Long-Term Fundamental Trends Point to Volatility and Currency Issues

 (Today’s post is a guest column from Forex Traders. – SmallIvy)

Current markets seem destined for a near-term correction, as exuberance over economic recovery data in the United States appears overly optimistic at best. After an amazing run up over the past seven months, the steam is already coming out of the balloon, as the S&P 500 Index has pulled back nearly five percent in the past three weeks. Now may be a good time to evaluate long-term trends in the market and to develop a long-term strategy for the years ahead.

The most dominant economic trend over the past decade has been the ascendance of the emerging economies of the world, often summarized by the “BRIC” anagram to reference Brazil, Russia, India, and China. Each of these countries, and especially their neighbors in Asia, has enjoyed real GDP growth that has doubled or trebled that seen in the Western world of developed economies. Although many investors are wary of current valuations in these markets, everyone from the IMF to major global economists are projecting these fundamental trends to continue.

Decades of off shoring activity has shifted the globe’s manufacturing base and related wealth factors to areas where labor costs are low and work ethics high. Forecasters predict great growth going forward, accompanied by volatility and pressure on currencies as a new world order emerges. China and India will be the big winners in this scenario of the future. However, you need not go to Asia to see these trends at work close hand.

Canada, our neighbor to the north, happens to have enormous oil reserves, second only to Saudi Arabia. The demand for energy resources from emerging economies has benefited Canada directly over the past decade. Its currency, often referred to in the forex market as the “Loonie”, reflects this success. Historical exchange rates for the “USD CAD” currency pair are depicted in the above 5-year chart. The Canadian Dollar has appreciated over 20% during the period versus the greenback, in line with a similar growth history for oil prices. The correlation between the Loonie and oil prices is clear.

 

If this type of trend is fundamental for the long term, what should a small investor do? There are a number of issues to consider:

• Diversification: Theoretically, a portfolio should contain a variety of holdings that are inversely correlated, so that if one goes down, another will rise in value to offset the loss. Investing in emerging stock ETF’s or even a few that are now devoted to specific currencies may offset the impacts of a weakening Dollar and take advantage of global growth dynamics;
• Asset Allocation: “Best Practice” for asset allocations from a portfolio for investing overseas has traditionally been 10% to 15%. Many pension fund managers have adjusted their parameters upward as high as 25% to 30%. Buying specific securities, however, can be risky. The best advice is to leverage the diversification that mutual or exchange-traded funds provide;
• Currency Risk: Investing overseas is a double-edged sword. Actual gains from overseas holding can be wiped out if our U.S. Dollar appreciates considerably during your holding period. Hedging this currency risk is best left to experienced professionals. An alternative approach would be to follow applicable exchanges rates to determine the impact that prevailing trends might have on your portfolio’s return dynamics.  Projected volatility, however, is another matter.  These fundamental trends are already causing strife in a number of regions of the world.  The forecast is for a rocky road ahead. 

A trader’s mentality of short-term buying low and selling high may be the best investing style over the next two decades and selling high may be the best investing style over the next two decades.

Bulls Make Money, Bears Make Money, Pigs get Slaughtered

The title of today’s post is an old Wall Street axiom related to asset allocation and greed.  It means that people who buy stocks (bulls) and those who sell stocks short (bears) can both make money.  There are times when each of these strategies are effective.  Those who hold for too long, or put too much in any one stocks, however, eventually get slaughtered.  It is important to remember that no stock will go up, or down, forever and one must always be wary of the possibility of sudden movements the other way.

As long-time readers of this blog will note, I tend to favor less diversification than is the standard.  Many money managers will advocate investing in hundreds of stocks, saying most investors should not even buy single stocks because they can’t get enough diversification unless they have millions of dollars.  The trouble with that philosophy is that 1)while it is true this provides downside risk, it also limits one to just making the market averages or less after fees, 2)one has little control over taxes because the taking of capital gains is up to the whims of the mutual fund managers, and 3)it leaves one subject to the little games that the mutual fund managers play, like buying the hot stocks just before reporting holdings to look like they were in the best companies all along.

There is nothing wrong with holding some mutual funds.  If one has quite a bit of money mutual funds provide good insurance against sharp declines that single stocks endure.  If one only has a few thousand dollars to invest, however, it makes little sense to spread that money out over 100 or 1000 stocks.  The advantage of being able to double or triple that $3000 in a year or two outweighs the risk of losing $1500 or $2000, or even the whole amount due to a missed earnings report or a scandal at the company.  Note also that investing over the long-horizon of years also reduces risk because over time most good companies will grow in price even though they may decline in any period of weeks or months.

Here again, though, one does not want to be piggish and face the slaughter.  For this reason my strategy is to concentrate in a few, great stocks, adding money all of the time to my investments, but when a position gets to be so large that I would not want to risk that amount, I pare it down and invest some of the funds in another stock.  This is true even if I think that the company has great prospects and will continue growing indefinitely.  I could be wrong and I don’t want to give back all of the gains I have made should the stock turn against me.  One strategy is even to sell enough to recover all of the money that had been invested.  Additional shares can then continue to be sold as the stock makes new highs.  In that way most of the profits made are secured as the stock rises should the stock turn around and fall.  It also gives a psychological boost to know you will make a profit no matter what, allowing one to “let the rest ride” with confidence.

As a portfolio grows from a few thousand dollars into hundreds of thousands, mutual funds should be purchased to lock in gains and provide security through diversification.  A portion of the portfolio remains concentrated in individual stocks with good prospects, however, but not so much so as to risk a loss that one cannot sustain.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.