A question for you: How much of your assets are in U.S. dollars?
I'm not talking about assets exclusively in cash, but your investments in the U.S. stock market, money markets, Treasuries or anything else based on the American dollar, such as your house.
My guess is that you are close to 100% fully invested in greenbacks. That would make you not unlike most people on this side of the pond.
And just how diversified do you believe that is?
While most people believe diversification comes through holding different types of investments (such as stocks, bonds and real estate), our trend-following paradigm is a little different.
We trend-followers believe sitting solely in U.S. dollars presents an overwhelming disadvantage: There is no way to safeguard against a declining greenback as it erodes the value of our U.S.-denominated assets and our buying power. The same is true for any one currency. Diversification into international markets, then, is key.
Everyone feels the financial pain of high oil prices and rising interest rates, but few are aware of the stealthy destructive power of currency devaluation.
A weak dollar affects everything in our lives, from our mortgages to the prices we pay for goods to the strength of the stock market.
Even if the financial future and inflation remain as tame as they were between 2001 and 2004, an account of $100,000 in 2005 that has been left sitting in cash will have $65,000 in buying power in 2007.
Anything less tame could erode value even more.
Still, the effects of dollar depreciation are somewhat relative.
Changes in dollar value will be much more noticeable to someone living or frequently traveling abroad than to someone who never leaves the U.S.
Yet over time, the erosion of dollar value against other major currencies would mean a corresponding reduction of purchasing power.
If the dollar loses half of its value, all our U.S. dollar-based assets -- for example, our homes and our investments -- essentially depreciate by half. That's not a good thing.
Over the last 35 years or so, the dollar has lost about 70% of its value compared to major foreign currencies, such as the Swiss franc.
The dollar did take a breather from its long-term downward trend and showed substantial gains in the period between 1995 and 2001.
But since 2001, the decline has resumed.
In the past year, our unprecedented triple deficit (the U.S. trade deficit, the federal budget deficit and the personal savings deficit) has accelerated the dollar's fall.
On May 1, the greenback hit a one-year low against the euro and seven-month low against the yen.
We've always believed currency hedging is a good element of any portfolio, but not the traditional form of hedging involving trading in foreign currencies.
In the slightly different paradigm of trend-following, currency hedging is achieved by investing in international stock markets.
Why is that? Currency is really like the common stock of a country, which is traded openly in the currency markets.
It goes up or down, much like the stock of a corporation, as a function of offer and demand. Its price reflects the collective perceptions of all buyers and sellers as to the future value of the country.
So when you invest in a foreign stock market by purchasing, for instance, shares of a country index fund, you are buying into the basket of companies represented by that index and their prospect for future revenue and earnings growth, all valued in that country's currency.
There are two main elements that affect performance of international investments: the relative strength of the local stock market as measured by an index, and the strength of the local currency compared to U.S. dollars.
In an interesting twist, within the world of long-term trend-following, world markets are generally correlated, and while they tend to move in sync, they do so at very different rates.
If I had a dollar for every time the U.S. market inched up while international markets skyrocketed, and one for every time international markets slipped slightly while U.S. markets bottomed out, I'd be very rich.
It follows, then, that responding to trends in foreign markets can strengthen your investments and increase your profits.
Note that this is both an issue of safeguarding your portfolio and benefiting from the natural -- and unnatural -- movements of the markets.
To profit from these patterns, then, you want to invest in the stock markets of regions whose markets closely correlate with, and are stronger than, the U.S. market.
You also want to choose a currency that has trended in such a way that it typically gains in value against the dollar.
It is not difficult for trend-followers to find the strongest currencies.
Since you can plot the relationship between two currencies over time, you can apply all the same strategies used for watching trends in stock market indices, such as moving averages, trend lines and other technical analysis methods.
Though this may change over time, the standouts in recent years have been Australia and Canada.
Both countries have strong commodity currencies (or currencies that depend greatly on the export of certain raw materials) and stock markets that are heavy with resource and mining companies.
This is an advantage when gold and other metals are rising, as they most often do during dollar bear markets.
The Case for ETFs
In addition to deciding in what part of the world you want to invest, it is critical to determine the instrument in which to invest.
We believe exchange-traded funds -- ETFs -- are a good choice for seasoned and unseasoned investors alike.
With the growth of ETFs, investing in a foreign country's currency is as easy as investing in any other stock, with the advantage of giving you a broad index.
This is the best option for a trend-following system that tracks the larger trend over a longer period of time, rather than individual stocks trending over days or weeks.
Any investment in a market comes with a recognized set of risks, but when the market is in a foreign country, there are some additional hazards which you need to keep in mind:
- Country or regional economic/natural/political issues occur from time to time that cause the local stock markets to suddenly perform poorly or fall out of synch with the major world markets. The East Asian financial crisis of 1997-99 is a good example of such events.
- Currency fluctuations can be primary considerations, but with the U.S. dollar in a long-term bear market, this may turn out to be more an asset than a risk.
- Typically, highflying stock markets also exhibit high volatility.
- The divergence between country indices and country funds can be a serious problem -- especially with closed-end ETFs and mutual funds, which are, for the most part, actively managed and do not track an index.
Frank Minssieux is president and co-founder of
TimingCube, a broad market trend-following model, and originator of its Trend Timing newsletter. Minssieux invites your questions and will answer as many as possible in future columns.