The pieces are in place for U.S. discount brokerages to begin allowing direct investment in stocks listed on overseas exchanges through online trading accounts. Ultimately, the fallout for the U.S. equity markets could be huge. Most important, this could make available new strategies that traders can employ to trade new and existing markets.
In fact, this trend is so significant that its influence could transcend stocks, and the U.S. dollar, bonds and commodities markets also could feel the impact.
One of the first of the online brokerage companies to offer this is E-Trade Financial, which is allowing access to stocks from Japan, Britain, Hong Kong, France, Germany and Canada. The company says two-thirds of traders are interested in trading stocks on non-U.S. exchanges, and 70% of those interested would trade overseas stocks if accessible.
There are several ways to formulate successful trading strategies. One is to correctly assess how industry trends and developments could affect how the markets move and then position your account accordingly. This is one of those times. Let’s consider some possible results of the easy availability of non-U.S. equities to U.S. equity traders and the strategies that can be employed to take advantage of this trend.
NATION ROTATION
Despite overseas markets being at the heart of this move, U.S. stocks may be the most affected. Consider that for online stock traders to free up funds to invest in overseas stocks, U.S. stock holdings must be converted into cash.
Of course there’s no way of knowing how much money online stock investors may rotate out of U.S. stocks and into overseas issues, but with many investment experts recommending investing at least 25% of a portfolio in non-U.S. stocks, the amount could be enormous. This immediately suggests a strategy of selling U.S.-based indexes like the S&P 500, the Dow 30 and the Russell 2000 and buying non-U.S. indexes like the like the STOXX 50, the DAX or the Nikkei 225.
It’s natural to expect this shift to be tempered by the amount of money already invested in non-U.S. mutual funds and by overseas firms listing their stock on U.S. exchanges. But consider E-Trade’s claim that nearly half of customers indicated they would trade these markets if accessible. That implies additional active investment, not apathy.
Results of this will be felt on U.S. shores. Although investment in non-U.S. stocks may have a reserved, if measurable, negative effect on U.S. stocks across-the-board, there are certain sectors that may be particularly hard-hit:
1. High-yielding stocks. With many stocks on overseas exchanges paying dividends of 5% to 10%, U.S. high-dividend stocks now will have new competition (see “Poised for a breakout?” below). High-yielding stocks in utilities, financials and real-estate investment trusts (REITs) especially would face increased competition.
2. Litigation-threatened stocks. U.S. corporations have to deal with an increasing risk of litigation. Investors who want exposure to U.S. stock sectors most affected by this risk may opt out of their U.S. holdings and move into those companies’ non-U.S. counterparts. (See “Litigation stagnation,” below.) Consider stocks in these sectors: tobacco, pharmaceuticals and health care.
3. Regulation-threatened stocks. U.S. corporations also face substantial regulatory risks. Investors may choose to rotate funds out of U.S. stock holdings most vulnerable to regulatory risk and, again, into non-U.S. counterparts. Affected sectors include health care, pharmaceuticals and airlines.
There are many specific strategies available to protect yourself in the advent of potential weakness in these U.S. equity sectors. The most basic technique is simply to reduce exposure. Another is to establish hard and fast risk controls that will liquidate the positions in the case of a quick fall in the market (stop-loss orders or put option purchases, for example).
However, exploiting major trends is more than just risk control. It’s also about opportunity, and one of the greatest exists in the exchange-traded funds (ETF) market. For example, the American Stock Exchange (Amex) lists options on a number of ETFs that represent the potentially-affected sectors. These options allow equity traders to establish bearish positions.
One example is the Select Sector SPDR-Health Care ETF (XLV), which is designed to generally correspond to the performance of the benchmark Standard & Poor’s Health Care Index.
In addition to an outright short, a potentially profitable position would be a bear put spread in the options on XLV. A bear put spread involves the purchase of a put, while simultaneously selling a put at a lower strike price. The put you purchase costs more than the put you sell, creating an initial cost, but the put with the higher strike (the one you bought) will ultimately be worth more if the sector suffers weakness. This method enjoys better downside protection than an outright short trade because the lower-strike put offsets some of the pain if the market doesn’t drop.
OTHER MARKETS
Of course, U.S. stocks aren’t the only markets that could feel the effects of this trend. Forex and U.S. bonds also could take a hit.
Because overseas stocks are priced in foreign currency, the rotation of funds out of U.S. stocks and into non-dollar-denominated stocks requires U.S. investors to trade dollars for the currency of the overseas issue. Due to currency market supply/demand, this would put pressure on the dollar. If millions of online stock brokerage customers shift some of their funds into non-U.S. stocks, the effect could be considerable.
Currency exposure is a big reason why non-U.S. stock investing is attractive to retail traders. In combination with non-U.S. stock ownership, investment in a non-dollar-denominated asset carries additional attractiveness as a diversification vehicle.
As far as Treasury bonds go, the inflationary implications of a pressured dollar may put upward pressure on interest rates. This, in turn, would push U.S. bond prices lower.
This pressure may be intensified by the high-dividend-paying nature of certain non-U.S. equities. This is because bonds, like stocks, may be less attractive to income-oriented investors, who will now have an alternative investment product available to them.
A potential wildcard for the U.S. bond market is China’s recent decision to diversify its $1 trillion in foreign currency reserves, much of which is invested in U.S. Treasuries. While the general weakness in the dollar would be ample reason for China to sell U.S. debt, additional dollar weakness from U.S. stock investors diversifying overseas could tip China in favor of divesting from U.S. debt holdings.
Amid all of the bearish news that direct overseas stock investing may have for U.S. stocks, the dollar and bonds, there is one bright side for bulls: commodities. In addition to all of the bullish arguments that have been echoed for commodities in recent years, now there’s one more. The dollar-down-interest-rates-up-commodities-to-follow argument is a familiar one, and it certainly holds true given this prevailing scenario.
STRATEGIES ABROAD
Although there are many overseas commodities companies with stocks listed in the United States, there are many that don’t have stocks listed in the U.S. This opens up a huge selection of new investment choices for all investors.
Examples include U.K. Coal (LSE: UKC), Britain’s largest coal mining company (see “Lump of coal, anyone?” below); and JKX Oil & Gas plc (LSE: JKX), an oil and gas exploration and production company.
In both of these cases, a front-running strategy of seeking long exposure in such markets, which could be poised to advance strongly in the wake of U.S. investment, could result in significant long-term gains.
While the selection of commodity ETFs listed in the United States is rather small, there are many overseas commodity ETFs that enable investment in commodities that don’t prominently trade in the United States. Take, for example, Euronext’s ETCs (exchange-traded commodity) funds. Like commodity ETFs, ETCs give investors access to commodities that aren’t widely available here, such as nickel and zinc (see “Nickel for your thoughts,” below).
Note, of course, that like most bold initiatives, this one is not without its challenges. Take, for example, the issue of stock research: While E-Trade says it will offer customers currently available research and plans to offer more research in the future, it remains to be seen how the company will handle seemingly mundane but critical considerations such as the language translation of non-U.S. company reports and the gathering of information on small overseas firms.
Despite the challenges, this event may well be looked back upon as a major milestone in the history of financial market offerings to U.S. investors and it is a trend that defies traders to turn it a blind eye. As in all cases, ignoring opportunity, however fleeting, only ensures that it will be a missed opportunity.
David Twyford is a former member of the Mid-America Commodity Exchange and former commodity futures broker. Reach him via his Web site at www.commoditiesinvestments.com.
