Thursday, September 24, 2009

Cover Your Assets Against Stock Market Pullbacks: Must-Avoid Misconceptions

Plenty of us are worried about a coming stock market crash, or at least pullback below 900 on the S&P. I and my fellow analysts and bloggers have provided abundant evidence that the current rally is way overdone. Just a few of the reasons widely cited include:

• Valuations are higher than they've been since 2003 when things were actually getting better.

• The fundamental causes of the recession, a banking system loaded with bad real estate loans, continued declining real estate values behind those loans are all still unresolved. Not one major bank managed to beat Q2 earnings estimates on the basis of steady revenues from likely-to-repeat ongoing operations. They did it either with high risk trading or asset sales.

• US consumers, whose spending is 70% of GDP, are getting poorer through job losses and stagnant (at best) incomes. Savings rates are rising as they cut debt, further eating into consumer spending.

• Most of the "good news" we hear is evidence that the contraction is slowing – we're still getting poorer, but more slowly.

• Etc.

In his article Seven Points to Look For in October, my fellow analyst Mr. Simit Patel recently echoed a widespread sentiment about trading commodities, stocks, and currencies in October. As one who spends his days researching and writing about global stock, currency, and commodity markets, and the interrelationships between them, I offer below evidence to debunk these widely held but dubious notions as they apply to the coming month.

Mr. Patel writes:

"Currently, I'm still long… the Australian dollar against the USD… "

"If the market crashes…will the dollar rally as well? That is what we saw in 2008. However at some point the market will not be able to buy US dollars, especially with the Fed continuing to print more money. So, if US equities crash, we will see a flight to safety -- though I think it's still unclear whether safety means US dollars (like it did in 2008) or if it means something else, particularly gold and silver."

1. If you are worried about a stock pullback then do NOT short the USD, unless you're using it to hedge long stock or other risk asset positions. Over the past few years, the dollar goes up when stocks drop. Most other currencies except for the JPY and CHF go down along with stocks, especially the commodity based growth dependent currencies like the AUD, or the anti-dollar EUR.

Over the past 2 years the USD has reliably moved in the opposite direction of stocks, not just in 2008, but throughout 2009 with rare exceptions. This relationship did not exist at other times in the past, and may well cease once again, but there is no reason to believe it will cease any time soon. The Fed's money printing is old news, and the USD's inverse relationship to stocks has still held solid. Indeed, international demand for US Government bonds has held up very well, and those bonds pay in dollars.

In addition, beware that USD shorts are at a record 12 month high (similar to stocks). Currencies always trade in pairs, one valued against another. Most of these dollar short positions ultimately come from traders buying / going long pairs such as the EUR/USD, which alone comprises about a third of all forex trade, or other popular pairs like the GBP/USD or AUD/USD. Together just these three pairs comprise about half of all currency trades, so they can move currency prices – a lot.

Buying these pairs involves selling the USD and in order to buy the other currency. Traders buy these pairs when stocks are rising and there is optimism. They sell these pairs (and thus need to buy USD) when stocks pull back. Reasons for this behavior vary a bit with each pair, but this is what has reliably happened over recent years.

Thus when stocks pull back, the USD rises against almost every other major currency except the JPY.

For example, look at the following chart of the most popular currency pair, the AUD/USD. When this rises, the AUD is gaining value against the USD. When it falls, the opposite occurs, and the USD gains against the AUD Compare this chart with the one that follows of the S&P 500 for roughly the same period. Note especially the similarities for 11/08, 3/09-Present.

AUD/USD Daily Chart: 8/09-9/09 Courtesy of AVAFX: Note how this pair closely follows the movements of the S&P as shown below. 10 sep 24

S&P 500 Daily Chart: 8/19/2008-24/09/09 Chart Courtesy of AVAFX 08 sep 24

For an even simpler illustration, look at how the UUP (an ETF that tracks the USD) moves compared to the S&P. They move in opposite directions. Not the best comparison, but a simple one for illustration.

UUP (Blue) vs. S&P (Red) 2-year Daily Chart 06 sep 24

LESSON 1: DO NOT BE SHORT THE USD WHEN STOCKS ARE PULLING BACK. That means do not be long the EUR/USD, AUD/USD or other pair with the USD on the right side of the slash mark. Unless perhaps you want to use these as a hedge against long stock or commodity positions.

Mr. Patel writes:

"Currently, I'm still long gold, silver, … "

2. If you are worried about stocks pulling back, then do not be long commodities, including precious metals. These also move in the same direction as stocks.

This makes sense, because commodity prices, like equity prices, rises with growth prospects, either because growth brings greater consumption, or in the case of precious metals, because they retain value in times of inflation. Growth tends to cause inflation, as more spending means relatively more currency is chasing relatively fewer goods than before. The only case in which precious metals have risen when stocks didn't is in times of extreme fear of financial collapse.

So are many traders, and these positions have been good over the past months, and are widely believed to be good positions for the coming years.

However, for the past few years at least, precious metals and other commodities have generally moved in the same direction as global equity markets. As with currency pairs, the relationship isn't always lock-step, there can be variations in timing and scale in the short term, but the long term direction and magnitude correlates well.

For example in the chart below for silver we see that while silver did hedge against stocks in the early part of 2009, it has followed the overall direction of stocks from 3/09 onward.

Silver Daily Chart: 8/19/2008-24/09/09 Chart Courtesy of AVAFX. 09 sep 24

Again, like the AUD/USD, it mirrors the S&P 500 index.


Finally, Mr. Patel writes:

"Non-US equities, in my opinion, remain safer than US equities. Many non-US equities have rallied more so than US equities."

At best partly true. Compare the above S&P 500 chart to that of any major international index, and see that the overall direction and timing is very similar. Diversifying into international stocks will not provide much, if any, protection from stock market risk ( though it should give some currency risk protection via diversification). Global stocks move together. This makes sense. Export oriented economies like China depend on the US and other net importers to buy their goods. The US depends on the export countries to buy its bonds and other financial assets. An oversimplification, but that's the basic idea. What's good or bad for one market tends to affect the others the same way.

Mr. Patel admits the chance of a USD rally in October, but many readers may miss this underemphasized possibility.


DISCLOSURE AND DISCLAIMER: The author's opinions are not necessarily those of AVAFX. The author holds positions in the above mentioned instruments.

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