Author: Clemens Kownatzki

Last week saw another mini-flight to safety.  The Euro was pushed down to the lowest point in about 4 years (before recovering), US Treasuries and other Bonds saw yet again an influx of scared money fleeing the global financial markets in drones.  But within this trend towards the illusive safety, many investors forget that US Treasuries and similar AAA rated sovereign debt instruments are not without risk.  I am not referring to pure credit risk but also to the inherent risk from the mechanics of Bond prices.  Although this is very basic, here’s a graphic reminder of the relationship of Bond prices to changes in interest rates.

The prices of Bonds, particularly the longer term Bonds (10, 20, 30 years), are rather sensitive to changes in interest rates.  Unless you hold a Bond to maturity, its price can fluctuate rendering your investment not all that risk-free after all.  Pension funds, Bond funds and Bond ETFs are not immune to this – something to consider before pouring all your money into the “safest of all” asset classes.

US short term rates are still at zero which makes it less likely that Bond prices could rise much further.  But let’s assume that the US will experience a multi-decade period of near zero short-term interest rates just like Japan since 1990.  What is the likelihood that longer-term Treasuries will retain their current ratings allowing them to continue to finance deficits at ultra-low rates?

IMHO, the Greek and Euro-zone crisis should serve as a wake-up call.  The long-held believe in the risk-free rate is beginning to fade.  Several US States, California being one of them, have budget deficits approaching Greek standards. Unfunded liabilities continue to rise, entitlement cuts are political suicide and therefore they cut the lowest hanging fruit first, education being one of them. 

For California, the proposed budget cuts in education have been so drastic that some Bond ratings agencies are now concerned about the long-term impact of these measures.  California and other US States are slowly approaching a tipping point of being no longer economically viable.   

In order to assess the credit worthiness of say a 20-year municipal Bond, ratings agencies must now consider whether California will have an educated enough labor pool to continue generating enough middle-class earners for the much needed tax revenues. By cutting education to the bone, governments dumb down society as a whole rendering their own state or country unable to get out of the debt spiral. For now, the ratings agencies are merely concerned that their clients might actually be paid back in 20 years.   

But with further cuts in education and other areas which contribute to the long-term economic viability of society, we should not only be concerned as long-term Bond investors.  Instead of cutting education, research & development programs for new and alternative energy, California as well as other States should heed the wake-up call from Greece. They must come up with cost-cutting measures for programs that do NOT contribute to sustainable long-term growth i.e. ridiculous pension and entitlement programs or building bridges to nowhere. If they don’t, the consequences are also clear.  Long-term financing at ultra-low rates will become increasingly difficult not just for California, Michigan and New York but it will affect US Treasuries, the mother of all  “risk-free” investments.

This guest post previously appeared at FXIS Market Insights >

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The demise of the Euro is just about upon us; that is the impression one can get from reading the financial news where the overall majority of economic commentators have been nailing the Euro to the proverbial death-bed.  Indeed, it has become more and more difficult to find supporters of the single currency in recent weeks.  The easy culprit is of course Greece and some of its Mediterranean neighbors who are at the center of this sovereign debt crisis which has been dragging the Euro lower and lower.

Ultimately, the markets will decide whether the Euro is “toast” or not.  In the meantime, there are a few considerations however and before completely writing off Europe and its single currency, let us remember that every crisis also creates an opportunity.  One of these potential opportunities from a declining Euro can be seen in last week’s performance of the German Stock Market.  The DAX was up nearly 6% for the week.   Since this is so relevant and rather timely, I wanted to share some of my sentiments towards the current Euro trashing.  The following is part of an email I sent to a friend last week:

The EU certainly has its problems but I am somewhat amazed how all eyes are on Greece when our very own backyard is such a mess too. I have a long list of issues with the whole market mess but just briefly…

California is in a pile of @#$% and other states and municipalities are in big trouble too. I am also slightly amused that New York still has a AAA rating.

The Euro hit a low of 1.2359 today and it looks like will be testing the 1.2300 area which was the lowest it reached during the financial crisis. I attended a panel discussion yesterday about the very same subject.  Concerns about further bad news especially from Spain and Portugal are making it more likely that speculators will continue to push down the Euro.

But just from a trader’s gut perspective, we’re now approaching a hugely oversold territory on the Euro. While I’m still holding my horses, there might be an opportunity on the horizon.  When the sentiment is so bad and everyone is talking about the certain demise of the Euro, that’s probably a good time to put on your contrarian hat. It was not long ago when everyone on the street said the US$ was “toast”;  we know what happened since…

Looking at things from a different angle, a lower Euro bodes well for the export oriented countries in Europe not just towards the US, but also towards China.  By contrast, China’s currency being pegged to the US Dollar has a slightly harder time now in terms of exporting their products to Europe at competitive prices.  The Euro fell almost 20% against the US Dollar in the past 6 months but that means the Chinese Yuan appreciated against the Euro by the same amount. 20% is a fairly big hit in terms of pricing products competitively.

Yet another thought, China is sitting on somewhere around $2 trillion worth of US$ denominated assets (presumably much more than that as I don’t trust those official stats) which are mainly in US Treasuries but also in a vast pool of foreign currency reserves.  These reserves are a problem for China and their Central Bank has been actively looking for ways to diversify such a huge one-sided risk.  The Euro at these beat-up levels is slowly looking attractive for a long-term play.  It may not be in the form of an outright currency purchase; the safer option for them might be German Bunds or Equity.

While this Euro slaughtering is going on, it may be a good time to look into other currencies which are somewhat isolated from general sovereign debt concerns.  The typical commodity currencies like Candy, Aussie and Kiwi come to mind with the Aussie Dollar leading the way in terms of a positive interest yield – central bank rates in Australia are at 4.5% now as opposed to 0.25% in the US.  But one could also look into other countries which are fundamentally in better shape possibly Norway and Singapore, maybe Korea (although I must do more homework on that).  All those are not without risk of course especially if global demand dries up. But for now, they seem a bit more attractive than a pure Euro/USD currency play.

In terms of trading these via ETFs, the major currencies are available and can be traded just like stocks.  So you don’t have to lever up 100:1 and trade futures or spot currency contracts.  You can trade currency ETFs just like any other ETF via your typical online stock broker.

FXE = Euro, FXA = Aussie Dollar, FXC = Canadian Dollar to name a few.

To my knowledge, there are no ETFs for Singapore $, Norwegian Krona or Korean Won on US Exchanges (found some in the UK though), but there are entire country ETFs for Singapore (EWS) and Korea (EWY); those would be equity plays with some currency exposure built in.

It is definitely a challenge to try and make some sense of global markets these days.  Very poor visibility and plenty more volatility are almost forcing you to stay on the defense for now. Until we see some of the “fog” clearing up it’s best to keep your seat belt fastened…

Read more at FXIS Market Insights –>

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(This is a guest post from FXIS Market Insights.)

The naughties (00’s) are often referred to as the lost decade culminating in the financial tsunami of 2008/09.  Total returns (including all dividends) on the S&P 500 were about –9% (-22% in nominal terms) for the entire decade.  With those numbers, it has become difficult to find a rationale for the “Buy and Hold” strategy that has been indoctrinated to the average investor for decades.

But despite the poor performance of stock markets over the past decade, there is ample evidence suggesting that stock picking and other active investing strategies are bound to run into substantial headwind over a longer period of time.  As Tom Lydon of www.etftrends.com suggests in his post: How to Become a Better ETF Trader:

According to a recent TrimTabs study, ETF investors are so bad at picking the right time to buy or short-sell the equity markets that those doing exactly the opposite of what ETF players did in the past 10 years would have ended up making sevenfold profits, reports Oliver Ludwig for Index Universe. 

The likelihood that a similar scenario would apply to most other active trading strategies in general is high and the rationale for that is quite simple: With more frequent transactions, trading approaches the realm of a zero sum game and the probability of outwitting other investors is by definition 50/50 minus transaction costs.  Unless you are an above average investor (trader), you won’t beat the crowd.  Although this may seem an oversimplification in terms of stock trading, an active investment strategy should on average under-perform the market by the amount of transaction costs incurred. 

So we have established that “Buy and Hold” didn’t work in the past decade and that market timing is also a particularly challenging task.   How can one improve the odds and what is the right strategy?

Tom Lydon suggests a few simple rules:

• Implement a simple strategy. Studies have shown time and again that there’s a direct correlation between how complicated a strategy is and how often you’ll use it. Keep it simple, silly.
• Have a stop loss. “It’s easy to buy and hard to sell,” goes the adage. Make selling easier by knowing when you’ll do it. And then do it.
• A simple strategy we suggest is trend following by using the 200-day moving average to determine when you buy and sell. You’re buying when a trend is there, and only when the trend is there. This allows you to check your emotions at the door.

Of these 3 basic trading tips, the third one is the most concrete example of a relatively simple and verifiable trading strategy. Brokerage firms often provide free access to research and trading analytics.  But these days, there are also free online resources available that let you back-test whether the proposed strategy would have worked for any given ETF. Let’s take this 3rd rule for a test drive then…

As a example, please consider www.etfreplay.com (no affiliation with the author) which has a tool allowing you to back-test a strategy using moving averages:  http://www.etfreplay.com/backtest_ma.aspx

Enter the ticker symbol SPY (the ETF for the US benchmark S&P500), use the suggested 200-day moving average and select “Trade On: Day of Cross”.  Choose your time frame, in this case, the past decade and hit the button to run the Back-test.  Here are the graphical results:

The proposed strategy seemed to have worked quite well with a more than 3:1 ratio favoring the 200 day moving average over the buy and hold period (Note: Returns are calculated from date of first backtest buy). 

There are  a few caveats however, again pointing towards a difficulty with regard to timing and money management.  For starters, the first trade did not occur until January 2002 which means staying on the sidelines for 2 years, had we implemented the strategy in January 2000.   That would have required a lot of patience!  Perhaps more difficult even for seasoned traders is the necessity to stick to a strategy during times when patience and conviction are severely tested.  The first 6 trades of this strategy were all losing money, albeit small percentage losses.  But the fact that the majority of the trades (77%) were losing trades can shatter the guts of the most confident traders.  Sticking to a strategy when the first few trades aren’t working isn’t everyone’s cup of tea.

In closing, I’d like to note that as with any trading strategy, simulated results from a backview mirror perspective are always to be taken with a grain of salt.  While the proposed strategy appears to have worked for the benchmark S&P 500 it may or may not work for other indices or other ETFs.  Please also note that this is just one example of an easy to implement trading strategy – there are many others.  In terms of an overall financial plan, a tailored asset allocation may be much more important and prove more successful over time than a serious of specific investments or individual trades, no matter what timing or trading strategy may be adopted.  Usual disclaimers and general investment risk disclosures apply here as well. 

Having said that, there are more and more trading tools available now that allow individual investors to test and verify if a given investment strategy could work, something which was available to only professional traders until recently.  Overall, the easier and often free access to professional trading tools and investment analytics should make for better informed and more educated investors.  But don’t take my word for it, test it yourself. 

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