Market Returns To Normalcy: Will It Last?

Includes: FXY, SPY
by: Everyday Finance

It's been a rough couple weeks. Somehow, I managed to make it out of this correction without losing as much as the major indices even though most of my holdings are high beta. I made some good moves and I made some mistakes, all of which will be highlighted here.

First of all, for weeks, I've been urging investors to dump anything related to mortgage back securities, investment houses and finance in general, as even the innocent would be punished in this melee. I sold out of the last remaining financial related stock, ACAS above 40.

I also recommended buying calls on the VIX and VXN, which rise substantially when fear sets in. This week, these indices rose to multi-year highs in conjunction with the market declines. For me, I only bought one contract on the VIX and I didn't exercise at the bottom of that 400 point drop Thursday, so it's about even now again. However, I plan on holding through expiry in September because I don't think we're out of the woods yet. An emergency Fed intervention is what brought this market back today, not a feeling that everything's OK and the past few weeks were just an overreaction.

A few weeks back, I had gone into an AAPL long strangle, whereby I purchased out of the money calls and puts on Apple stock just before earnings looking to capitalize on the massive swing that ensued. As it turned out, it didn't reach the 150 on the long end and that option expired worthless, but I had a Jul 125 on the short end and that one was sold for a handsome profit. I also had several QQQQ puts that I'd been holding all year that I unloaded this week for a moment just like this. Of course, a perfect market timer would have unloaded them at the trough on Thursday, but I wasn't too far off on Wed.

I took some gains on the likes of CROX, BIDU and FMCN before they continued their slide down. I'm now holding a fair amount of cash and will likely be buying bargains again next week provided there's some stability. I may just hold off and wait until the next Fed meeting to see what's really going on with rates. At this point, it looks as though the market's pricing in a cut an if that doesn't happen, the market could slide again.

The carry trade
Another big risk I see is if the carry trade unravels. This is where investors borrow currency at lower rates and purchase US dollars, which are then invested in US treasuries yielding a higher rate. This carry trade business has been going on for years and many prominent economists see this as yet another unsustainable practice that will come to an ugly end. Just like internet stocks with no potential of ever earning a profit doubling each month and just like lenders giving money to borrowers with no income verification and nothing down, this can be viewed as another scheme that will eventually collapse on itself. If there's a stampede out of the dollar and the yen rises against the dollar rapidly, the market confidence will be shaken once again.

What's an informed investor to do?
Under this scenario, one would profit handsomely from holding yen, right? This isn't done easily unless your into trading Forex. However, there is a convenient ETF which mimics this exchange. It's FXY. As noted in the attached chart it has an inverse correlation with the market. I bought into this earlier this week and profited handsomely when the market went south.

Chart: note FXY inversely crushing the S&P during the past month.
click to enlarge

Now, I'm not one to advocate diversifying yourself out of a profit, but holding multiple non-correlated instruments can protect you from a market decline and cashing these in on the way down or at the bottom provides for some nice liquidity to go bargain hunting following a week like this.

Disclosure: I am still long FXY, VIX and all stocks mentioned in this article.