In a column published on 11/12/07 by Forbes, Ken Fisher, the well-known author of The Only Three Questions that Count argues that the evolution of the S&P500 “is all in the yen/euro, almost every day”.
After a brutal week in the stock market, where the S&P500 index fell 3.7 percent and the NASDAQ composite index lost 6.5 percent of its value, Ken Fisher's argument deserves closer attention.
I will start by first summarizing the main points Fisher makes in “Put Some Money in Japan” and his follow up column under the title “The Carry Trade Connection”; and secondly provide some further evidence and refinements, hence "The Carry Trade Fine-tuned"
Ken Fisher wrote that when the Japanese economy is weak, the central bank of Japan lowers the interest rates (“to give it a spark”), however extremely low interest rates (the overnight rate in Japan now being 0.5%) stimulate Japanese capital to flee the country. “Speculators in Europe and North America borrow in yen at low rates, convert the yen into euros and other currencies, and invest in higher yielding assets elsewhere. This is called the yen carry trade”. Fisher argues that the borrowed Japanese money goes heavily into stocks. In his follow up column, Fisher wrote that “on days the yen falls to the euro, stocks almost always rise; when the yen strengthens to the euro, stocks fall”. The point is illustrated with an intraday chart of the evolution of the S&P500 and the yen/euro rate on October 31, the day that the Fed announced a 25-basis point rate cut.
A chart in Fisher's column shows there is a 0.93 correlation between the yen/euro rate and the closing prices of the MSCI World Index. In what follows I investigated how the fluctuations of the yen/euro rate influenced the S&P500 over the past year.
Chart 1 * shows the daily movements of the S&P500 (light gray line) together with the Currencyshares for the Yen (FXY) --black line) and the Euro (FXE) (green line) where the latter were obtained from www.currencyshares.com.
Chart 1This daily chart shows that from early March 2007 till the beginning of June the FXY decreased while the S&P500 increased; in contrast from early July till mid August the yen increased and the S&P500 fell. The chart also shows that the euro strengthened in value versus the US$ since the beginning of the year.
A marked up version of the same, Chart 2, shows these general trends even more clearly. The green upward trends in the S&P500 coincide with the downward trends of the FXY; the black downward trends in the S&P500 coincide with the yellow upward trends in the FXY.
However, there are periods in these charts when the yen and/or the euro move sideways while the S&P500 bumps up and down in a trading range, e.g. the period from May 25th till July 6th, the period from august 3th till September 14th (dates chosen by casual observation of the charts, not to be taken as exact turning points).
Chart 2 It is exactly these periods of "absence of correlation" that deserve a closer look. For these I assembled the daily currency rates for US$/Yen, Euro/US$ and Euro/Yen rate (using free widgets available on the world wide web).
Chart 3 of these daily currency rates zooms in on the period since August 9th or just about before the current market rally (now under pressure) was confirmed. This middle of the chart shows the steady upward rise of the euro versus the dollar; the top segment shows first the dollar rising against the yen, but from October 10th, the yen strengthening against the dollar; the bottom segment shows that the yen first rose against the euro, then dropped slightly and has in recent days again risen against the euro.
Chart 3 A closer look at the evolution of the S&P500 in the last couple of weeks shown in Chart 4 shows that the S&P 500 index evolved in the opposite direction of the Currencyshares for the Yen (FXY). Note the widening spread in the last few days when the yen strengthened both against the dollar and the euro.
Chart 4 These charts provide further evidence of the arguments made by Ken Fisher in regard to the correlation between the stock market and the yen/euro rate. However, they do not provide evidence that the strengthening of the yen versus the dollar, or even the yen/euro rate, should cause investors to consider investing in Japan. The last chart, Chart 5, shows the FXY versus EWJ, i.e. the ishares for the Japanese stock market. The EWJ has dropped since the Yen started rising in September.
Chart 5. I would also take issue with Ken Fisher on the value of a 2% overweight (10% versus versus 12% in Japan) as “an hedge against the possibility that the yen carry trade reverses”. When the Japanese stock market turns around, of which there is at present no evidence looking at EWJ, there will be ample opportunities to consider the strength of that turnaround versus the alternative opportunities in other developed or developing markets. The golden rule that all students of IBD have mastered, is to always let the market “tell” you where it is heading, not to bet on the turning points.
The correction the stock market is now experiencing, the strengthening of the yen versus the dollar and of the yen versus the euro, are clearly showing a change in trend! This change in trend deserves all our attention. The Forbes column by Ken Fisher together with this fine-tuning piece, should provide you with ample material for study in the coming week.
* all charts in this article were produced using DailyGraphs, a service of Investors Business Daily
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