Making Sense of the US and Japan Stock Rallies

In my last four years of investing in stocks and forex, two major market rallies eluded me. The massive S&P500 rally that began in March 2009 until now was partially missed. I could not understand why a country that struggles to grow at 2% per year in GDP can see such inflated valuations. With corporate earnings growth of around 15%, the S&P500 is at around 16x PE now. It has risen by almost 140% since March 2009.

The Nikkei rally that started in around Nov 2012 was spotted by me. But I underweighted it. Since then, the index rallied almost 70%, although USDJPY rose by 25%. I had it both ways by going long USDJPY and long Nikkei. But just like a fisherman's tale about "the big one that got away", I just put less than 10% into it.

On hindsight, both rallies made sense to me. When Obama announced a massive QE1 in Nov 2008, Bernanke QE2 in Jackson Hole in July 2010, and QE3 in Nov 2011, cheap funding was readily available to hedge fund managers. They borrowed USD and punted US stocks, or switched to AUD bonds for that positive carry. As long as the USD depreciated, they will make money both ways. It was a party that lasted as long as inflation remained low and unemployment rate above 6.5%.

But now, there is talk of gradual tapering of QE. We saw USD appreciate in the last three months. I caught this rally big time going long USDSGD. Hedge fund managers unwound their carry trade and switched to borrowing JPY.

Abenomics convinced money managers that JPY is the next currency to borrow and short. The same drill is being repeated in Nikkei now.

But something else is happening. I've shorted AUDUSD since March 2013 and made quite a bit. It was a totally technical trade. the fundamental reason is that the Australian economy is sputtering. Inflation is expected to hit 2% by end 2013. The RBA lowered rates repeatedly until it hit around 2.75%. The positive carry between USD and AUD shrank. Lots of carry trades were unwound in the last three months. Since the USD was repaid, and a lot more JPY was drawn down, one wonders where the funds are flowing to. I think Nikkei will have another move upwards. But some of it will be used to chase up the cheapest stock markets in the world. The HSCEI is still at rock bottom valuations. Russia as well, with PE at only 5x. Money is still not flowing to mining though because of poor profitability.