Kaeppel's Corner: John, John He's Right On

Last week I wrote about the presentation given by Mr. James Rogers in June at Optionetics OASIS 2007 Conference (“Jimmy, Jimmy He’s My Man,” dated 10/10/07). In that presentation Mr. Rogers offered a very bullish case for all things China as well as all things physical commodities, particularly crude oil. As I detailed in that article, it would be hard for a guy to be more “right” than Mr. Rogers has been in the intervening months. However, Jimmy Rogers was not the only legend to take the stage during OASIS 2007. The other keynote presentation was given by John Murphy, perhaps best known for his best-selling works Technical Analysis of the Financial Markets and Intermarket Analysis: Profiting from Global Market Relationships. His presentation was no less enlightening.

The Japanese Yen/U.S. Stock Market Relationship

I like to think that I keep pretty close track of the important factors influencing the world’s financial markets. But last June, Mr. Murphy alerted me (and anyone else who thought they had been paying attention) to something that I had missed. Something important. It’s called the “yen carry trade.” Now the truth is, part of the reason I missed this is that all things related to “currency conversions” just seem to befuddle my poor brain. I mean sure I can trade currency futures. Okay, let’s see a one point move in the yen contract is worth $12.50. Check. But when you start getting into what the numbers actually mean, and the fact that some “currency crosses” are quoted in dollars and other are quoted in the other “non U.S. dollar” currency, for some reason my eyes start to glaze over. Never mind the fact that the most popular currency trade is the Euro/Yen cross which typically involves trading 125,000 yen quoted in euros – er, was that 125,000 euros quoted in yen?  I think I’d better lay down.

Anyway, John Murphy explained something known to “financial types” as the “yen carry trade.” More importantly, he highlighted the fact that this trade has been driving the world’s financial markets for much of the last year or so. Here’s how it works:

The goal is to take advantage of the fact that different countries pay different interest rates on their bonds. For much of the past year, interest rates in Japan have been at or near 0%. In a nutshell a trader sells the currency of a country with a relatively low interest rate and purchases the currency of a country offering a higher rate of interest. The trader is attempting to capture the difference between the rates. Many traders use a great deal of leverage in order to maximize the potential profitability of this trade.

So in a typical “yen carry trade,” a trader will borrow a certain amount of yen from a Japanese bank, then convert the funds into U.S. dollars and buy a bond for the equivalent amount. Let's assume that the bond pays 5% and the Japanese interest rate is presently at 0%. The trader stands to make a profit of 5% (5% - 0%), as long as the exchange rate between the countries does not change. Many professional traders have been actively using the yen carry trade using leverage. For example, if the trader uses a leverage factor of 10:1, then he stands to make a profit of 50%.

There are of course some potentially big risks involved. One big risk in the yen carry trade is the fact that if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, because this trade is typically done using a lot of leverage, even a small movement in exchange rates can result in huge losses. Lastly, because so much money is now tied to this particular carry trade, any run ups in the price of the yen – which can in turn cause large losses for those heavily invested in this trade – can cause massive ripples in the financial markets. Let’s look at the most relevant example.

Chart 1 displays a weekly bar chart for the Japanese Yen versus the S&P 500 ETF (). Take a moment to look at this chart. If you do not notice something fairly compelling about this chart then perhaps you should consider having someone else manage your money. For the two are almost mirror images since at least July of last year.

Chart 1 – Japanese Yen versus SPY (Weekly)

Chart 2 displays the same data since May of this year on a daily basis. The level of inversion, or “non-correlation” is amazing. During the past six months the correlation coefficient between the yen and the S&P has been -0.532 (a reading of +1.00 means they trade exactly the same, and -1.00 means they trade exactly the opposite. In the world of financial markets, a reading of -0.532 is extreme and rare – and potentially useful.

Chart 2 – Japanese Yen versus SPY ()

So what is the upshot of all of this? Should the average investor now rush out and start selling yen and using the proceeds to buy treasury bonds? That is not exactly the angle I was going for. For the average U.S. investor, the primary nugget of information here is the fact that because so much money is tied to the yen carry trade, the action of the Japanese yen is apparently exerting a huge influence on the U.S. stock market. So here is the thing to watch for the time being: 

Chart 3 displays the yen with a simple 10 and 30-day moving average overlaid in the upper clip. The lower clip displays the action of SPY based on those simple signals. Clearly, this appears to be something worth watching as we go forward.

Chart 3 – 10 and 30-day moving average crossover signals on the yen being used to track the U.S. stock market

The yen is presently quite oversold. With the stock market testing resistance, a bounce in the yen in the near-term could cause a failed breakout for the stock market. Looking further out, some things aren’t that hard to see coming. I mean you didn’t need to be a genius to know that the internet bubble of 1999-2000 couldn’t last (stocks of companies with no prospects for earnings selling at 100 times sales, I mean really though). You didn’t have to be a genius to see trouble coming in the housing sector (a couple bazillion dollars lent at rock bottom interest rates in adjustable rate mortgages to people who could barely afford the original payments in the first place – duh). And now if the yen carry trade is in fact driving the world’s financial markets, is it really a stretch to envision all hell breaking loose the next time the yen stages a major “surprise” rally? 

Great. Now I have something else to worry about.

The Gold/U.S. Dollar Relationship

Okay, now this one I knew about (yeah, sure you did Jay) but it was another important relationship that John Murphy talked about in his presentation in June. This is the relationship between the price of gold and the U.S. dollar. Like the yen versus the SPY, these two key markets have a highly inverse relationship. In the past six months the correlation coefficient between the gold ETF ticker symbol GLD (an exchange traded fund that tracks the price of gold) and the U.S. Dollar (using Rydex Strengthening Dollar Index fund, ticker symbol RYSDX) has been –0.731. Chart 4 displays this relationship, although a little explanation of the numbers is in order. 

The only reason for all the calculations was to try to highlight the inverse nature of these two securities as much as possible.

Chart 4 – StreetTracks Gold Trust (GLD, black line) versus U.S. Dollar Index (purple line), 5/25/07 through 10/12/07

The key to this relationship is pretty simple. As long the U.S. dollar remains weak gold is more likely to remain strong. So if you see the U.S. dollar start to rally, it may be time to look to play gold from the short side.

Summary

Back in the day, you were either a stock guy or a bond guy. If you were a stock guy then you were either a growth guy or a value guy and if you were a bond guy you were either a corporate bond guy or a muni-bond guy. Today things are “a bit different.” Today the number of possible opportunities for profit is seemingly endless. While this can be a good thing, the fact remains that you still need to know what you’re doing in order to achieve those profits regardless of the market/ venue/method/etc. that you are utilizing.

It helps to listen to people like Jimmy Rogers and John Murphy.

One Last Word of Caution Regarding October

In my article dated 9/26/07, titled “Fear and Loathing in the Month of October,” I highlighted the history of the stock market during the month of October during Years ending in “7.” In a nutshell, “it hasn’t been pretty.” Chart 5 displays the growth of $1,000 invested only during October of years ending in “7” (1907, 1917, etc.) through 10/15/07, with all other trading days taken out.

Chart 5 – Growth of $1,000 invested in Dow (all Octobers of Years ending “7” strung together)

While October 2007 started with a bang (the Dow was up 192 points on 10/1), I think that the results displayed in Chart 5 suggest that when it comes to the month of October, “it ain’t over ‘till its over.”

One More Thought

Here I go thinking for myself again, but the metals markets look a bit “toppy” at the moment. Please note that this is not a prediction that the metals are going to decline, it is simply an alert to traders who are looking for a countertrend opportunity.

The gold market is presently displaying a significant bearish divergence between price and several useful indicators. If you look at the top clip in Chart 6 you can see that December gold futures has made an impressive series of new highs. At the same time however, a slightly lower peak in the 3-day RSI has met each successive new high. Likewise, the MACD indicator is presently in a bearish downtrend.

Chart 6 – Bearish Divergence between Gold and several indicators

Now the truth is that gold could easily continue to advance and completely wipe out these divergences. Still, it might be worthwhile to see how this progresses. A four-divergence pattern is fairly rare and typically – though not always – signals a market that is losing momentum and is due for a pullback.

The silver market has also reached a couple of new highs that were accompanied by lower peaks in the 3-day RSI. The silver market also put in a key reversal day on 10/15, first breaking out to a new high and then reversing to close lower on the day. For shorter-term traders this could represent an opportunity to play the short side.

Chart 7 – Bearish divergence between Silver and the 3-day RSI plus a key reversal day

Jimmy and/or John: if you want to give me a call on this one, feel free.

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Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site