The Year Of The Currency

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Includes: EUO, FXA, FXE, UUP, YCS
by: Macro and Cheese

As stocks remain in a choppy two-month range and bonds set to stay stubbornly overvalued on government intervention, investors need to be on the lookout for assets that can generate real returns. Happily, such an asset class does exist. Even better, it's the most liquid asset class in the world, and some currency valuations are hitting extremes. As if that's not enough, currencies can offer significant diversification, potentially enhancing returns while reducing risk.

I'm not the only investor to lament the state of global stock markets at the moment. It's a dangerous world. Normally we could sell in May and go away until 2015 -- if stocks weren't so cheap. With the S&P 500 trading at less than 14 times trailing earnings, the index yields about 7%, very expensive when trading from the short side. These conditions make timing absolutely critical from both sides, and research has shown that market timing is a very difficult proposition.

Bonds are no better. With yields of 1.90% and inflation running at 2.3%, after tax an investor is losing about 1% per year. And don't think conditions are liable to change soon: Since Japan's government bonds broke below 2% in 1998, they have never been above that level, and currently yield 1% less than our bonds of the same maturity.

Now consider currencies. Over the long term, currencies should--and I stress, should--gravitate towards their purchasing power parity. That is to say, a pair of Ugg boots in Paris should cost about the same as the same boots in New York, after taking the exchange rate into account. If not, enterprising Americans could ship a boatload of cheap Uggs and sell them on Paris streets. Over time, that sort of arbitrage keeps the currencies in line. French boot buyers need to buy dollars to buy cheap boots, which drives up the price of the dollar relative to the euro.

There are a number of measures to gauge the purchasing power parity ("PPP") of a currency, and I have found the OECD's to be the best. (Another very simple one, and not bad at that, is the Economist's "Big Mac Index." It just compares the price of Big Macs around the world and computes fair value.) Here is a sampling of how the OECD values currencies:

Swiss Franc 39% overvalued
Australian Dollar 37% overvalued
Japanese yen 25% overvalued
Canadian Dollar 19% overvalued
Korean won 37% undervalued
Mexican peso 59% undervalued
Click to enlarge

I don't want to oversell the idea that currencies should trade in line with their purchasing power -- they rarely do. But if we can identify currency strategies that make sense, it is comforting to say the least to have PPP on our side. I do trade against it at times, but only on a tactical basis. Any longer-term strategies are generally in the direction that PPP would suggest. In other words, I usually sell overvalued currencies and buy undervalued ones.

One major factor that can interfere with currencies gravitating towards PPP is interest rates. In other words, there are times when investors trump trade flows. The Aussie dollar may be overvalued, for example, but because Australian interest rates are considerably higher than US rates, demand for the Aussie can remain strong. However now we are in an environment where interest rates around the world are converging to between 1 and 2%, so there is little reason to buy another currency for investment purposes. Even the Aussie is losing its interest rate prop, with Australia's central bank recently cutting short term rates by 0.5%.

To paraphrase Warren Buffett, now that the interest rate tide has gone out, we can see who's been swimming naked. This interest rate convergence should exert pressure on currencies to move towards their PPP. As investors this pressure can be of keen interest to us, because even if the Australian dollar, for example, were to move 1/3 of the way to its PPP, this would represent a 12% return. (I caution that this return does not take into account the interest rate differential, currently between 2 and 3% per year.)

Another very attractive aspect of currencies is their diversifying benefits. To the extent that we can find investments that are not correlated with each other, we can lower the risk level of our portfolios. Currencies have a way of going through shifts in correlation -- at times the euro, for example, is highly correlated to the stock market -- but more recently this has not been the case. In fact, the euro had a minus .40 correlation with the S&P on a 90-day basis back in February, and currently has a positive correlation of .70.

One word of caution if you are new to currencies: As with all types of investing, currencies are not easy. They can change direction abruptly; they're subject to political risks; they can stay far away from fair value for months and years at a time. If you do consider them, stay small initially at least, and identify a trading stop that you can live with that is not too close to the current price. In other words, give your investment a cushion against market noise. Do your homework.

All investments have their time in the sun. In 2009 and 2010 it was stocks. (We know what happened in 2008.) In 2011 the torch was passed to bonds. For my money, 2012 will be the year of the currency. There is plenty to do, and lots of time to do it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am short the Australian dollar, the euro, and the Japanese yen.