Preliminary Thoughts and Positioning on Japan’s Current Situation March 18, 2011

In a natural disaster that dwarfs most others in recent memory, our thoughts and prayers go out to the courageous people of Japan. In the face of dire conditions, we see a brave nation coming together to begin what will certainly be a long road to recovery. Amazingly, with power, food, water and services in short supply or even non-existent, there has been essentially no looting. What a credit to the character of a nation.

Before we look at the financial side of the event, we have to be aware of how fluid the nuclear plant situation remains. Despite the many designed-in redundant defense systems at the Fukushima Daiichi nuclear power facility, the reactors are far from under control. This lack of control will continue to add to the uncertainty of the markets until the plant has been stabilized. Even as I was proofreading this article on Wednesday before lunch, the Dow plunged 155 points in about twenty minutes on what was thought to be new information from a European nuclear official. That new information, however, turned out to be an opinion based on old information. Any snippet of news over the next days and weeks could send the market into a tail spin or rocketing higher. Be on high volatility alert until the situation (especially on the highly emotional nuclear front) stabilizes.

Let’s turn our attention now to the economic aftermath of the tragedy; we have a number of factors to consider.

A Few Economic Thoughts

Morgan Stanley’s Steven Roach, a well-regarded thinker, points out that this earthquake/tsunami disaster comes on the tail of an economy in Japan that has been suffering for years. The population of Japan has been aging AND declining for some time now. The effects of that demographic profile have been compounded by a very strict immigration policy that has put extreme pressure on economic productivity in the country. After the short-term stimulus and aid package effects wear off, these background circumstances do not bode well for a speedy recovery in Japan.

Let’s look at a few other issues:

• Japan’s overall economy could be devastated. Power loss and disaster recovery have caused many industries essentially to shut down for the near term. In addition, a more valuable yen will continue to depress the Japanese export trade. Early indications are that the effect on Global economic growth will be at least 30 basis points, just in the short term.
• Repatriation of the yen to assist in the disaster recovery process has significantly strengthened the currency—too much so for the central bank. In the period of an hour on Monday, The Bank of Japan bought 186 BILLION dollars (selling the yen) to keep the yen from strengthening further. A hedge fund manager that I know calculated that without this intervention the yen could have jumped to 70 yen per dollar (instead of 81 or where it stopped on Monday). If the aftermath of the Kobe earthquake in 1995 is any indication, the yen has more appreciating to come.
• The Bank of Japan has very few bullets left to help the economy. A $500 billion stimulus package is already underway. This amount basically equals the US’s QE2 expenditures, but it enters an economy that is only one-third as large.
• The effects of the earthquake are actually quite bearish for crude oil. A global slowdown should depress oil prices. Current political tensions in the Arab League nations will continue to keep oil prices elevated and may offset any global slowdown. This tug-of-war between fundamental and geopolitical pressures will result in a very volatile energy market into the intermediate time frame.
• As an interesting aside, the Japan Exchange Traded Fund (Symbol: EWJ) had its highest volume trading day ever on Tuesday. SPY is the highest volume stock in the world, trading an average of 150 million shares a day. EWJ is a very active stock, trading 30 million shares a day on average. On Tuesday, EWJ traded more shares than SPY, with 396 million shares traded vs. 359 million, respectively. This is just another indication of the market’s news sensitivity.
• In the face of all the market negativity, we must remember that the Japanese people have shown themselves time and again to be an extremely resourceful, resilient and industrious group. A national tragedy like this will only strengthen their resolve and very likely mitigate many of these negative factors in the long run.

Short Term Actions to Consider

In the face of expanding volatility across almost all markets and with the market’s news sensitivity level at a 10+, swing traders would be wise to curtail activity, widen stops and reduce position size. Swing trading systems tend to get chopped up in extremely uncertain markets.

Long term traders and investors need to mind their stops and more sophisticated players may want to consider adjusting position size to take into account the extra market volatility.

Intraday traders can enjoy the ride! Be nimble to change directional expectations at a moment’s notice, with huge swings possible on news or even rumored news.

As a final note, you may want to check out the stunning before and after satellite images that show the devastating effect of the tsunami and give at least a modicum of appreciation for what the Japanese people are going through. The images can be found here. Moving your cursor across the pictures shows the scale of the devastation.

I’d love to hear your thoughts and feedback on this article or about trading and investing in general at drbarton “at” iitm.com. Until next week…

Great Trading,
D. R.