Bottom up Security Analysis: Currency Matters in International Investing

In a recent blog I wrote about the breakout in the Japanese Yen versus the US Dollar, (http://echoesfromthepit.blogspot.com/2010/04/keep-eye-on-yen.html), I described how a lower Yen may be a catalyst for a breakout in Japanese stocks. The primary reason a lower yen may help the Japanese equity market is that the Japanese economy still has a heavy reliance on exports. A lower Yen should mean an increase in exports which leads to higher earnings. It would also help to combat the deflationary conditions that have existed in Japan for decades.

In Pinnacle portfolios we own limited Japanese exposure at this time, but what we do own is a security that is not hedged against a falling yen. An un-hedged security has served us well for some time, but now it appears the tide may be shifting.

Today I embarked on a search for a security that would give us exposure to Japanese stocks, but also protect assets from a falling yen. After calling the managers of our current holding and running multiple filters on other securities in the Japanese equity space, there appears two ways we could eliminate the currency exposure we currently have.

One would be to leave the un-hedged fund (SPARX) alone and buy a security that makes money if the yen were to depreciate. There is a security available that bets against the yen (YCS), but it has numerous drawbacks. The first drawback is that the Exchange Traded Fund is leveraged, which increases the risk and the tracking error of the instrument over time. The second is that this approach requires more of a capital commitment since we would have to purchase both SPARX and YCS to get the net exposure desired. The third is the construction of the ETF makes it somewhat tax inefficient.

Our other option is the exchange traded fund DXJ (Wisdomtree Japan Hedged Equity), and it appears to be a much more efficient way to gain the desired result. DXJ owns Japanese stocks and hedges out currency exposure, and does this at a cheaper expense than what we currently own.

Tomorrow we’ll meet and talk about what we own in the Japanese space, and whether we should make a switch to the hedged security. We may or may not decide to pursue this particular investment after debating the pros and cons of making a switch at this time. Regardless, bottom up security construction is considered an important part of what we do, and meetings on security construction are a normal part of our process.

MACD

MACD, which stands for Moving Average Convergence/Divergence, is a tool used to determine momentum in a securityor index. To calculate the indicator you subtract the 26 day Exponential moving average (EMA) from the 12 day Exponential moving average (EMA). In essence, this allows the investor to see if the faster moving average (12) is above or below the slower moving average (26). Additionally, a 9 day EMA of the MACD is plotted to identify trade signals. With the MACD and the 9 day EMA, there are various ways to generate trade signals including crossovers and divergences. At Pinnacle, we typically monitor the MACD of the S&P 500 to assess the momentum in the broad market.

This chart is from 4/9/09 to 4/9/10. The S&P 500 is shown in the top panel along with the 12 day EMA in pink and the 26 day EMA in green. So when the MACD is created, which is the white line in the bottom panel, it is above 0 because the 12 is higher than the 26. The 9 day EMA of the MACD is also plotted in the bottom panel with a red line. With the index, the indicator and the trigger line plotted we can now assess the momentum in the market.

The first concern is the negative divergence between the S&P 500 and the MACD as indicated by the two white arrows. The S&P 500 is continuing to make new highs while the MACD is starting to rollover. The second concern is the MACD is starting to crossover the 9 day EMA to the downside which would be an additional sell signal. The last time a negative crossover occurred was right at the January peak so we will be keeping an eye on this indicator.

Quick Update on Equity Markets

So far this year US small cap stocks are leading the charge. Small Cap stocks are traditionally companies valued below $1 billion. They are up an impressive 12.23% year to date through 4/7/10.

IWM (Russell 2000 Exchange Traded Fund) +12.23%

SPY (S&P 500 Exchange Traded Fund) +6.59%

EFA (MSCI EAFE Index) +2.15%

EEM (MSCI Emerging Markets Index) +4.48%

Generally considered dollar strength beneficiaries, the nice rally in the green back has certainly provided strength to the small cap stocks. Meanwhile, the European stock proxy (EFA) has seen slight underperformance due to the Euro weakness. For instance, the DAX Index which is comprised of 30 selected German Blue Chip stocks is up 3.6% this year in local currency (Euro), but is down 3.42% in US Dollar terms. Additionally, emerging stocks have failed to keep pace with US markets.

All in all, this pattern of outperformance in small cap stocks can be very comforting to bullish investors. Outperformance reflects investor comfort in risky positions. Coupled with a bullish trend there is still reason to anticipate more gains.

Greek-German Spread Update

Below is a chart that we discussed during our Inside the Investment Committee presentation. It is the yield of a 10 year Greek bond (orange line), the yield of a 10 year German bond (white line), and the spread between the two (yellow line in the second panel). The German bond is generally considered the safest bond in the Euro zone, and the spread allows an investor to gauge the risk level in other countries. When the spread moves higher it means that the yield on the Greek bond is moving higher when compared to the German bond, or the country is seen as riskier. And as a refresher, when yields move higher bond prices fall and when yields move lower bond prices rise.

When we showed the chart at the beginning of March the spread had been narrowing, or Greek bond prices had been rising when compared to German bonds. That was due to rising expectations of a bailout for Greece by the other Euro member states. However, over the past month the bailout has not moved forward and the spread has jumped right back to the highest point since the adoption of the euro. The bond market is definitely signaling concern over Greece’s ability to reign in this debt crisis and avoid defaulting on their bonds.

And that brings us to the equity market. This latest move higher in Greek to German spreads has been of little concern to equity traders and this has certainly intrigued me. During the last spike in January, equity markets sold off close to 10% as fiscal fear spread throughout investing circles. So are we worrying too much about the fallout from sovereign default, or are equity traders the last ones to get it?

Short-Term Energy and Summer Fuels Outlook

The Energy Information Administration (EIA) has released their projections for West Texas Intermediate (WTI) crude oil, regular-grade motor gasoline, and Henry Hub natural gas. The EIA provides information and data covering energy, and prepares analyses and reports on topics of current interests. The projections for WTI crude oil spot prices have changed very little over the last five Outlooks, and they expect prices to average $81 per barrel this summer. Also, they project prices to average $85 per barrel by the fourth quarter of 2011. The strong global economic recovery will help keep prices firm over the next few months while several outside factors including the strength of the recovery and OPEC production could impact their projections.

As you may have noticed over the past few months, gasoline prices have been steadily climbing towards the $3 per gallon range. Well, the EIA forecasts that regular-grade motor gasoline retail prices will average $2.92 during the summer driving season and prices could even exceed $3 at various times during the season. Although consumers seem to have taken the steady rise in prices in stride, they are becoming increasingly burdened by the additional cost. If you recall the June 2008 high in price was $4.10 per gallon but I don’t think we need to see anything close to that level before the Federal Reserve starts to worry about commodity inflation.

For those interested in the full report it is found at the following address:http://www.eia.doe.gov/emeu/steo/pub/contents.html?featureclicked=5&

Keep an Eye on the Yen

The relationship between the euro and the U.S. dollar has captured most of the headlines recently, and that’s understandable given the problems with the PIIGS (Portugal, Italy, Ireland, Greece, and Spain), and the fact that the trade-weighted dollar index is so heavily weighted toward the euro (about 58%). But lately we’ve been watching the relationship between the dollar and the Japanese yen with a lot of interest as well. We hold small positions in our more aggressive strategies in Japan, mostly because of attractive valuations and because their equity market has underperformed so miserably that it may be due for at least a cyclical “mean reversion” trade. With the right catalyst we think Japan's equity markets could have significant upside even with the backdrop of poor demographics and much less robust growth than other countries.

The catalyst we have been waiting on is a weaker currency. One of the main problems with the Japanese economy for more than a decade has been a bout of chronic deflation. A weaker currency can help to counteract deflationary forces. Having a strong currency in recent years has hurt their economy, as well as stock prices. But the yen has recently been losing ground to the dollar, and appears to have broken above an important downtrend line on the news of a recently enacted fiscal stimulus package. With the largest percentage of government debt to GDP among developed economies, the currency has reacted negatively to the latest round of spending. The catalyst may have arrived.

Tony Boekh on Sound Money Management

The Gloom, Boom, and Doom Report is one of our favorite pieces of institutional research. Written by Marc Faber, it is one of the most stimulating and contrarian reads you are likely to find. I highly recommend it. In the March letter, Faber quotes from Tony Boekh’s upcoming book, The Great Reflation. Boekh is a former lead editor for BCA Research, another of our favorite institutional reads. Sometimes you read something that is so good that you just have to share. Here is Boekh discussing portfolio management:

From my 40 years in the business of trying to understand and predict markets, I cannot emphasize strongly enough the importance of having a mental framework of how markets work and how to integrate into this framework different indicators, which reflect the various forces that drive markets. Without that, the investor is like a boat on the ocean without a rudder, with the direction determined by which way the wind is blowing. In the world of investments, Wall Street blows by far the most wind, and it does not have the investor’s well-being in mind, only profits and bonuses for employees and shareholders of the firms there.

A framework of analysis for understanding markets is not the same as building a model or set of indicators fitted to back data. I can assure you, from a lot of experience that they always break down. An eclectic approach that is based on common sense, strong logic, and objective data, balanced by right-brain intuition and lots of curiosity, is what works best. The investment world will never be deterministic, never amenable to scientific models, at least for any period of time. Some approaches work well in some periods, other approaches in other periods. Successful investors not only know how to think outside the box but, from experience know what to pay attention to in each market environment.

What a beautiful statement of an investment philosophy that perfectly matches our own. As active portfolio managers, we are always trying “to think outside of the box” and to “use our experience to know what to pay attention to in each market environment.” Thank you, Tony, for saying it so eloquently. Needless to say, I will be buying his book ASAP.