When Stocks and Currencies Rise Together

Not all foreign stock markets offer this feature.

China, for instance, is up 102% this year in local terms and the same exact amount in dollar terms. That’s because China pegs its currency to the dollar. This phenomenon only applies to markets where currencies float.

But, of course, a currency that floats can also sink. So you could suffer currency depreciation from your foreign shares as well. That’s why it’s best to invest in economies that are rapidly improving. In this situation, stocks and the currency tend to rise at the same time because the forces that are bullish for stocks are often bullish for the currency as well.

Here’s a typical scenario…

A consistently rising GDP translates into rising earnings. At the same time, a rapidly growing economy may require higher interest rates to keep inflation in check. (For developing economies, this is even more pronounced since they must compensate for perceived higher risk, even when the perception is inaccurate.)

The net result is higher earnings and yields that attract a growing tide of foreign capital. And the money that flows in to buy local stocks, bonds and real estate constitutes more demand for the currency, pushing its exchange rate higher.

This combination of higher growth, higher yields and higher inflows creates the double windfall of higher share prices and currency appreciation for foreign investors.

There are many places where this is happening right now. The Economist tracks 42 stock markets with floating currencies. No fewer than 42 of these are up more in dollar terms than in local terms this year.

That’s mostly because the dollar has been in a general downtrend. And this trend could very well reverse if the dollar stages a rally. That is a real possibility, particularly if stocks crash and there is a general flight to safety. In that case, foreign stocks that fall 20% or 30% in local terms may fall 40% or 50% in dollar terms.

Yet in the long-term, there are markets that have very good potential for appreciation of both the stocks and currencies. Chief among these is India, a country that my colleague Ashish Advani and I have written about in detail over the past week.

1. Euro: Yes, the euro WAS King of the Hill for the most of this decade. But those days are long gone. Right now, the Eurozone is only as strong as its weakest members - and some of its weakest members happen to be suffering emerging markets in Eastern Europe.

Not to mention, the European Central Bank has already started following the Federal Reserve in slashing their own interest rates. And, just last week the European Commission urged all EU member states to unite in an EU-wide fiscal stimulus package worth 200 billion euros (US$260 billion) to stave off recession. That spells disaster for the single unit currency.

2. Pound - The London markets have been the most overexposed to the subprime-credit crunch for quite some time. In fact, the pound started to turn as early as November of last year.

Today, a year later, the pound is still suffering for the same reasons - deteriorating housing wealth, frozen credit market and heavily indebted consumers, among other sore spots.

The U.K. labor market (especially in London) is also still at risk from financial-specific job losses (even after massive layoffs this year). And, the Bank of England too is racing to catch the Fed in lowering interest rates to stem the economy’s collapse.

3. Australian dollar - Australia has been a satellite country to China for years. Australia is used to providing so much of what hungry Chinese manufacturers need to produce their “stuff.” But if China further cuts back their demand for such input products and commodity prices continue to drop, then Australia will lose the financial boost of its best customer.

In other words, Australia’s exports will suffer mightily and crush the Aussie dollar even further. If that’s not bad enough, the Reserve Bank of Australia is on a similar path with monetary policy. As it is now they can’t seem to cut interest rates fast enough.

4. South African rand - The ramifications from a sick global economy will reach beyond just the major currencies.

Whether South Africa’s economy lives or dies is based largely on their commodity exports. And as commodity prices continue to drop next year, which we think they will, the South African rand will suffer even more. Plus, economic troubles will likely rekindle political and social unrest.

Right now jobs are at risk in South Africa, so many South Africans could face the constant threat of unemployment. Of course, a rising jobless rate doesn’t sit well with a nation’s citizens. And civil unrest doesn’t exactly reflect well for the body politic. (A situation like this doesn’t bode well for any currency.)

But as you’ll see, you can use economic slowdowns the coming 2009 recession to grab never-before-seen profits in the Forex market. In fact, in just the last 12 weeks, investors have grabbed 1,229% shorting the Hungarian Forint, 1,509% betting against the Czech koruna, and earned an astounding a 2,997% as the Polish zloty dropped.

Capital Flows ,Where the money goes ?

But honestly, that’s only part of it. The other reason there is always at least one currency rising is because of capital flows. As a currency trader, you’re constantly watching where capital is flowing, so you know where traders are dumping their money.

Every time markets suffer around the world, there’s always a line-up of investors ready to sell-off their positions.

Each time, those investment funds have to go somewhere. Even if that’s just back to cash – which pushes a handful of currencies higher. That’s exactly what happened in 2008. As investors ran from stocks, bonds and even CDs, certain currencies rose.

However, not all currencies (or markets) are created equal.

Currencies and the Law of Relativity

We live in a world made up entirely of fiat currencies. “Fiat” means “an arbitrary order or decree.” In other words, our money doesn’t derive its value from a particular good or basket of goods, but from the government decree that brings it into law.

So the value of these currencies isn’t fixed. Instead, it tends to fluctuate and vary, depending on everything from interest rates and policy decisions to exports and civil unrest. So if you want to know what a currency is worth at any given time, you just have to ask yourself, “What could it buy?”
 
A soda, a half-gallon of gas, a big mac etc. And we do the same thing in the Forex world when comparing currencies. A particular currency can only buy so many yen, so many Swiss francs, etc. 

So it stands to reason that if a currency’s exchange rate is falling, then another’s is rising. That’s the law of relativity when it comes to currencies. If the dollar’s exchange rate against the yen is declining, then you can buy less and less yen with your dollar. But at the same time, you’re able to buy more and more dollars with your yen.

This is where the idea of an eternal bull market comes from.

So as traders all around the globe watch their bottom lines bottom out and their hedge funds blow-up, I’m flat-out loving this market.

Why? I have a secret weapon that lets me profit when markets are sinking, while my stock trading buddies can barely stay afloat with their stocks.

What’s that secret weapon? The Japanese yen. You see, when volatility increases in the markets and stock traders lose their shirts, their loss is my gain. The Japanese yen experiences an uptrend when almost every other asset class (even commodities) is headed downhill.

At times like these, I can pair the yen with almost any currency in the foreign-exchange market and I’ll win. I know the yen thrives off of volatility, so one of my buddies’ strongest tools works even better for me during bear markets.

Stock traders all over the country look to the VIX (Volatility Index) to gauge when the stock market may bottom. They wait until the VIX rises to an extreme level and then they go in and buy. However, I watch the VIX heading higher and I know it’s giving my yen trades another boost.

Then when the VIX appears to peak, and these stock traders are just beginning to make some headway in their trades; all I have to do is reverse my yen trade and I’m still making a killing the whole time. If they only knew it was so easy…

Take a look at the VIX in the chart below, and the Japanese yen price right above it. When the VIX hits extreme levels (above 30 but especially around 35 or higher), the yen starts to peak. At that time, I just reverse my trade and start shorting the yen.

The VIX and the Yen…Traveling Buddies!

As a currency trader, you can buy or short the yen based on what you see using the VIX, their so-called “stock tool.” If you’re a stock trader and you understand the VIX, then you also understand the yen whether you know it or not.

As you can see above, the yen’s run may be almost over because the VIX is showing an extreme reading (i.e. it’s soaring higher). So it may be time to reverse your Japanese yen trades.

Secret Weapon #2: Collect Daily “Dividends” from the Currency Market

But there’s one secret that would REALLY push my stock buddies over the edge if they knew about it. It’s one I use in “up” markets, when stocks are also doing well

Most traders know the S&P 500 hasn’t gone anywhere for a number of years. However, once you take into account these companies’ dividends, then you could have an overall gain even while stocks stay flat.
However, these stocks only pay out dividends on a quarterly basis, while currencies pay out interest on a daily basis. Yes, you read that right…

It’s like getting a dividend daily.

So I have 365 opportunities a year to profit, while my stock buddies get four. If they only knew…

Secret Weapon #3: No Commissions, So There’s Less Fees in Currencies

The third advantage I have over stock traders is my stock buddies have to pay a spread AND a commission for each stock trade, while I ONLY have to pay the spread.

And I pay a smaller spread than they do because I control more currency with less money down and because the currency market has more volume which leads to tighter spreads.

So while my stock buddies are trading in this bear market, losing money on their positions AND paying commissions along the way, I’m earning profits now and paying less in fees.

Let’s say my stock trading buddies and I place the same number of trades each year. My stock buddies pay a measly US$7 per trade (even though many firms charge more). If we both made only 10 trades each month, we’d both have 120 trades over the course of a year.

Now remember that stock traders are charged twice on each trade (when they buy and when they sell). So over the course of the year, my buddies must pay 240 different commissions, costing US$7 each. That’s US$1,680 in commissions. That doesn’t even count how much they also pay in spreads.

What do I pay in commissions for completing those same 120 trades? Nothing! I only pay my much smaller spread all year long.

My stock buddies have to earn that much more in profits before they even break even. So obviously, the deck is stacked in my favor. If they only knew…

You now know my three secret weapons that give me an edge in the currency markets.

Why Currencies Are Easier to Trade Than Stocks

If you’re looking for what stocks to buy, you have over 13,000 publicly traded stocks to choose from right now.

That’s a lot to weed through and it significantly drops your odds of choosing a winner. Even the best of stock pickers don’t always screen for the exact combination of things that you would look for in a stock.

However, in the currency world, there are only eight major currencies: U.S. dollar, euro, British pound, Japanese yen, Swiss franc, Canadian dollar, Australian dollar and the New Zealand dollar. So this makes about seven major pairs when paired against the U.S. dollar.

If you’re trading in the FX market, you could technically also pair these currencies with other currencies besides the U.S. dollar. But even then, you only have 15-30 pairs to choose from - compared to over 13,000 stocks.

In other words, you don’t have to watch thousands of currency pairs, because the pairs are such “macro” instruments.

This makes things simpler. All you have to do is pay attention to the most important data that comes out each day on those eight currencies. The economic announcements for a country can easily be found on an economic calendar at www.dailyfx.com or www.forexfactory.com.