A 'Yen' For A Stock Market Hedge

 |  Includes: FXY, SPY, TLT
by: Eric Parnell, CFA

After a rousing start for the first three months of 2012, the stock market (SPY) has stumbled out of the gate thus far in the second quarter. And after posting such a strong advance on what could be argued has been a rather shaky foundation these last few months, the potential for a meaningful correction is increasingly rising, particularly with the end of the latest Fed stimulus program now looming around the corner in June. After all, one has to look no further than the past two calendar years to see how the stock market reacts once the Fed withdraws stimulus.

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With these concerns in mind, many investors are increasingly seeking hedges for their stock market exposures. Others are looking for ways to outright short the stock market but with less risk. In several past articles, I have highlighted the effectiveness of Long-Term U.S. Treasuries in this regard. Fortunately, a handful of other options also exist that also help hedge against the stock market. As an added plus, they also tend to complement Long-Term U.S. Treasury exposures as well.

The Japanese yen (FXY) currency is a leading alternative in this regard. Now before going further, it should be noted that any suggestion of allocating to the yen is in no way a bet on the outlook for the Japanese economy. It is well known that the Japanese economy has massive challenges in regards to the fiscal situation. Instead, just as with Long-Term U.S. Treasuries, any position to the FXY should be viewed with a short-term time horizon as an inversely correlated tactical position relative to the U.S. stock market.

The yen has exhibited a variety of attractive characteristics in this regard since the beginning of the financial crisis.

First, the yen currency has been a consistent performer. Overall, the value of the yen is 30% higher relative to the U.S. dollar than it was at the beginning of the financial crisis back in 2008. During this time, it has not experienced a correction of any duration in excess of -10%. And while the Bank of Japan has done its fair share of stimulus in recent years, it still pales in comparison to the work that the U.S. Federal Reserve has been able to accomplish over the same time period. Looking ahead, one gets the sense that the Fed is not likely to take its foot off of the monetary gas pedal anytime soon.

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Second, the yen is uncorrelated to the U.S. stock market. Overall, its weekly returns correlation to the U.S. stock market dating back to the Lehman bankruptcy is 0.04. More importantly, the yen's correlation to the U.S. stock market is 0.36 during rally phases but -0.25 during periods when the stock market is in a corrective phase. In other words, the yen has shown the ability to rise when the stock market is rallying but also rise when the stock market falls into correction.

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As an added plus for those using Long-Term U.S. Treasuries (TLT) to hedge against the stock market, the FXY is also essentially uncorrelated to the TLT with a correlation of 0.02. Thus, both positions can coexist in a portfolio together as complements to one another while still hedging against a stock market decline.

Lastly, a recent pullback in the yen has provided an attractive entry point to establish positions. After peaking at 129.36 on the FXY at the end of January, the Yen fell into a correction, bottoming at 117.13 by mid March. The yen found support at its upward sloping trend line at these levels (see the "Staying On Track" chart above) and has rebounded solidly since. And just yesterday it broke out above its 50-day moving average. Its ability to hold above this technical level will be important to watch in the coming days. If it can hold, the next major resistance is roughly 3.3% higher toward the 125.70 level on the FXY that includes both the 200-day moving average and a previous horizontal support line. And if it retreats lower once again, watch for a potential double bottom in the 117 range.

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Thus, for those investors who are either seeking a hedge for their stock market exposures or are looking for ways to get outright short the stock market with less volatility, the Japanese yen is worth consideration. Once again, any positions should be viewed tactically with a short-term to medium-term time horizon. Also, currencies are notoriously volatile, so these are positions that should not go unattended for any length of time. But in a marketplace with so few options available to protect against a stock market decline, the Japanese yen is an appealing alternative.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long FXY, TLT.