2011 Could Be the Year of the Euro and European ETFs

by: Moby Waller

As we begin to approach the mid-point of 2011, let’s take a look at international trends in relation to currency movements. We’re seeing some interesting developments, especially for ETF and ETF option traders.

I looked at the single country ETFs, which trade over 25k volume daily. On a 2011 performance chart there was a notable group outperforming the US benchmark S&P 500 Index (NYSEARCA:SPY) (SPX) and 3 large countries notably underperforming.

Europe is the region that is beating the SPYders thus far this year. There are 6 different ETFs clearly above the SPY on YTD performance in the chart below, all Europe-based. These are all iShares ETFs: Italy (NYSEARCA:EWI), Germany (NYSEARCA:EWG), Sweden (NYSEARCA:EWD), Switzerland (NYSEARCA:EWL), France (NYSEARCA:EWQ) and Belgium (NYSEARCA:EWK). Not every single country Europe ETF is outperforming, but all of these are.

2011 International ETF Relative Performance Chart
- (click charts to enlarge)

And there are 3 clear laggards on 2011 performance, iShares Japan (NYSEARCA:EWJ), South Africa (NYSEARCA:EZA) and Brazil (NYSEARCA:EWZ). All of the other single-country ETFs with signficant volume are underperforming the SPY to a lesser degree, many near break-even on the year. Japan has had massive natural disaster troubles this year, so that’s expected. Brazil is reliant on Oil and South Africa on Gold, but neither of those are the sole reason for the underperformance there thus far this year.

These Europe ETFs highlighted above are up around 10% year to date, with SPY up around 5%, and the 3 laggards down between 5 and 7%. That’s a 15%+ performance discrepancy between the best single country ETFs and the worst just for the first 5 months of this year. And with the leverage provided in option trading, a savvy investor/trader can exploit these performance gap trends for strong profits in both directions.

Note that the patterns of performance of the SPY and the European country ETFs is similar, but basically you’re getting more “bang for the buck” to the upside with the outperformers. Specifically you may note that iShares Italy (EWI) [grey], and to a lesser degree iShares Germany (EWG) [orange], have been the best of the best this year when the upside moves occur.

One wonders why Italy has rallied the most when one consistently hears about debt & fiscal problems over there and specifically concerns about the “Mediterranean Boot.” Not being an expert in that region and with fewer Europe-based industry sources than I used to have, I’m not quite sure what the answer is here, but as we say “the trend is your friend.” The top holdings of EWI (from Yahoo Finance) include oil company ENI (NYSE:E), banker UniCredit (UCG), energy/electricity Enel , banker Intesa Sanpaolo, automaker Fiat, and insurer Generali Assicurazioni.

When one looks at the Euro and Dollar performance through the lens of Currency ETFs, the gains made by Europe country ETFs seem to be correlating with gains in the Euro. Take a look at the relative performance chart of CurrencyShares Euro Trust (NYSEARCA:FXE) and PowerShares US Dollar Index (NYSEARCA:UUP) in the chart below.

Euro and Dollar ETF Performance Chart

There’s been a fairly clear inverse correlation between FXE and UUP this year, with the Euro making gains and the Dollar losing value. Note however that since the beginning of May the Dollar has had a mild rally at the expense of the Euro. This coincides with the the tightening of the performance gap of the S&P 500 and the European ETFs. And by the way, this recent Dollar strength hasn’t benefited the underperforming Japan, Brazil, and South Africa ETFs.

Bottom line, one would have to assume that the Currency tail is wagging the Equity ETF dog. As the Euro gains relative value, dollar-denominated European ETFs see money flow into them. So the question for the rest of 2011 is will the recent Dollar rally and Euro weakness have legs, or will it revert back to the earlier longer trend? The answer will likely give traders the direction in which to trade the Europe indexes vis-a-vis the US markets.

Disclosure: I have no current ETF Trade open positions in the securities mentioned.