.

That leaves financial markets as a necessary part of any serious-money allocation. So where do you park $100 billion? The sums allocated to precious metals and real estate are limited by the conditions noted above, and that leaves a significant percentage to park in capital markets somewhere.

The choices are not unlimited. Europe and the euro: risky, for all the reasons we know; a quick "solution" is essentially impossible. You could wake up and find you've lost 20% just as a reflection of a weakening euro. China: anecdotally, money is leaving China as the boom is over, and all sorts of difficult-to-gauge risks are rearing up. Emerging markets: too small to be liquid, and despite the happy-talk about permanent developing-world booms, they're all linked to the markets in Europe, the U.S., China and Japan. (For example, the Indian rupee is in a free-fall against the U.S. dollar.)

That leaves Japan and the U.S. as the only available large, liquid markets. But Japan's basic dynamic is stagnation and malaise; corporate and government players there are questioning the entire Japan, Inc. model, as it is obviously failing to meet global challenges and spark a new era of growth. Japan's 20-year Keynesian "experiment" is an abysmal failure, having accomplished little while digging the nation a fiscal debt hole.

Even with these difficulties, Japan is perceived as a "safe haven" of stability, and that explains the relative strength of its currency, the yen.

In other words, there are visible limits on the stability of Japan and limited opportunities for growth in that economy.

That leaves the U.S., warts and all. Anyone responsible for $100 billion needs transparency, predictability and good intelligence to manage risk and return. For all its many problems, the U.S. offers relatively plentiful transparency, predictability and market data. Its equity, bond and currency markets are so vast that you can move $100 billion in and out with relative ease.

This "safe haven" status can be discerned in the strengthening U.S. dollar. Despite a central bank (The Federal Reserve) with an avowed goal of weakening the nation's currency (the U.S. dollar), the USD has been in an long-term uptrend for a year--a trend I have noted many times here, starting in April 2011.

That means a bet in the U.S. bond or stock market is a double bet, as these markets are denominated in U.S. dollars. Even if they go nowhere, the capital invested in them will gain purchasing power as the dollar strengthens.

All this suggests a "decoupling" of the U.S. bond and stock markets from the rest of the globe's markets. Put yourself in the shoes of someone responsible for safekeeping $100 billion and keeping much of it liquid in treacherous times, and ask yourself: where can you park this money where it won't blow up the market just from its size? What are the safest, most liquid markets out there?

The answer will very likely point the future direction of global markets.

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We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.

We cannot know when the Central State and financial system will destabilize, we only know they will destabilize. We cannot know which of the State’s fast-rising debts and obligations will be renounced; we only know they will be renounced in one fashion or another.

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