From the September 01, 2006 issue of Futures Magazine • Subscribe!

When opportunity presents itself

The days of double-digit stock returns for small investors with a buy-and-hold mentality are gone. So these days traders need to find alternative methods to beef up returns.

The problem is traders still want to pick stocks and don’t consider looking outside the squawk box, so to speak. When stock indexes are hitting multi-year highs, it might not make sense to buy.

One long-term investment strategy for a buyer who is willing to look to other pastures is to exploit the divergence between the U.S. dollar and U.S. stock market. The U.S. dollar is approaching multi-year lows while U.S. stock market indexes have hit multi-year highs in 2006, despite recent action that suggests the most recent runup is starting to stall.

Historically a country’s currency will typically move in the same direction as its stock market counterpart on a monthly time scale. When the trends move in opposite directions —as have the U.S. dollar and U.S. stock market today — a divergence has occurred and subsequently an arbitrage trade has presented itself.

The setup of the arbitrage trade would be determined by the individual investor’s tolerance to risk, with the reward occurring from an eventual return to the mean. The length of time relevant to all events allows the investor to take time in determining strategy, risk and adopting successful buy-and-hold positions.

WORLDLY RELATIONSHIP

Chart comparisons from three countries demonstrate the relationship between their underlying currency and their representative stock market index. Futures data work best for the currency and stock index data plots. To predict a strong downward trend that would initiate the two issues moving back toward each other, monthly data points for the Dow Jones Industrial Average were analyzed with the volatility oscillator.

Results were examined under the presumption that a country’s currency value will typically follow its stock market index. This presumption is based on several admittedly oversimplified parameters:

• Movement in a stock market index reflects capital flow into that country’s investment environment.

• Capital flow into that country’s investment environment increases productivity.

• Increasing productivity creates buyers for that country’s currency anticipating inflationary forces will occur.

• The opposite is presumed in a capital outflow situation.

Using these parameters, it can be expected that any divergence in movement between a country’s currency and its stock index will be followed by a correction. One of the trends will move back toward the other, ultimately creating a more complete, and presumably more accurate, representation of that country’s economy.

Through research you can determine with a high degree of accuracy whether an equity will move and the size of the correction, a simple long-term strategy can capture a substantial basis of percent yield when the correction occurs.

Initial observations with the Japanese yen and Nikkei 225 stock index futures (see “Consistent trends,” below) show that when the two trends diverged in 1995 and 2002, the shift lasted for roughly a year before the two instruments moved in tandem again. Once moving in synchrony, it can be presumed that they will correct for the divergence at some point after stabilization. We saw this in the Japanese markets in 1998 and 2005.

These observations are further supported with the British pound futures and the FTSE index futures (see “Pound of correction,” above). Divergences are seen in 1987 and 1996, followed by parallel movement before correcting in 1993 and 1998, respectively. In both cases here, the return to parallel movement before correcting lasts a few years.

In the United States, the theory remains consistent. There was a brief divergence in 1999 before the markets continued to move in tandem, with a correction by 2001 (see “Uncle Sam demands,” below).

Another divergence occurred in 2003, being further exacerbated in 2006. The markets diverged further in 2004 and 2005 after beginning to move in tandem, so some losses should be expected before the markets realign.

The correction, if the theory holds true, has yet to occur. Therefore, looking for a change in sentiment can give clues to the change in trends. Ideally, first the two issues will move in like fashion before a correction will occur, based on the past. This would be the cue to enter the spread of choice.

PREDICTING REVERSAL

One tool you can use to find a change in sentiment is the volatility oscillator (see “Volatility cues can lead equity prices,” November 2005), which graphs the daily change in closing price against the 10-day average of the standard deviation for the equity of interest.

By plotting the Dow Jones Industrials’ index volatility oscillator graph, you can clearly see a change in sentiment in “On the edge.” A change is signified by both trends crossing the Y-axis at 0 in the same direction. The change in sentiment graphed shows a reversal occurring in July. Therefore, you can expect a negative price trend to be established.

A drop in price trend by itself may only signify a buying opportunity, but in conjunction with the presumption that the market is due to correct from its divergence with the dollar breathes a large sigh of caution.

THE SETUP

Based on this analysis, various strategies can be developed that adhere to an individual trader’s risk tolerance. Some mutual funds base their share value on the price of the U.S. dollar and some stocks will benefit from a rising dollar.

Taking advantage of this could be done in combination with shorting other overvalued equities traded on U.S. stock exchanges that create indexes that will have an adverse effect to a rising dollar. A strategy with higher risk would be to trade the actual futures themselves, rolling the contract as needed until the desired goal is reached.

It is important to use an analysis based on a monthly time frame as these trends take place throughout years, broken down into three phases: a divergence, a return to parallel price movement and a correction for the divergence. The first two phases may take years, so rushing into a strategy is often detrimental to the investor. All charts when looking for a change in sentiment should be observed on a monthly time scale.

The volatility oscillator is nice to use as it points to the obvious. When the trend in the change of daily closing price is positive, and the average standard deviation above 10 days is positive, it is fairly predictable that the price of the underlying issue is advancing, while the opposite conditions confirm declines. Unlike moving averages and other analyses that traders use as support and resistance markers, which make it difficult for the average small investor to decide if the trend will continue, the volatility oscillator ignores these markers and displays the nature of the trend in all its simplicity.

Once a strategy to exploit the divergence is decided upon and opened, a buy-and-hold frame of mind should be adopted to see which equity issue, the stock index or the currency, will correct at a faster rate. Of course, tops and bottoms are extremely difficult

to predict, so the investor should expect not to make money immediately and expect to take a loss while waiting for the correction.

However, because the decision is based on a macroeconomic scale and the position is taken in the form of a spread, the investor should not expect a significant loss and ultimately a net gain once either reversal is established and held.

Geoffrey Dennis is a molecular biologist and a private futures and stock trader. E-mail him at geoffreydennis@yahoo.com.

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