Can your investing strategies handle a falling U.S. stock market? One great way to keep safe is to sell short emerging markets. Especially emerging market currencies. Let me explain why.
The US dollar is still one of the world’s safe haven currencies. Despite the recent cut in credit rating, there are few alternatives to the US dollar. It is a huge, highly liquid market where investors can put their money to work.
The emerging markets and their currencies are seen as speculative. These economies often grow quickly, attracting investors seeking fast capital gains. Emerging market currencies are borne on the same tide of speculative enthusiasm.
But what happens when economic risk peaks when there is global uncertainty? When the great safe-haven markets such as the U.S. fall, investors’ appetite for risk evaporates. They pull back from what they think are speculative investments, and put money into what they think is secure.
When U.S. stocks fall, emerging market currencies and emerging markets usually fall with them. This happens even if the real economic linkage between the countries is limited. It’s a matter of emotion. People feel hard times call for quitting (speculative) emerging markets.
Emerging markets don’t always rise when the U.S. rises. They must be seen as growth opportunities before that happens. But the reverse is almost always true: when the U.S. falls, emerging markets fall.
Here’s a chart comparing the iShares MSCI Mexico Index Fund (EWW) with the Standard & Poor’s 500 Index for the past year. Notice how they move together.
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Here's another chart comparing the SPDR S&P Emerging Europe ETF (GUR) with the Standard & Poor's 500 Index for the past year. Again, they move together.
So how can we use this knowledge to shape safe investing strategies? Two ways:
- First, short emerging market stocks during times of U.S. market volatility. You can do this by selling short the ETFs that track emerging market stocks, or buying puts on these ETFs. You can spread your risk even further by shorting ETFs that track baskets of emerging markets, such as iShares MSCI Emerging Markets Index (EEM).
- Second, short emerging market currencies on the foreign exchange market. Foreign exchange trades allow up to 50 times “leverage”, using borrowed money. This is a high-risk approach not suited to safety-minded investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.