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Excerpt from fund manager John Hussman's weekly essay on the U.S. market:

Needless to say, last week's decline had virtually nothing to do with China. While the decline in China (reflecting similarly overvalued, overbought and overbullish conditions) may have been a catalyst, blaming China for the U.S. decline is like having an open can of gasoline next to your fireplace and blaming the particular spark that sets it off...

Currently, my impression is that the undervalued Japanese yen represents a destabilizing risk much greater than that of overvalued Chinese stocks. Until recently, one of the factors that suppressed the value of the yen has been the “carry trade,” whereby yield-hungry investors borrow yen at low Japanese interest rates, sell the yen for U.S. dollars, and invest the proceeds in higher yielding Treasury securities. That works provided that the yen does not appreciate – if it does, the borrowed yen have to be paid back at an unfavorable exchange rate that can offset the difference between interest rates.

I am not a fan of this carry trade precisely because I view the yen as the most undervalued among the currencies of developed nations. The yen carry trade represents a speculation rather than a sound transaction. As we saw in the stock market last week, the hallmark of bad speculations is that they tend to unwind abruptly.

The yen did strengthen enough last week that a standard “fast, furious, prone to failure” rebound in the U.S. dollar (a pullback in the yen) is a good possibility in the near-term. Longer term, however, the risk of U.S. dollar crisis (essentially a sharp depreciation of the dollar against other currencies) should not be overlooked. We've fed a habit in recent years whereby the U.S. has run enormous trade deficits with China and Japan, and these countries, in turn, have lent us back the money (by accumulating U.S. debt securities) so that we can maintain our standard of consumption through increased indebtedness. This is not an equilibrium, and disequilibrium situations have a tendency to produce painful adjustments. Once certain extremes emerge in the currency market, as in the stock market, the main cause of a market plunge is usually the inevitability of a market plunge...

While the market's recent decline has the capacity to extend much lower, the evidence is not clear that investors have abandoned their speculative whims. Having cleared the recent overbought condition, we're now willing to accept a contained amount of speculative exposure to market fluctuations (using call options only). The appropriate strike prices of those calls are no lower than about 2-3% under current levels. On a further deterioration of the S&P 500 below about 1350, all bets are off...

Though the markets may not experience an extreme flight to quality here, my impression is that the re-introduction of risk concerns last week may prompt a more moderate shift in investor preferences, toward higher quality stocks.

Source: John Hussman: The Yen Worries Me More Than China