Following big trends is the primary way long term traders make money in the stock market. The largest hedge funds and money managers on earth utilize trend following rules and tactics in their trading. In other words, trends are how the majority of profits are created on Wall Street.
While following trends may sound easy at first glance, it is often difficult to identify strong trends before they end. The trouble identification is due to hindsight bias and other psychological issues affecting most people. Skilled traders and market analysts have the ability to identify and act on trends before it’s too late to capture large profits from the move. It is this skill that often distinguishes the winners from the losers in the investment game.
Right now, the major market trend is the flow of capital to European and other off-shore based equities. This trend has just begun in earnest and has created a tremendous opportunity for investors who jump onboard the train!
This article will explain the why’s and how’s behind this new trend, how to position your portfolio, and exact stocks to buy to profitably exploit this trend.
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Let’s start with the why and how we know that money flows have shifted off-shore.
How we know is by tracking exchange traded fund data. The latest metrics reveal that ETF’s just ended a record opening quarter. Unbelievably, $97.2 billion of new assets flowed into the ETF space last quarter. Out of this nearly $100 billion of fresh money, over $70 billion was directed at ETF’s that hold international investments. A truly astounding number!
You see, in the previous quarter, a record amount of cash flowed into U.S. equities. This heavy fund flow pushed U.S. equities sharply higher which was witnessed in the recent runaway bull market. It is very clear that the smart money is moving to greener pastures to ride the next bull market higher.
Add in the facts of the roaring U.S. dollar bull market, likely increased interest rates, and increased labor costs starting to pressure U.S. equities, the shift to Europe makes perfect sense for savvy traders who like to get in at the start of the trend.
Here’s a look at each of the factors driving money offshore.
- The Roaring U.S. Dollar Bull Market
A strong dollar erodes the profitability of corporations that conduct business offshore. This is due to currency conversion costs, higher export costs, and higher production costs compared to offshore firms.
In addition, since commodities are denominated in greenbacks, a strong dollar means higher prices for raw materials that further eat into a company’s profit. Finally, emerging economies that depend on purchasing inexpensive goods from the United States will be forced to shift to importing from countries with lower priced currency.
As you can see from the above chart, the USD rally is showing no signs of ending. There is strong technical support at the 50 day SMA and lighter resistance at the 100 zone double top. Once the 100 zone resistance is broken, the sky becomes the limit for the U.S. dollar.
The fundamental picture also appears strongly bullish for the upward trend to continue. Once interest rates start to climb, it can only support the upward move.
- Climbing Interest Rates
The Federal Reserve has made it very clear that rates will start to climb soon. We detailed this major economic change in a previous article. Suffice to say, the majority analysts believe that climbing interest rates will create strong headwinds for U.S. equities. Right now, it’s not a question of if rates climb, it is a question of when.
The above long-term interest chart through 2010 shows how rates have fluctuated over time. Today, with rates near zero, the environment has been extraordinarily bullish for U.S. stocks. This is about to change.
- Increased Labor Costs
According to the U.S. Bureau of Labor Statistics, Labor costs in the United States increased to 104.91 Index Points in the fourth quarter of 2014 from 103.85 Index Points in the third quarter of 2014. Labor Costs in the United States averaged 57.68 Index Points from 1950 until 2014, reaching an all- time high of 105.10 Index Points in the first quarter of 2014 and a record low of 17.12 Index Points in the first quarter of 1950. These high tics in labor costs further erode U.S. company profits, which in turn, act to lower share prices overall.
These factors together build a strong case that the U.S. bull market is close to topping out.
Now The Good News
Equity valuations are simply much more attractive in Europe than the United States due to the above U.S. headwinds.
In addition, the European Central Bank is following the Federal Reserve’s lead with the start of quantitative easing programs. This could easily be a multi-year or even decade-long endeavor. These programs will likely launch a monster bullish trend in European equities. Over $1 trillion in bond-buying power has already pushed yields negative ground.
Savvy traders are already jumping on it.
This is evidenced by Europe experiencing record capital flows of over $36 billion into stock-based ETF’s. Germany, alone, saw $4.8 billion during this same time frame.
It’s not just Europe that is benefiting from the massive quantitative easing programs planned for the euro zone. The broad EAFE and Japanese stocks are also reaping rewards. For example, Japanese stocks have attracted over $14 billion in new assets. At the same time, the Godzilla-sized Japanese pension fund has recently announced 100% additional relocation of capital into the equity market. A bullish trend will nearly be unavoidable with these capital inflows.
Another extremely bullish Japanese fact is the pro-growth leadership of Prime Minister Abe. Just like in the USA, anywhere the government helps business grow, stocks grow.
Add these points to the fact that European equities remain undervalued when compared to U.S. equities, and a very compelling picture emerges.
The Primary Issue With Euro Zone Stocks
While it is very clear the bull market should continue to gain traction in Europe and Japan, a major issue exists. Despite profits being earned in the off-shore markets, the exchange rate will guarantee you will give up some of the profits when you sell the stocks and transfer the gains back into U.S. dollars.
The solution to this vexxing issue is to purchase currency hedged ETF’s. iShares Currency Hedged MSCI Germany ETF (HEWG) and iShares Currency Hedged MSCI EMU ETF (HEZU) are two of the more popular hedged ETF’s that will provide exposure to European equities while mitigating the currency risk.
If the pro-business and fund inflows attract you to our Japanese neighbor, the currency hedged ETF iShares MSCI Curency Hedged Japan ETF (HEWJ) fits the bill.
The Key Takeaway
Trends are how money is made in the stock market. A long term quantative easing program in the U.S. super charged the bullish stock market. Now, this bull run appears to be coming to an end due to the wrap up of quantative easing, higher interest rates and record glabor costs.
A new bull market is just getting started in the euro-zone and Japan. The start of the bull market is evidenced by capital inflows to European ETF’s, the giant Japanese pension fund increasing its stock holdings and Japan’s pro-business government. Savvy investors are already riding this bull move higher.
It’s not too late yet to jump on the bullish train. One way to do this and avoid the inherent currency risk is by purchasing currency hedged ETF’s.