(Reuters) – For months, markets have been dancing to central bankers’ tune, but that may now be changing.

It must have been fun to be a central banker in the early part of 2013: You say “jump” and Mr. Market says “how high?”

That seems to have ended rather abruptly in the 24 hours beginning with the Bank of Japan’s disappointing response to bond market volatility on Thursday and including Ben Bernanke’s anodyne but market-roiling comments on Wednesday on the possibility of a policy taper.

Tokyo’s Nikkei tumbled more than 7 percent on Thursday, European shares suffered their worst day in about 10 months and even the perpetual paper wealth machine known as Wall Street fell, with the S&P 500 down by as much as 1 percent before leveling off.

The re-introduction of this kind of two-way risk, both for markets and for policymakers, highlights some of the difficulties of the heavy reliance on asset-pricing markets as a policy tool.

“The tremors we have seen in stocks and currency markets yesterday and today are a sharp reminder that while the Fed can fine-tune its exit from QE, moving gradually and adapting to economic developments, it cannot control the markets’ reaction, which is likely to be a lot more sudden and disruptive,” said Marco Annunziata, chief economist at GE in San Francisco.

“Market reactions are a lot harder to manage than inflation expectations — no matter how careful the Fed is, the exit will not be smooth.”

It all makes quite a contrast from the earlier part of the year. Central bankers worldwide appear to have enjoyed rare power and respect in financial markets, in some cases a function of new policies, as with the Bank of Japan. But in others, like the Fed’s, they have been pursuing the same policy all along.

The Bank of Japan, with strong support from the new administration of Prime Minister Shinzo Abe, has successfully inflated Tokyo share markets, while at the same time deflating the yen.

The Fed, which has explicitly followed a policy of inflating assets to generate economic growth, has enjoyed the support of the metronome-like equity market, which has risen 13 percent so far this year with little volatility.

Even the European Central Bank, which faces serious structural issues in the single currency zone, has seen a satisfying fall in effective sovereign interest rates, in part because markets themselves have given full credit to Mario Draghi’s “whatever it takes” pledge to defend the project.

SEA CHANGE OR DAY TRADE?

So was Thursday simply a bad day for markets, or does it presage more difficult conditions for policy makers, the economy and investors?

Japan’s situation is particularly complex. While the BOJ and central bank head Haruhiko Kuroda paid lip service to concerns about spiking interest rates, of note was that actual bond buying didn’t stop 10-year JGB rates from hitting 1 percent for the first time in two years. The BOJ launched a 2 trillion yen fund supply operation, as well as two bond-buying efforts totaling 810 billion yen.

The worry is that spiking yields will draw more speculative bets, as well as potentially imperiling bank lending and capital adequacy.

As for the Fed, there really wasn’t much in Ben Bernanke’s congressional testimony or in the release of the Federal Reserve minutes that should have changed minds in the market, but nonetheless it did.

While Bernanke did say in answer to a question that if the data merits, the Fed “could take a step down in the next two meetings,” he also balanced that, as he has in the past, by noting that premature tightening could slow or end the recovery. He further gave no indication that he regards the recovery as self-sustaining, thus making the promise, or threat, of an early taper somewhat empty.

Of the two issues, in Japan and the United States, the threat of rates in Japan is far more serious. Theoretically, Bernanke can and will keep the bond purchases coming, thus neutralizing and reversing a destabilizing market tumble. It is the fact that markets in Japan were tumbling because its bond market wasn’t reacting as wanted to BOJ purchases that is scary.

In the case of the Fed we can debate whether or not its policy is having the needed economic impact without losing faith in its ability to influence asset prices. In Japan, with its heavy debts, the fear is that authorities are losing control in a more profound way.

What is true in Japan has meaning everywhere, which is perhaps the best explanation for the global sell-off.

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by Dan Grebler)

It must have been fun to be a central banker in the early
part of 2013: You say “jump” and Mr. Market says “how high?”

That seems to have ended rather abruptly in the 24 hours
beginning with the Bank of Japan’s disappointing response to
bond market volatility on Thursday and including Ben Bernanke’s
anodyne but market-roiling comments on Wednesday on the
possibility of a policy taper.

Tokyo’s Nikkei tumbled more than 7 percent on Thursday,
European shares suffered their worst day in about 10 months and
even the perpetual paper wealth machine known as Wall Street
fell, with the S&P 500 down by as much as 1 percent before
leveling off.

The re-introduction of this kind of two-way risk, both for
markets and for policymakers, highlights some of the
difficulties of the heavy reliance on asset-pricing markets as a
policy tool.

“The tremors we have seen in stocks and currency markets
yesterday and today are a sharp reminder that while the Fed can
fine-tune its exit from QE, moving gradually and adapting to
economic developments, it cannot control the markets’ reaction,
which is likely to be a lot more sudden and disruptive,” said
Marco Annunziata, chief economist at GE in San Francisco.

“Market reactions are a lot harder to manage than inflation
expectations – no matter how careful the Fed is, the exit will
not be smooth.”

It all makes quite a contrast from the earlier part of the
year. Central bankers worldwide appear to have enjoyed rare
power and respect in financial markets, in some cases a function
of new policies, as with the Bank of Japan. But in others, like
the Fed’s, they have been pursuing the same policy all along.

The Bank of Japan, with strong support from the new
administration of Prime Minister Shinzo Abe, has successfully
inflated Tokyo share markets, while at the same time deflating
the yen.

The Fed, which has explicitly followed a policy of inflating
assets to generate economic growth, has enjoyed the support of
the metronome-like equity market, which has risen 13 percent so
far this year with little volatility.

Even the European Central Bank, which faces serious
structural issues in the single currency zone, has seen a
satisfying fall in effective sovereign interest rates, in part
because markets themselves have given full credit to Mario
Draghi’s “whatever it takes” pledge to defend the project.

SEA CHANGE OR DAY TRADE?

So was Thursday simply a bad day for markets, or does it
presage more difficult conditions for policy makers, the economy
and investors?

Japan’s situation is particularly complex. While the BOJ and
central bank head Haruhiko Kuroda paid lip service to concerns
about spiking interest rates, of note was that actual bond
buying didn’t stop 10-year JGB rates from hitting 1 percent for
the first time in two years. The BOJ launched a 2 trillion yen
fund supply operation, as well as two bond-buying efforts
totaling 810 billion yen.

The worry is that spiking yields will draw more speculative
bets, as well as potentially imperiling bank lending and capital
adequacy.

As for the Fed, there really wasn’t much in Ben Bernanke’s
congressional testimony or in the release of the Federal Reserve
minutes that should have changed minds in the market, but
nonetheless it did.

While Bernanke did say in answer to a question that if the
data merits, the Fed “could take a step down in the next two
meetings,” he also balanced that, as he has in the past, by
noting that premature tightening could slow or end the recovery.
He further gave no indication that he regards the recovery as
self-sustaining, thus making the promise, or threat, of an early
taper somewhat empty.

Of the two issues, in Japan and the United States, the
threat of rates in Japan is far more serious. Theoretically,
Bernanke can and will keep the bond purchases coming, thus
neutralizing and reversing a destabilizing market tumble. It is
the fact that markets in Japan were tumbling because its bond
market wasn’t reacting as wanted to BOJ purchases that is scary.

In the case of the Fed we can debate whether or not its
policy is having the needed economic impact without losing faith
in its ability to influence asset prices. In Japan, with its
heavy debts, the fear is that authorities are losing control in
a more profound way.

What is true in Japan has meaning everywhere, which is
perhaps the best explanation for the global sell-off.

(Reuters) – Spiking interest rates in Japan threaten to undermine, and possibly end, the recovery being engendered by Abenomics.

That could reverse gains not only in Tokyo stocks, but in stock markets world-wide which have benefited from Japanese liquidity.

While a rebound in activity has allowed the Bank of Japan to upgrade its assessment of conditions for a fifth straight month, bond yields have risen sharply in extremely volatile conditions.

Yields on 10-year Japanese government bonds have risen to 0.88 percent, nearly triple their April 5 low of 0.315 percent, just after the BOJ introduced its latest easing campaign, part of Prime Minister Shinzo Abe’s overall policy of Abenomics, including stimulative monetary and fiscal policy and economic reforms.

“I don’t think the recent rise in yields is having a big impact on the economy,” Bank of Japan governor Haruhiko Kuroda said on Wednesday after a two-day BOJ policy meeting.

“We will continue to monitor market moves and respond with flexibility in the pace and maturities of bond purchases and in market operations.”

So why are rates rising even as the Bank of Japan is buying huge amounts of bonds?

In large part this is because the BOJ has been successful in convincing investors that it is deadly serious about engendering 2 percent inflation, a goal it has vowed to reach.

“The implication is that the JGB market could plunge and send interest rates sharply higher in a short period of time if people actually start to believe that Mr. Kuroda will use any and all means available to create inflation,” Nomura economist Richard Koo said in a note to clients.

“Once inflation concerns start to emerge the BOJ will be unable to restrain a rise in yields no matter how many bonds it buys.”

That is both the promise and the problem with extraordinary monetary policy: market effects can move much more quickly than any recovery in the real economy. So far Japan has mostly been the beneficiary of market moves. The yen has fallen rapidly, theoretically giving its exporters an advantage, at least in profitability. And Japanese stocks have soared, engendering hopes of a wealth effect which would boost consumer spending and corporate investment.

JAPAN UNUSUALLY VULNERABLE

If interest rates spike, however, Japan will face a number of very serious sequencing problems.

In the normal order of things inflation follows a recovery, rather than preceding it, as it threatens to do in Japan. If inflation comes first, it means the government is hit with rising debt service costs before the increased tax revenues of a stronger economy begin to roll in. With Japan having government debt of well over two times the size of is economy, the costs would mount quickly. That might get in the way of planned government stimulus and, as rates spike, could ultimately be self-reinforcing, with rises in rates causing yet more rises in rates.

This, in essence, is the Japanese bond crisis thesis in a nutshell – the big bet that many hedge funds have made, and lost money on, in recent years. There is a real possibility of significant amounts of money piling in to a short Japanese government bonds bet if the spike continues.

A rate spike would also gum up the credit market in Japan. Not only might people who planned to borrow and invest decide not to as rates rise, banks themselves will be hard hit. After all, banks in Japan are hugely exposed to fixed income generally and government bonds in specific. As prices of those bonds tumble, they may refrain from lending and might even need new capital.

All of this could easily undo any progress in Japan, and indeed if things got bad enough, prompt policy to be rolled back or even reversed.

This should matter to you even if you haven’t got a single yen of Japan exposure. It is no accident that the advent of Abenomics has come alongside the most recent, and giddy, period of stock market gains in the past six months.

Japan, and the BOJ, are a significant source of stimulus for the global economy, both indirectly, and directly. That is even before we think about the destabilizing effect that a Japanese bond market or banking crisis would have on the rest of the world.

To be sure, none of this is pre-ordained. The BOJ has been clumsy in how it operated in the bond market, which is itself a bit of a creaky place after decades of on-off deflation, and is ill-suited to heavy volumes. Both of these issues can and probably will be resolved without great cost.

Still, a near tripling of interest rates in weeks in a highly indebted country is a warning signal investors must heed.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

For his mental health, let’s hope he believes it.

For our economic wellbeing, let’s hope he doesn’t act on it.

While a series of economic revolutions has driven a 30-fold
increase in living standards between 1700 and 1970, economists
have recently fretted that the information technology changes of
recent years will yield less growth.

Bernanke, speaking last weekend to graduates at Bard College
at Simon’s Rock, in Massachusetts, was having nothing of it. Not
only will humans continue to innovate and to find ways to wring
value out of recent innovations, the rise of the Internet allows
for massive and rapid collaboration, he argued. And, as Mark
Zuckerberg can tell you, the potential rewards for innovation
exceed those in the past.

“Both humanity’s capacity to innovate and the incentives to
innovate are greater today than at any other time in history,”
Bernanke said.

While Bernanke was careful to couch his views as being about
the long-run future, this kind of thinking, while perhaps
appropriate to graduation day, is a tad scary when done by the
man with his hands on the levers of monetary policy.

Hazy faith in a future of explosive growth from as yet
undreamt-of technologies is exactly the kind of thing which in
the past has led us to stock market bubbles, busts and
recrimination.

“In the past, Bernanke explicitly stated that his ultra-easy
monetary policy is aimed at driving stock prices higher. Now
that they are at record highs, his recent cheerleading could
contribute to a melt-up, just as Alan Greenspan did during the
second half of the 1990s. We all know how that ended,”
strategist Ed Yardini of Yardini Research writes in his blog. ()

And indeed, Alan Greenspan entered his late, late, rococo
period of central banking with his own touching faith in
technology, opining in 2000, just as the tech bubble was about
to burst, that there was a virtuous cycle between technological
advances, the economy, the efficient use of capital and the
wealth effect of a booming stock market. If only, Alan, if only.

It all seems a long time ago, and while Bernanke is no
Greenspan-style booster of the stock market, we have more than a
decade of reasons for caution.

4’33″

And really, those who downplay the effects of technology on
the economy and argue that indoor plumbing and the internal
combustion engine represent the low-hanging and high-value fruit
now plucked are not taking the large view.

After all, someone 20 years ago who wanted to listen to
composer John Cage’s 4 minutes and 33 seconds of a pianist
sitting in silence in front of a keyboard had to troop down to
the nearest avant garde music store; whereas today a click of a
button, an instant transfer of money and the recorded silence is
yours via iTunes.

What could be more efficient? Take that, Mr Ford and the
Brothers Wright!

The other difficulty, unstated and unexplored, in Bernanke’s
millennial faith in innovation is the ways in which it may raise
problems for one or both of his mandates: full employment and
price stability.

The depressing thing about the technological revolution is
that it has coincided with a period in which both income growth
and meaningful employment have been increasingly difficult for
the average U.S. household to obtain. Technology seems to have
become rather better at efficiency than job creation, at least
for those with modest skills. At the same time, in helping to
drive down prices it has set the stage for overly loose monetary
policy leading to destructive booms and busts.

Equally depressing is the way in which income inequality has
only grown, arguably helped along by monetary policy which tends
to inflate the value of those things owned by the rich
without increasing, by much, the value of the unused labor which
the poor possess in abundance.

To be sure, for hundreds of years it has been wrong to bet
against human innovation. It has, and very likely will,
continued to advance and yield benefits.

The worry is that Bernanke, as he appears to be doing with
quantitative easing, takes that mindset and applies it to the
world of money and finance, where, on the evidence, innovation
benefits practitioners at the expense of the rest of us.

(Reuters) – Quantitative easing may well be pushing investors to hold more cash rather than risk assets, blunting its impact as monetary policy.

Known as the portfolio rebalancing channel, the thinking behind QE rests partly on the assumption that buying up government bonds will drive interest rates down and entice investors to tilt their holdings towards riskier investments like stocks. That in turn is supposed to goose investment and consumption.

Unfortunately, that assumption may be running afoul of, or fouling up, the way in which most investors construct their portfolios, according to Toby Nangle, head of multi-asset investments at London-based Threadneedle Investments.

He argues, convincingly, that by driving rates to rock-bottom levels, government debt can no longer properly play its role as ballast in an overall portfolio, steadying the ship and allowing investors to take on more risk than they otherwise would dare.

“Despite working in asset management for sixteen years, I have never met a major, sophisticated, institutional end-investor who did not believe (with a good degree of confidence) that on a five-year horizon stocks outperform bonds,” Nangle writes in a note to clients. (here)

“This begs the questions of why give out bond mandates at all when clients could go all out on their favorite asset? The answer, of course, is that they care about the volatility of their overall portfolio returns.”

In a normal market, government bonds and stocks are complementary assets; owning the former allows you to hold more of the latter for a given level of risk tolerance. That’s because although both assets are quite volatile, when held together in a portfolio they actually produce less volatility.

Investors care about volatility – deeply. Suffering swings in value isn’t just stomach-sickening, it can be ruinous, both for the careers of the asset managers involved and for the real needs of the owners of the capital.

And indeed, the data shows – and this is elementary portfolio construction – that mixing longer-dated government bonds with equities leads to less volatility than would be suffered if you held either asset in isolation.

Government bonds, therefore, are not just a hedge, but a hedge with a positive yield. That, in fact, is a principal reason for their popularity.

THE QE EFFECT

Now consider what happens when government bond-buying lowers the yields on those bonds to essentially nothing, or to a negative yield in inflation-adjusted terms. And also consider that under QE you as an investor are participating in a market dominated by one buyer – one whose motivation isn’t profit but jobs and inflation and who might if it served its purposes at some point in the future become a massive seller.

“Most developed government bond markets now achieve little for my portfolio and I have sold them down to zero. I prize those markets that do offer the promise of offsetting equity volatility with a positive yield and use them to maintain chunky exposures to the most attractive equity markets,” says Nangle.

So, what then to hold?

The problem is that most of the available assets other than government bonds which have a positive yield, such as corporate bonds, are much more highly correlated with equities. That means that they add risk and volatility to a portfolio.

That leaves cash, which has zero return but which doesn’t have the capital loss downside of a bond. Sadly, if you hold more cash you need to cut your exposure to equities or again take on more risk. Either way, QE may be having the unintended effect of driving some to hold more cash.

So what are investors really doing?

A look at markets would seem to indicate that most are stepping up their risk, but the evidence isn’t all one way. While money market holdings, in the U.S. at least, are down substantially from credit crisis peaks, they are still at historically high levels. And cash assets at commercial banks have skyrocketed, undoubtedly for complex reasons, but something which can be clearly read as showing household and corporate caution about the future.

As for QE, this all adds to the impression that its success as monetary policy is unproven.

For investors the bottom line is that the world has become a riskier place, and central bankers are forcing you to share the burden.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

Known as the portfolio rebalancing channel, the thinking
behind QE rests partly on the assumption that buying up
government bonds will drive interest rates down and entice
investors to tilt their holdings towards riskier investments
like stocks. That in turn is supposed to goose investment and
consumption.

Unfortunately, that assumption may be running afoul of, or
fouling up, the way in which most investors construct their
portfolios, according to Toby Nangle, head of multi-asset
investments at London-based Threadneedle Investments.

He argues, convincingly, that by driving rates to
rock-bottom levels, government debt can no longer properly play
its role as ballast in an overall portfolio, steadying the ship
and allowing investors to take on more risk than they otherwise
would dare.

“Despite working in asset management for sixteen years, I
have never met a major, sophisticated, institutional
end-investor who did not believe (with a good degree of
confidence) that on a five-year horizon stocks outperform
bonds,” Nangle writes in a note to clients. (here)

“This begs the questions of why give out bond mandates at
all when clients could go all out on their favorite asset? The
answer, of course, is that they care about the volatility
of their overall portfolio returns.”

In a normal market, government bonds and stocks are
complementary assets; owning the former allows you to hold more
of the latter for a given level of risk tolerance. That’s
because although both assets are quite volatile, when held
together in a portfolio they actually produce less volatility.

Investors care about volatility – deeply. Suffering swings
in value isn’t just stomach-sickening, it can be ruinous, both
for the careers of the asset managers involved and for the real
needs of the owners of the capital.

And indeed, the data shows – and this is elementary
portfolio construction – that mixing longer-dated government
bonds with equities leads to less volatility than would be
suffered if you held either asset in isolation.

Government bonds, therefore, are not just a hedge, but a
hedge with a positive yield. That, in fact, is a principal
reason for their popularity.

THE QE EFFECT

Now consider what happens when government bond-buying lowers
the yields on those bonds to essentially nothing, or to a
negative yield in inflation-adjusted terms. And also consider
that under QE you as an investor are participating in a market
dominated by one buyer – one whose motivation isn’t profit but
jobs and inflation and who might if it served its purposes at
some point in the future become a massive seller.

“Most developed government bond markets now achieve little
for my portfolio and I have sold them down to zero. I prize
those markets that do offer the promise of offsetting equity
volatility with a positive yield and use them to maintain chunky
exposures to the most attractive equity markets,” says Nangle.

So, what then to hold?

The problem is that most of the available assets other than
government bonds which have a positive yield, such as corporate
bonds, are much more highly correlated with equities. That means
that they add risk and volatility to a portfolio.

That leaves cash, which has zero return but which doesn’t
have the capital loss downside of a bond. Sadly, if you hold
more cash you need to cut your exposure to equities or again
take on more risk. Either way, QE may be having the unintended
effect of driving some to hold more cash.

So what are investors really doing?

A look at markets would seem to indicate that most are
stepping up their risk, but the evidence isn’t all one way.
While money market holdings, in the U.S. at least, are down
substantially from credit crisis peaks, they are still at
historically high levels. And cash assets at commercial banks
have skyrocketed, undoubtedly for complex reasons, but something
which can be clearly read as showing household and corporate
caution about the future.

As for QE, this all adds to the impression that its success
as monetary policy is unproven.

For investors the bottom line is that the world has become a
riskier place, and central bankers are forcing you to share the
burden.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

The U.S.’s share of global manufacturing output fell by 23
percent in the 40 years to 2010, as China rose, outsourcing
boomed and a new highly integrated global supply chain was born.
This has utterly remade the U.S. and global economies, affecting
everything from how much and how U.S. workers make money to how
most companies are organized and compete.

Now a combination of factors – from cheap U.S. energy to new
technology to a falling wage gap – may partly reverse some of
those changes, bringing some manufacturing back on-shore.

If, and to the extent, this happens, literally every
investment in your portfolio will be affected.

RENAISSANCE OR CYCLICAL UPTURN?

First off there is a host of solid reasons to think U.S.
manufacturing may finally be catching a break. The
low-hanging fruit of globalization has mostly been gathered, and
while we can’t expect a return to the U.S. dominance following
World War II, many of the advantages enjoyed by U.S. competitors
have been eroded.

Energy is a great example. The discovery and exploitation of
shale gas and other new energy sources in the U.S. will likely
give manufacturers close to the source a real and ongoing cost
advantage. Consultants PWC have estimated that an additional one
million manufacturing jobs may be created by 2025 solely due to
the advantages of cheap shale and demand for the products used
to extract it. That alone is 1/6th of all the manufacturing jobs
in the U.S. which disappeared between 1998-2010.

At the same time, the wage gap between China and the U.S.,
once vast, has been narrowing sharply. While Chinese factory
workers cost just 3 percent of their U.S. counterparts in 2000,
by 2015, according to Boston Consulting, they may cost 17
percent as much. And while productivity per worker hour is
growing in China, it is not keeping up with wage growth. Taking
all costs into account, Boston Consulting says that South
Carolina, Alabama and Tennessee are among the least expensive
manufacturing locations in the industrialized world.

Technological change may also benefit the U.S., notably the
rise of 3-D printing, a form of manufacturing where products and
parts are literally sprayed into existence by laser and other
printers, rather than being hewn from solid metal. It makes the
most economic sense to site 3-D plants close to markets and in
places where intellectual property rights will be best
protected, two arguments in favor of the U.S.

To be clear, this is a speculative play. New energy sources
may well be found elsewhere, wage growth might accelerate in the
U.S. and any number of other roadblocks can and probably will
arise. What now looks like a secular shift may turn out to be
just a cyclical recovery in manufacturing, and possibly a
short-lived one.

HOW TO PLAY IT

One huge beneficiary of all of this will be the U.S.
Treasury and its securities. Higher tax revenues and growing
employment will make deficit issues easier to handle, while an
improving trade balance should benefit the dollar.

While energy production and related companies will be an
obvious beneficiary, expect better growth in manufacturing to
also help chemicals and capital goods firms.

But, just as the hollowing out of manufacturing hit
everything from house prices to banks in the mid-West, so will
the benefits of a reversal be widespread.

“Due to the strong multiplier effect of manufacturing jobs,
the beneficiaries of a U.S. manufacturing renaissance will be
found in small and midsize U.S.-focused industrial suppliers and
in other sectors of the economy,” Shirley Mills, of fund manager
The Boston Company, argued in a recent paper.

That means everything from component suppliers to retailers
to banks.

Catching the flip side of this trade, lightening up on those
who will be hurt, is just as important. The obvious losers are
emerging market countries and companies, which will be at a
relative disadvantage and which, if manufacturers, may have to
cope with rising wages and falling profit margins.

You might also want to look skeptically at some of the
classic U.S.-listed, globally diversified companies which have
done so well in the past decade or two. If re-shoring – the
bringing back to the U.S. of manufacturing – becomes
economically compelling, the global supply and production chain
many of these companies have built will be an expensive and
counterproductive sunk cost.

Your best bets therefore may be the smaller and midsize
publicly traded companies which have never been able to
diversify production internationally.

Like offshoring, this is likely to be a big and slow-moving
trend, so making slow but significant changes to portfolio
holdings over time is probably the strategy which offers the
best risk/reward combination.

(Reuters) – Buy Japanese stocks if you must but don’t expect Abenomics and the fall of the yen to revitalize Japan’s economy.

The yen has fallen by more than 20 percent since Prime Minister Shinzo Abe, who advocates aggressive monetary and fiscal policy, was elected in December, busting through the 100 yen to the dollar level last week.

In part the theory behind Abenomics is that a weaker yen will revitalize industry, which will export more and plow the proceeds into hiring and capital investment.

The stock market certainly believes: benchmark shares in Tokyo are up 36 percent this year and more than 68 percent over six months.

But a look at the actual data shows Japanese companies, like British ones during a similar bout of currency weakness in 2008, appear to be more eager to use a newly competitive currency to pad profits through higher margins rather than higher export volumes.

Thus far, Japanese exporters appear to be doing just that. Despite yen falls the price of Japanese exports in local currency has barely budged.

“Japanese companies have not actually cut the foreign currency prices of their exports. Just as with the UK exporters, the Japanese have chosen to hold foreign prices constant, maintain market share, and increase the yen value and thus the yen profit associated with yen depreciation,” UBS economist Paul Donovan writes in a note to clients.

This idea, called a “pricing to market” strategy, refers to the strong tendency of exporters of finished products like cars and technology to respond to price pressures from their competitors but not themselves to use a cheaper home currency to cut prices and boost sales.

This was certainly the case in Britain, whose exporters of goods and services used a 24 percent fall in the value of the pound in 2008 and 2009 to boost profits but to hold their export prices essentially unchanged.

Even worse, from the point of view of the Bank of England, which must have hoped cheap sterling would lead to economic recovery, British companies showed a strong tendency to do very little with the extra cash, piling up an additional $40 billion in bank deposits between 2008 and 2012.

GLOBAL STIMULUS

If Japan follows that model, Abenomics may in the end succeed in enriching investors but have a disappointing impact on Japanese growth and inflation.

Of course, many of those investors will be Japanese savers, and some, feeling flush with newly valuable portfolios of stocks, may spend more than otherwise they would, helping Japan’s economy in much the way the Federal Reserve hopes quantitative easing will help the U.S.

Still, the Japanese experience with equity booms, and with the bust of the past two decades, is such that it is hard to see many of the country’s aging population going on a buying spree because the Nikkei index has had a few good months.

Still, the extra profits made by Japanese exporters are real, and will have to go somewhere. Donovan of UBS lays out four options.

The first is to stockpile cash, as British companies appear to have done. This is possible, but Japanese companies are already cash-rich in aggregate.

The second is to pay the money out, either as dividends to investors or as higher wages to employees. This would be positive for Japan’s economy, but there is little evidence thus far it is happening.

The third, and this one is the devout hope of the Bank of Japan and the Abe administration, is that some of the money gets plowed into increasing production at home. Why domestic investment would increase in the absence of a pick-up in demand is unclear. Foreign demand for products which aren’t cheaper will depend on foreign economic conditions, while domestic demand will be tempered by an aging population.

That leaves foreign investment as the final, and perhaps likeliest beneficiary of the Abenomics-driven revival in corporate profitability. While there may be some temptation to invest in more capacity at home, especially if corporate executives believe the weaker yen is here to stay, this would be a big reversal of the trend Japanese corporations have followed in recent years. Foreign direct investment out of Japan has doubled in size compared to domestic fixed investment since 2004, and is now actually larger.

Given that there is good demand growth globally for Japanese products, but little of that demand growth can be expected to come from the aging island itself, this makes sense.

Abenomics contains an irony: the effect of its stimulus will be enjoyed in substantial part by hedge fund managers and clients in New York and London and by workers in Japanese factories as yet unbuilt in places like Kentucky.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

(James Saft is a Reuters columnist. The opinions expressed are his own)

In fact, your dad and mom very may well have abandoned the market entirely. That could be the single best indicator that stocks have room to run.

The Dow Jones industrial average closed above 15,000 for the first time on Tuesday, the same day the S&P 500 made its all-time high for the fourth consecutive trading session.

You can argue all you like about how corporate profits are vulnerable and the market is hung from the clouds on slender threads spun by Ben Bernanke, but what you can’t say is that we are in classic broad-based stock market mania.

Two facts:

1 – Only 52 percent of Americans own stocks, according to polling from Gallup published on Wednesday. That’s the lowest since they started asking the question in 1998.

2 – Only 31 percent of small investors describe themselves as bullish, well below historical norms, and nearly 36 percent are bears, well above historic averages, according to an American Association of Individual Investors survey released on May 2.

The demographics underpinning these facts may argue for caution, but they do not suggest that we are poised for a correction (absent, of course, some external shock). Instead, these studies suggest there are still some people out there who might, if things stay calm and stocks keep going up, have the money to give the market more gas.

Yes, the stock market rally is in large part the creation of extraordinary central bank policy, and yes, that is a narrow ledge upon which to build a solid foundation.

And indeed, mom and dad may well not own stocks because they are a good bit less well off than they were five or 10 years ago, which in itself does not argue for a sustainably vibrant economy.

Still, if you subscribe to the “manias and crashes” school of financial markets, the single best indicator of an end-stage bubble is that everyone is doing it and, even worse, won’t shut up about it.

We are not there. You probably don’t have a shoe-shine boy, but if you do he definitely isn’t trying to talk you into shale oil plays. Neither is your dentist, though he might well be clubbing together with friends to buy rental properties. And if you tell your cab driver you do something having to do with finance, he is more likely to complain about the iniquities of the investment system than crow about how it is making him rich.

All of this should give those of us with bearish, or as I prefer, skeptical, tendencies, some comfort.

STOCKS, JOBS AND HISTORY

The AAII survey of small investors has been running since 1987, taking in several of the booms and busts of modern Greenspan-style central banking. The survey is simple and asks investors to describe themselves as bullish, neutral or bearish. One of the most striking things about the data is how often extremes line up with market tops and bottoms.

The highest-ever bullish figure was 75 percent, near the peak of the dot com bubble, while the lowest-ever such figure was 6 percent in 1990, when Iraq controlled Kuwait and the first Gulf War was in preparation. Similarly, bearish sentiment hit its all time low at 6 percent in the summer before the crash of 1987.

In the same vein, the Gallup poll showed an all-time high of stock market participation at 65 percent in 2007, and it has been falling ever since, even as the unemployment rate partly recovered.

Now, it may be that small investors have learned the lessons of the bubblicious last three decades and have simply decided to sit this one out, but that is an argument that rests on the hope that human nature has changed. My guess would be that as people get their 401(k), brokerage and mutual fund reports in coming months, they will like what they see and it will fill many with a painful mix of greed and regret. That kind of thing is the true building block of a mania, and that we have yet to see.

So whose money has been driving the rally? Partly it is professional money managers, whose performance is benchmarked against the market and who will thus have been conditioned by the strong recovery in stocks since the crash to be in the market or to look bad. It also has partly been driven by institutions like pension funds and endowments taking on risks, reinvesting the money handed to them by central bank bond buying in something with more yield and upside.

The one common denominator is that all of these professionals know that authorities have effectively underwritten the market.

So yes, you can say this is a cynical rally. Cynical yes, but not crazy, at least not yet. That stage may well come, but it could be when stocks are quite a bit higher than now.

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Chelsea Emery and Dan Grebler)

In fact, your dad and mom very may well have abandoned the
market entirely. That could be the single best indicator that
stocks have room to run.

The Dow Jones industrial average closed above 15,000 for the
first time on Tuesday, the same day the S&P 500 made its
all-time high for the fourth consecutive trading
session.

You can argue all you like about how corporate profits are
vulnerable and the market is hung from the clouds on slender
threads spun by Ben Bernanke, but what you can’t say is that we
are in classic broad-based stock market mania.

Two facts:

1 – Only 52 percent of Americans own stocks, according to
polling from Gallup published on Wednesday. That’s the lowest
since they started asking the question in 1998.

2 – Only 31 percent of small investors describe themselves
as bullish, well below historical norms, and nearly 36 percent
are bears, well above historic averages, according to an
American Association of Individual Investors survey released on
May 2.

The demographics underpinning these facts may argue for
caution, but they do not suggest that we are poised for a
correction (absent, of course, some external shock). Instead,
these studies suggest there are still some people out there who
might, if things stay calm and stocks keep going up, have the
money to give the market more gas.

Yes, the stock market rally is in large part the creation of
extraordinary central bank policy, and yes, that is a narrow
ledge upon which to build a solid foundation.

And indeed, mom and dad may well not own stocks because they
are a good bit less well off than they were five or 10 years
ago, which in itself does not argue for a sustainably vibrant
economy.

Still, if you subscribe to the “manias and crashes” school
of financial markets, the single best indicator of an end-stage
bubble is that everyone is doing it and, even worse, won’t shut
up about it.

We are not there. You probably don’t have a shoe-shine boy,
but if you do he definitely isn’t trying to talk you into shale
oil plays. Neither is your dentist, though he might well be
clubbing together with friends to buy rental properties. And if
you tell your cab driver you do something having to do with
finance, he is more likely to complain about the iniquities of
the investment system than crow about how it is making him rich.

All of this should give those of us with bearish, or as I
prefer, skeptical, tendencies, some comfort.

STOCKS, JOBS AND HISTORY

The AAII survey of small investors has been running since
1987, taking in several of the booms and busts of modern
Greenspan-style central banking. The survey is simple and asks
investors to describe themselves as bullish, neutral or bearish.
One of the most striking things about the data is how often
extremes line up with market tops and bottoms.

The highest-ever bullish figure was 75 percent, near the
peak of the dot com bubble, while the lowest-ever such figure
was 6 percent in 1990, when Iraq controlled Kuwait and the first
Gulf War was in preparation. Similarly, bearish sentiment hit
its all time low at 6 percent in the summer before the crash of
1987.

In the same vein, the Gallup poll showed an all-time high of
stock market participation at 65 percent in 2007, and it has
been falling ever since, even as the unemployment rate partly
recovered.

Now, it may be that small investors have learned the lessons
of the bubblicious last three decades and have simply decided to
sit this one out, but that is an argument that rests on the hope
that human nature has changed. My guess would be that as people
get their 401(k), brokerage and mutual fund reports in coming
months, they will like what they see and it will fill many with
a painful mix of greed and regret. That kind of thing is the
true building block of a mania, and that we have yet to see.

So whose money has been driving the rally? Partly it is
professional money managers, whose performance is benchmarked
against the market and who will thus have been conditioned by
the strong recovery in stocks since the crash to be in the
market or to look bad. It also has partly been driven by
institutions like pension funds and endowments taking on risks,
reinvesting the money handed to them by central bank bond buying
in something with more yield and upside.

The one common denominator is that all of these
professionals know that authorities have effectively
underwritten the market.

So yes, you can say this is a cynical rally. Cynical yes,
but not crazy, at least not yet. That stage may well come, but
it could be when stocks are quite a bit higher than now.