Good reads from around the Web.

Like it always does, the first half of the financial year has confounded all but the Internet geniuses who claim to have seen it all coming.

The US engine is trying to pull global growth forward, while Europe is asleep in the coach carriage. Meanwhile there’s trouble in the boiler room – China is spluttering in fits and starts. Assets have run hither and thither, with stocks and bonds up and down (and up) and the gold price crashing.

Meanwhile UK house prices are ahead nearly 4% year-over-year, which is the fastest rate of growth for three years. I was still wrong to claim an early victory for UK PLC, but the double dip recession has been revised away and more people are employed in Blighty than ever before, to the consternation of 50-something grumblers everywhere.

Indeed the most salient takeaway of the past few years is how markets and economics conspire to make fools of us all.

I may have been too optimistic – not about stock markets, but about how long it’d take to pull the global economy out of the mire. But equally wrong-footed were the doomsters who predicted we’d be feasting on tins of spam cooked over fires fueled by worthless stock certificates.

Where did these death-eaters go wrong? I think they got blindsided by moral justice, and what they perceive as the lack of it.

I saw the pre-crisis boom as unsustainable as much as anyone did, and I’ve ranted about bankers’ antics since the turn of the Century. My big mistake was to underestimate how deep and wide the subsequent slump would run.

The pessimists, on the other hand, got greedy. Nostalgic for the fear and hysteria of 2008 – markets in turmoil, investment firms crumbling, gold soaring at last – they wanted more.

So they got furious at Central Bankers like Ben Bernanke for doing his job, and endlessly churned out prophecies of doom like so many rain-dancers.

Super bad

I think some of these people underestimate just how big the blow-up has been, particularly in the US – it has seen nothing like it for 80 years.

On Friday we got an unexpectedly strong jobs report in the US – 195,000 net new hires, and revisions to last month, too. But as the next graph shows, the American recovery remains insipid compared to its super-virulent Alpha machismo of yesteryear:

Source: Business Insider

Look at that red line! Six years after the recession began, the US is still understaffed and hesitant. This has been carnage.

This is what the market’s retribution looks like, and if some of the wrong people have suffered – marginal wage earners, say – while the guilty prospered – a few of the 1%-ers, say – then tough tomatoes as far as investing is concerned. Complain to your politician, not to your broker.

Fact is nobody is very good at reading the economic runes, although like most investing maniacs I concede I have a meddling economist on my shoulder. (My other shoulder is even worse – there swaggers a midget day trader…)

The best thing for most people to do will always be to go passive and mechanical. Investment plans and economic punditry rarely mix, as Carl Richards put it this week in his usual style:

Carl says:

While it may be fun to chat about what the market might do next at your neighborhood barbeque, don’t kid yourself. What we know about the market comes down a bunch of guesses, also known as forecasts.

Forecasts about the future of the market are very likely to be wrong, and we don’t know by how much and in which direction. So why would we use these guesses to make incredibly important decisions about our money?

The answer is we shouldn’t.

If you must trade actively – and I admit I do – then look first (and more or less last) to valuations.

[continue reading…]

Currency risk arises from exchange rate moves between pairs of currencies.

If you have investments or assets in a foreign country with a different currency, you face currency risk, unless the foreign currency is pegged to your domestic currency or your exposure is hedged.

A simple example shows how currency risk affects your returns.

Suppose you’re an American investor and you put $10,000 into a European stock market tracker fund. The fund is not hedged, and so you’re exposed to changes in the exchange rate between the dollar and the euro. That is, you’re exposed to currency risk.

Let’s say that over the next 12 months the European stock market and therefore your tracker goes up 20% in local euro terms:

• If the dollar and the euro is at the same exchange rate after 12 months as when you first made your investment, your holding is now worth $12,000. (i.e. The $10,000 investment increased by 20%).

• Say the dollar appreciated by 25% versus the euro over 12 months. Your holding would be worth $9,600 (12,000 / 1.25). i.e. Your euro position now buys fewer dollars.

• What if the dollar depreciated by 25% versus the euro over 12 months? Your holding would now be worth $16,000 (12,000 / 0.75). i.e. Your euro position now buys more dollars.

As you can see, currency risk can dramatically affect your returns, from magnifying your gains to turning gains into losses in your own currency.

The basic rule is:

• When the foreign currency strengthens versus your own currency, your overall return goes up.

• When the foreign currency weakens versus your own currency, your overall return goes down.

Currency risk and businesses

Any business that operates across different territories that use different currencies will face currency risk. Businesses will be hurt and helped in different ways from exchange rate moves.

Some examples:

• If you’re a British manufacturer and your main market is Europe, you will benefit when the pound weakens. The euros you receive in return for your goods will be worth more pounds, so profits increase and/or your goods become more competitive due to their lower price in euro terms. The opposite happens when the pound strengthens.

• What if instead you’re based in the UK, your main market is America – but you also use lots of raw materials priced in dollars? Here you will still benefit if your local currency depreciates versus the dollar, but some or all of the gains will be wiped out because of the extra cost of buying raw materials with more expensive dollars.

• A multinational firm operating in lots of different countries may find these exchange rate moves broadly cancel each other out.

• Companies sometimes hold debts in foreign currencies. An unhedged move in the exchange rate can greatly increase their debt burden if they service the debt via a different currency.

Companies often hedge exchange rate exposure to try to deal with currency risk. The theory is they should concentrate on their proper business, rather than have a side business in currency trading.

However hedging does cost money, and a poor call can make a big dent in profits.

Dealing with currency risk when investing

So much for business, what about the likes of us one-man investing bands?

Opinion is divided as to whether currency risk is a good thing for us. There is some academic evidence that exposure to currency risk does not reward investors with higher returns. Others argue it increases diversification and so reduces risk, on top of the usual benefits of investing overseas.

Hedging away the currency risk – which comes built into some funds and ETFs – has its own snags. It costs money, whether born separately by you as an investor, or in the shape of higher costs via a hedged fund. You also give up potential rewards, which is always the unarguable price of hedging but still annoying when it happens.

Some notable investors believe currency risks can be ignored if investing in overseas equities for long periods. Sir John Templeton, the grandfather of far-flung investing, believed currency movements were neutral over the long-term when investing in equities.

Overseas bond funds are usually best hedged though – the shorter life of bonds reduces the time for currency affects to even out.

Not all foreign investments expose you to currency risk, especially if you’re an American investor. Many emerging market countries have currencies pegged to the dollar. This means their currencies rise and fall with the dollar, so currency risk can be ignored by U.S. investors putting money there.

Hedging as a side product of an investment

Some investments are inherently hedged.

Suppose you’re a U.S. investor, and you buy shares in AstraZeneca, the UK-listed drugs giant.

The value of your investment is determined by:

a) the performance of the AstraZeneca share price, and

b) currency risk.

The currency danger for you as a U.S. investor is that the pound may fall versus the dollar after you’ve made your investment.

Let’s say you buy $1,000 worth of Astra shares at an exchange rate of $2 to £1. You have £500 in Astra shares.

Now suppose that after some years the pound falls to parity with the dollar, so £1 is worth $1.

If the AstraZeneca share price stayed the same over the period, you’d have only $500 when you sold up and brought your pound sterling money back into dollars. You’d have lost $500 due to the change in the exchange rate.

However – the Astra share price would be very unlikely to stay the same if the exchange rate changed like this, because Astra does most of its business in dollars.

As the dollar strengthened towards parity with the pound, the dollars that Astra made overseas would be worth more pounds when repatriated back home to the UK.

Astra’s earnings and profits would thus rise in pound terms purely from this exchange rate change, and its share price would almost certainly rise too.

For US investors, such a rise in the share price could potentially cancel out for U.S. investors the loss from the exchange rate change!

Good reads from around the Web.

Josh Brown is a curious blogger and acerbic wit who publishes financial market arcana for his fellow investment pros, sprinkled with the odd post about how stupid and venal some of them are.

I like his blog, The Reformed Broker, a lot, even though it’s wildly inconsistent and goes into the unlikely-to-prove-profitable ‘guilty pleasure’ bracket alongside spread betting and CNBC ¹.

Anyway, this week he flagged up two factoids revealing how so-called ‘dumb money’ can be pretty smart.

In his post Why Behaviour Is Half The Battle, Josh shared a graph from Fidelity showing how keeping up steady investment throughout the turbulent market has delivered a solid result for American pre-retirees:

He notes:

Behavior, ie continuing to contribute through the difficult conditions of the Great Recession and Credit Crisis, was about half the battle. Market performance did the half of the heavy lifting and those who did the right thing have been ² richly rewarded for it.

These simple investors don’t realize it, but they have outperformed almost every hedge fund manager and smart-ass market-timer in the universe.

Or perhaps they do realise it? Anyone who digs through our passive investing HQ should have a good grasp of the essentials. (i.e. That returns from expensive fund managers lag those from cheap index funds, and forecasting the market doesn’t work).

A couple of days later Josh brought us stats from Merill Lynch revealing that retail investors – that’s the likes of you and me – were happily buying the shares that gibbering money managers were throwing overboard as the market tanked.

Josh comments:

The hedge fund segment sold again last week, three in a row. They are now net sellers of the equity market on the year – they were only net buyers during the March and April period of new highs, because, en masse, they are essentially benchmark-chasing pussies who jump in and out of the tape like they’re “managing risk” and then lever up like maniacs when they begin to trail the markets.

… and of course they charge 2-and-20% for doing so. Then again, I’m blogging about how silly they are, and they are driving Ferraris. Who’s the muppet?

I wonder what car Josh drives? Metaphorically speaking, I mean. Perhaps he takes the subway when it comes to actual non-metaphorical transport.

[continue reading…]

1. Which I just remembered he also appears on. Maybe I’ve got a man crush?[↩]
2. Josh actually wrote “ben”, but I am happy to correct the error and make him look good, due to my man crush.[↩]