Tags: carry | trades

Carry Trades Rise From the Dead

By    |   Thursday, 16 October 2008 10:19 AM EDT

Wow, what a difference a week makes in the currency market! Where do I even start?

Last week, the ink had not even dried from publishing my last article that predicted the carry trade would be dead through 2009. That's because I expected the carry trades to fall another 2,500 or more pips. And that normally takes a year or more to accomplish.

Well, can you believe that it happened in about a week? I couldn't either. While stocks were gyrating up and down 700 to 1,000 points a day, currencies were making bigger moves than I could find on 10- and 30-year charts. So these may be the biggest short-term moves of all time!

There were one or two carry trades that moved down 2,000 to 3,000 pips over a couple of days. This is simply unheard of, yet it happened!

Veterans who have been in the industry for over 30 years were shocked!

So, like any good analyst, I reassessed where these pairs are today, and I must say that now I have to change my story. The move that I predicted did in fact happen, it just manifested in a week instead of it typically taking a full year to move that far. Unbelievable!

With that said, some select carry trades will make a good go of it next year now (in light of the discount that they are trading at right now as opposed to where they were just one week ago).

Yes, some of these pairs made it down to 10-year lows in a matter of a week or two.

So here are a few carry trades that will do well from these levels going though 2009: EUR/JPY, AUD/CAD, USD/JPY and AUD/CHF to name a few.

Let me explain why.

For starters, historically, these are some of the more beaten-down pairs out there. They are trading at the greatest value when looking at their 10- to 30- year price charts as well as their distance from technical levels, such as their 200-day simple moving averages.

Another reason is that these will be some of the ones to recover as stocks recover. What? Stocks recovering? Yes!

As I'm writing on Oct. 12, I see a bottom forming even now in stocks. Those with long-term time horizons should be buying up stocks at these levels with 5 to 10 year outlooks (and no margin buy with cash).

They should also be buying up the carry trades mentioned above because these carry trades will likely move further and have higher percentage returns than will stocks.

In general, carry trades tend to follow the mood of stocks. In up markets, investors are willing to take risk and therefore buy stocks. At the same time, currency traders are also willing to take on risk and buy carry trades like the ones mentioned above.

(Formerly, we were in a down market where investors were "risk adverse" and would shun taking on risk, and rightfully so. And stocks and carry trades both plummeted, as they should.)

So why in the world would I say that stocks are in the process of forming a bottom right now? Here are many reasons why I know that this is the case.

For starters, the VIX (volatility index) reached a level never seen before. That's right! It wasn't higher on 9/11. It wasn't higher at the NASDAQ crash. It wasn't higher during the Asian Contagion.

Typically, when the VIX is hitting highs, a bottom is near because put options in the options market are very high. It means that people are paying for options, which act like an insurance policy for their stock portfolios. History has shown that when these reach extreme levels, stock market bottoms have formed. We're at one of those levels once again.

In the past, it has offered the very best buying opportunities around. You'll notice that Warren Buffett has been on a buying frenzy this past year. He hasn't been this excited about purchasing stocks in a long time. So they are finally reaching values that make sense to him and pose little risk in his view (and mine as well).

Another reason that I believe we are at a stock market bottom and therefore a carry trade bottom is because there has never been a time when there were more mutual fund redemptions than there are right now! That's right. You're living in historic times for the VIX and also for mutual fund redemptions.

Historically, when the retail investor (which institutions call the "dumb money") gives up and throws in the towel, that's when the best buying opportunities present themselves and bottoms form. You see, these "weak hands" have finally been flushed out of the market and a recovery can now begin. Institutions, in the mean time, have been sitting on the side lines waiting for these times while hoarding cash.

They run in with both guns blazing when a bottom is forming. A few of them are smart enough to realize that a bottom is forming right now, while some won't realize it for a month or so. Either way, they will do very well even one year from now, and even more so five and 10 years from now.

Yes, these are the times when investors can run in and double their money more quickly than ever. The same goes for carry trades.

You earn daily interest on your position, and you will likely see your balances within one year reach levels that would normally take you years to gain just because you bought in at distressed levels. In other words, you were brave enough to go in when the fear was the greatest and others were scared out of their mind.

Warren Buffett has a great saying which I love and subscribe to. It's "get greedy when others are fearful, and get fearful when others are greedy." This has benefited me handsomely through the years as I've dived in when others thought I was crazy.

You see, I get worried when too many people agree with me and pat me on the back. That's when I know I'd better reevaluate things. Because the masses always get it wrong. They don't have a clue!

It's the big institutional investor who typically gets it right if anyone (over time). So one has to learn to think like them in order to survive like they do.

Well, that's exactly like what I'm talking about here.

Now, even when an investor buys carry trades at these distressed levels, they have to account for more volatility than typical. Yeah, you will need to invest with 1/3 of the size that you normally do. But you will likely still come out as well as times when you have bigger positions due to the increased volatility and due to how quickly these carry trade pairs propel off of their bottoms.

So get ready for a stock market recovery around the world that may have even begun on Friday but will be in full force likely in a week or two or less.

That's why, whether you catch the exact bottom or not, get into a few of these positions by buying a low number of lots in proportion to what you normally buy, and make sure you have a very well-capitalized account in proportion to the positions you have.

Remember that the main way investors will mess this up is not by picking the timing or direction wrong but by loading up too heavily in proportion to their account size. Err to the conservative side rather than the more aggressive side, and you'll be glad you did.

Get ready to hold onto these positions until they reach their 200-day simple moving averages on the charts or until stocks finally weaken once again, whichever comes first.

You will likely be in these for a while unless the run up happens as quickly as the run down did. We are living in historic times! So moves can happen more quickly than in times past. That's for sure. We found that out last week didn't we?

So with your carry trade positions, have a 1-year time horizon, and with your stocks have a 5-year time horizon. If you do, then you will be glad you got in during these times, whether it's the exact bottom or not. A year from now, you won't care when you see where you got in and where the masses finally get back in.

The masses are always historically late to the party, on the upside and on the down side. In order to be successful in the financial markets, you have to be willing to buck the crowd and go in when people feel you are insane to do so. That's when the biggest opportunities present themselves, and we are living in one of those historic opportunities right now!

So grab equal-weighted positions in these carry trades (EUR/JPY, AUD/CAD, USD/JPY, and AUD/CAD) now, and hang on for the ride! The gyrations will be huge, and they may even be more against you a good bit at first. Be mentally prepared for that, but buy in and hang on for the ride.

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Wow, what a difference a week makes in the currency market! Where do I even start? Last week, the ink had not even dried from publishing my last article that predicted the carry trade would be dead through 2009. That's because I expected the carry trades to fall another...
Thursday, 16 October 2008 10:19 AM
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