WITH CHINA AND JAPANESE STOCKS DOING SO WELL, DON'T FORGET ABOUT EUROPE -- GERMAN STOCKS HIT FIVE-MONTH HIGHS -- BUT BE SURE TO HEDGE OUT CURRENCY RISK -- RECORD LOW GERMAN YIELD PULLS TREASURY YIELD LOWER
CHINESE AND JAPAN STOCKS HAVE BECOME WORLD LEADERS... The two largest Asian stock markets have become two of the world's best gainers this year. The red bars in Chart 1 show the Shanghai Stock Exchange Composite Index ($SSEC) rising to the highest level in more than three years. Shanghai stocks started rising during the spring when the planned Shanghai-Hong Kong Stock Connect was first announced. That program, which was launched on November 17, offers international investors access to mainland stocks through the Hong Kong Stock Exchange. Last Friday's surprise announcement of a Chinese rate cut has also boosted Chinese stocks. [Shanghai stocks are up more than 1% in today's trading]. The SSEC 2014 gain of 21% puts it ahead of the S&P 500 which has risen 11%. The orange line (top of Chart 1) shows the Nikkei 225 Index reaching the highest level in seven years. The Nikkei gained 7% during 2014. However, it has gained 16% over the last month following a surprise announcement of more Japanese monetary stimulus.
(click to view a live version of this chart)
Chart 1
BE SURE TO HEDGE OUT FALLING YEN... The main driving force behind rising Japanese stocks has been the falling yen. A falling yen hurts the performance of foreign investors. That's why I've suggested several times over the last year that the best way to deal with that is through the Wisdom Tree Japan Hedged Equity Fund (DXJ). That's the orange line in Chart 2. The green line shows Japan iShares (EWJ) doing much worse. Since mid-October, the DXJ has gained 15% versus a 6% gain in the EWJ. The difference in their performance is due to an -8% drop in the yen. Since the EWJ is priced in dollars, it has lagged behind the DXJ which hedges out the falling yen. [As you'll see shortly, the same principle holds true in Europe].
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Chart 2
GERMAN STOCKS SHOW STRENGTH... In case you haven't noticed, European stocks are also turning up. That can be best seen by charting German stocks, which represent the biggest economy in Europe. The daily bars in Chart 3 shows the Dow Jones German Stock Index moving above its September high to reach the highest level in nearly five months. [That index closely tracks the German DAX Index]. The solid blue line (above chart) shows that the German/S&P 500 ratio is starting to turn up after lagging behind most of the year. German stocks have risen nearly three times as fast as the U.S. over the last month (6% versus 2%). Other European stock markets are rallying as well. That suggests that it may be time to take another look at the eurozone. There again, however, it's necessary for foreign investors to hedge out the negative effect of a weak Euro.
(click to view a live version of this chart)
Chart 3
HEDGING OUT THE WEAK EURO ... As is the case in Japan, a falling Euro hurts the stock performance of foreign investors who invest in eurozone stocks. That's why it's necessary for foreign investors to hedge out the negative effects of a falling Euro. The green line in Chart 5 shows the EMU Index iShares (EZU) which is quoted in U.S. dollars. The blue bars show the Wisdom Tree International Hedged Equity Fund (HEDJ), which hedges out the falling Euro. The visual difference in their performance is obvious. Since the start of the year, the HEDJ has risen 6.5% versus a -4% loss for the EZU. That difference was caused by a -9% drop in the Euro. The message here is twofold. First, it may be time to take another look at European stocks, which are starting to act much better. Second, it's necessary to hedge out the negative currency effect of a weak Euro. The HEDJ offers one way to do that. Eurozone stocks are getting a big boost from Mario Draghi's statement last week that the ECB is ready to expand its quantitative easing program to include purchase of sovereign bonds. While that's bad for the Euro, it's good for eurozone bonds and stocks which have rallied together. That in turn has pushed eurozone bond yields to record lows.
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Chart 4
GERMAN YIELD PULLS TREASURY YIELD LOWER... Yesterday's report that the U.S. economy expanded by 3.9% exceeded expectations. That also marks the strongest six month U.S. economic performance in more than a decade. Normally, that strong news would push Treasury prices lower and yields higher. Instead, Treasury yields have dropped while bond prices have risen. The reason why that's happening is explained in Chart 6 which compares the German 10-Year yield (blue line) to the 10-year Treasury yield (green line). Both are plotted through yesterday (Tuesday). The lower line shows the German yield falling to a record low of 0.75% yesterday. [Several other eurozone sovereign bond yields fell to record lows]. The 60-day Correlation Coefficient (below chart) shows a positive correlation of .86 between the two lines. Falling eurozone yields are pulling U.S. yields lower. That's because foreign investors are buying Treasuries which offer much higher yields. When Treasury prices rise, their yield falls. That suggests that the direction of Treasury prices and yields has less to do with the U.S. economy (and prospective Fed action) and more to do with historic low yields in Europe and Japan resulting from their aggressive monetary policies.
(click to view a live version of this chart)
Chart 5
SEASONAL TRENDS REMAIN FAVORABLE... Seasonal trends remain favorable for the U.S. stock market. The month of November starts the "best three month" span that usually lasts through January, and the "best six month" span that usually lasts until April. In addition, the Stock Traders Almanac points out that the day before and after Thanksgiving have been up 78% of the time over the last 61 years. The week after Thanksgiving has seen the Dow rise in 15 of the last 20 years. The fact that this is a midterm election year provides another tailwind for the market. Another positive sign is the recent upturn in small caps. Chart 6 shows the Russell 2000 Small Cap Index clearing its early September high which is a positive sign for it and the rest of the market. The fact that foreign stocks in Asia and Europe are acting better is another benefit for U.S. stocks. It's always better when global stocks are rising together. On that pleasant note: HAPPY THANKSGIVING.
