Readers of this blog have been following the dollar equity correlation since Aug. 21 when I first write about it (and to my knowledge, I was the first analyst to publish about it — if you know of others please let me know).

Now the dollar-equity correlation issue is top of the financial blogs, for example this summary of views at FT’s Alphaville blog:

 On Monday, none other than Nouriel Roubini, aka Dr. Doom, was making much the same argument in an FT opinion piece. Roubini, though, had dubbed it  ‘the mother of all carry trades’ saying:

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius — even if they are just riding a huge bubble financed by a large negative cost of borrowing — as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade — you short the dollar to buy any global risky assets.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe — for now — for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

So will it all end in tears?

Inevitably, according to Roubini, it will — because the dollar simply cannot continue falling to zero. And when the proverbial buck does stop, the effects will lead to nothing less than the biggest coordinated asset bust ever. 

Now that does sounds scary.

Roubini, it will be recalled, was the one-trick pony (he did get it right in 2007) who told you to sell bank stocks at the bottom because they were all going to be nationalized. Roubini is an academic economist who doesn’t know a bubble from his — well, never mind. There is NO evidence that the world is borrowing money to buy equities. American assets have gotten cheaper, American companies earning cash flows in foreign currency or producing international tradables are worth more — and that’s it. Now, I think stocks will fall from present levels for a number of reasons, but that is not a collapsing bubble.

Bubbles are created through leverage. There are plenty of worrying applications of leverage, for example, the Private-Public Investment Partnerships that have levered up distressed structured securities a dozen times, and goosed up the price of what used to be called toxic waste. I described this as a mini-bubble toxic waste which contributed to high “trading profits” during the third quarter. My recommendation was to sell the banks. As the mini-bubble burst at the end of October (I reported last week) banks stocks have come down.

Stocks are overpriced, the economy’s weak, and things are bad. That’s not quite the same as the end of the world. If we do get an end-of-the-world scenario, it will be due to some outside the usual range of worries (e..g, Israel strikes Iran’s nuclear program, Iran shuts down the Straits of Hormuz, and oil goes to $300 a barrel).

The trouble with being a consulting economist is that you have to get the world’s attention, and Roubini’s attention-getting act is getting a bit tiresome.

This entry was posted on Wednesday, November 4th, 2009 at 9:34 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.