Quite a bit has happened the past week. There have been numerous earnings reports, President Obama delivered his annual State Of The Union address, the European Central Bank proposed a $58 billion dollar a month asset purchase program (aka quantitative easing), S&P reached a partial settlement on mortgage-backed security ratings, radicals demanded a $200 million ransom for two kidnapped Japanese citizens, the Oscar nominees were named, and the Super Bowl participants have been identified. Depending on your ideology and personal interests, some of these were probably important to you while others likely failed to grab your attention.
To us, the event of the past week vying for the title of most important was the activity taking place in a small and non-threatening European country. Switzerland has persevered in maintaining its reputation of neutrality. The country has not engaged in war in 200 years, is home to the Red Cross, and is famous for its chocolate, cheese, watches, and conservative bankers. Although physically located in central Europe, Switzerland did not adopt the euro, choosing instead to keep its own currency, the Swiss franc.
The Swiss National Bank, the central bank of Switzerland, capped the value of the Swiss franc versus the euro 3½ years ago, perhaps as a kind gesture to the Eurozone during its financial crisis. Although it was technically a cap, it acted as a peg since traders viewed the franc as the stronger currency. Last week, afraid the European Central Bank would begin quantitative easing and put further downward pressure on the euro, the Swiss surprised the world and removed the cap. The value of the Swiss franc immediately soared in value against all major world currencies. It gained more than 17% against the U.S. dollar and more than 18% against the euro.
In the world of currency trading, value changes of 2% in a week often receive the “big move” label. As such, plain vanilla currency trading can be boring. To make things interesting, traders typically employ large amounts of leverage in the currency markets, and we do mean large.
Leverage amounts of 10x, 25x, and even 50x are common. Most currencies trade 24 hours a day, and while they sometimes move quickly, they usually do not experience large price gaps. As such, trades can be closely monitored and positions easily liquidated if the trend changes. Even with large amounts of leverage, currency traders can usually get out of an unprofitable position before it becomes a large loss.
The franc had a reputation for being one of the most stable currencies in the world. Last week’s instantaneous 17% jump in its value caught the world off-guard.
It will take a while for the dust to settle, but a few things are already clear. Anyone betting against the Swiss franc with 10x, 25x, or 50x leverage had their hat handed to them. Unlike investing in unleveraged stocks where you can’t lose more than 100% of your investment if your stock goes to zero, a 17% loss at 50x leverage equates to a -850% return. For every dollar invested, you lost that dollar plus you now owe $7.50. That will wipe out many traders and will probably take out a few entities lending money to those traders. One currency brokerage firm, FXCM Inc., went $225 million in the hole and received a $300 million rescue package.
Swiss stocks plunged on the news because their exports will be hurt by higher prices. The performance of the iShares MSCI Switzerland ETF (EWL) is a combination of stock price performance and currency fluctuations. Since the elimination of the currency cap, EWL has advanced about 3%. This gain comes despite the approximate 13% plunge in Swiss stocks thanks to the more than 16% jump in the franc as measured by CurrencyShares Swiss Franc (FXF).
Poland is another loser in this mess. Many Polish homeowners prefer to finance their properties in “stable” Swiss francs instead of the Polish zloty. Since they have to repay their loans in francs, the amount they owe and the monthly payments increase a percent for every one percent rise in the value of the franc. Polish businesses are feeling the pain, too, and the iShares MSCI Poland ETF (EPOL) is already off more than 6%. Polish homeowners are caught under an avalanche of debt, and no rescue from a St. Bernard is forthcoming.
Real Estate marks its third week at the top today and has a comfortable margin over the other groups. The Utilities sector regained steam and recaptured the #2 spot by displacing Health Care. Consumer Staples rounds out the top four, and there is a large drop in momentum between it and the categories below. Telecom climbed three spots although it is barely clinging to a positive score. Consumer Discretionary and Technology both slid down a notch, and their momentum has all but disappeared. The bottom four categories are in negative trends. Industrials improved a spot as Financials slipped two and flipped from green to red. Stocks in the Energy sector bounced a little this week but not enough to change the big picture.
The style rankings became much more compressed over the past week going from an 18-point spread to just an 11-point difference between the top and bottom categories. There weren’t any dramatic shifts in the relative strength rankings, but larger capitalizations came out ahead in the changes that did take place. Micro Cap and Small Cap Growth remain at the top, although Micro Cap’s former buffer has evaporated. Mid Cap Value and Small Cap Blend swapped places with Mid Cap Value gaining the edge. Another position swap involved Large Cap Growth moving ahead of Mid Cap Growth. Near the bottom, Large Cap Value exchanged places with Small Cap Value, and both moved from green to red this week. Mega Cap is on the bottom for a fifth week.
China maintains its first-place ranking for a seventh week and shows no sign of relinquishing that position. The U.S. has been in the #2 spot those same seven weeks, and while it has made the occasional challenge for first, it is making no such attempt at this time. Japan jumped three places to third despite encountering weakness in the yen. World Equity slipped a notch, and Emerging Markets held steady. EAFE climbed a spot while Pacific ex-Japan fell three. Europe posted a good week, although it only climbed one spot in the rankings, displacing the U.K. in the process. There is a large drop in momentum between the U.K. and the bottom two categories. Canada and Latin America are far below the others and remain mired in steep downtrends.
“Holy God. Who could think this was possible?”
Adrian Frost, retail currency trader regarding currency markets moving so fast that liquidity dried up and the automatic stops he had put on his trades failed, 1/20/15
© 2015 AllStarInvestor.com All Rights Reserved. Protected by copyright laws of the United States and international treaties. Nothing in this e-mail should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. Any investments recommended in this letter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. All Star Investor employees, its affiliates, and clients may hold positions in the recommended securities.
Distribution is encouraged. Please do not alter content.