Currency Trading Offers Stock Hedge

NEW YORK ( -- The S&P 500 has a tipping point at 1250 that has been pivotal for more than a decade.

The index ended 2010 at 1257.64, just slightly higher than that level. Although it gained 13% for the year, the 2010 close was only 28 points, or 2.3%, higher than its 1998 close.

This confirms once again that the buy-and-hold mantra is outdated. Once we factor in inflation, the index's return has been negative over the last 12 years.

The ride hasn't been quiet, however. The index has seen big intraday moves, 100% yearly reversals and the birth of a new generation of high-frequency trading that has come to dominate exchanges.

S&P 500's Tipping Point

  • December 1998: 1250. On the way to 1574 in a 87% gain from the October 1997 lows.
  • February 2001: 1250. On the way to 767 in a 51% drop from the December 1998 highs.
  • November 2005: 1250. On the way to 1586 in a 107% gain from the February 2001 lows
  • July 2008: 1250. On the way to 665 in a 58% drop from the November 2005 highs.
  • December 2010: 1250. Closed with a 88% gain from the July 2008 lows.

2010 Trading Patterns

The S&P 500 saw a new norm in trading in 2010, with massive monthly moves. For example, the index lost 8.2% in May, while it gained 6.5% in December.

Participation levels were below the historical norm as the year went into the close, with few sessions able to close outside of the previous session high or low with ease, and most sessions dominated by futures market trading that left the cash sessions to pick up the pieces. The dominant factor of 2010 trading was that S&P 500 futures moved hard when regional Asian and European markets made a break, as the index quickly became a barometer to test the risk tolerance and momentum in global trade.

The volatile daily, weekly, and monthly movement created a new "normal" in trading patterns, with interconnected global markets buying and selling risk and balancing books on an hourly basis instead of a daily basis. Weekly chart closing prices were replaced with 8-hour closes in line with Asian, European and U.S. cash market closes.

Buy and Sell or Buy and Hold

If buy and hold has proven to be unreliable unless investors got lucky in picking tops and bottoms over the last 12 years, then buy and sell should continue to dominate trading patterns in the near term. However, most investors do not play the futures market nor do they play the cash premarket because of thin liquidity and the coin-flick approach to daily momentum swings.

The long-term investment portfolio that has been designed to balance risk with a mixture of bonds and stocks has raised many questions as to its sustainability as a benchmark, and has led to an increase in traders and investors looking for correlated markets with leverage to offset the portfolio roller-coaster ride.

The 12-month inverse correlation of the dollar to equities and commodities is still holding at more than 90%. When so-called risky assets (such as commodities and stocks) are purchased, the dollar is sold, and vice versa.

The dollar is the unit used to price commodities, it backs the largest bond market in the world (U.S. Treasuries) and it is the dominant central bank reserve currency. The greenback is not just a reflection of the American economic outlook. It is a complex vehicle that is used as a counterbalance to equity, bonds and commodities. Just as an exchange floor needs a market maker to be balanced by a speculator, equity trading (risk) has to be balanced by the dollar (safety).

Currency Trading To Hedge Investing

There is only a finite amount of capital to call upon on any given day, and as such the movement to and from equities when not backed by new investment flows has to be balanced by a move in and out of another market. Just like a book ledger balances a credit to a debit, equity moves are balanced in general by a move in the dollar.

The last quarter of 2010 saw intraday correlations between equities and the dollar break down. Financial reform legislation was implemented in October and had an instant impact on the way that financial institutions run their proprietary trade desks, which led to a further increase in daily volatility, stoked by ever-decreasing volume and participation.

November heralded the long-awaited quantitative easing program from the Federal Reserve. Initially, this has a big impact, as the Fed bought back Treasury notes from primary dealers, who were in turn expected to place the cash into equities and commodity positions.

December trading held equities and the dollar in a tight range, with breakouts only coming after violent intraday tests of the previous session's support and resistance.

Now that the S&P 500 has moved to yearly highs, the question is whether the dollar index will play catch-up and drop lower, or whether equity trade will pull back to test support once again.

The dollar index low in November at 76.00 coincided with the S&P 500 high at 1225, but the push to 1250 on the S&P 500 has not been matched by the dollar index, which is still sitting at 79.00 support.

There are compelling reasons to think that it will be equities that pull back in the near term while the dollar gains. This is mainly because of commodity inflation. Crude oil is at $91 a barrel, but this is not backed by growth. Instead, it's backed by the Fed's quantitative easing program.

The fly in the ointment, and it is a big ugly blue-bottle sitting in a vat of dirty oil, is that commodity inflation without growth is unsustainable in the long term. Meanwhile, Fed-induced ramps have crushed Treasury note values.

Mortgages, credit cards, lines of credit, commercial lending, and interbank rates have all ballooned higher in an inflated move not backed by growth. There are still 46 million Americans on food stamps, with 50% of the U.S. population having less than $2,000 in savings, nearly 10% unemployment, and the business cycle not yet showing sustained reports that will lead to economic expansion. All of that is not conducive to the recent moves in equities being able to easily hold, unless a tsunami of volume hits in January.

Whatever the outcome, those traders and investors who have made the move to currency trading will be able to leave the long-term portfolio alone and trade long dollars on weak equity days or short dollars on strong equity days.

The forex market's leverage, ease of access, 24-hour momentum, and lack of sustainable manipulation by the powers that be creates a market that can challenge the outdated concept of buy-and-hold.

The equity roller coaster can go wherever it likes, those who have currency exposure know the ride will be more enjoyable in the long run with some insurance in place.

This commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management. The London Forex Broadsheet (known as TheLFB) is a is a global forex trader portal based in the U.S. TheLFB's mission is to educate retail and institutional clients on the links that bridge the trader and investor to the free-flowing global market. It serves the needs and develops the skills of forex trading clients with its 30 years of trading and market experience.

TeamLFB maximizes a forex trader's day with support that instills discipline, confidence and structure, enabling the only daily variable to be market-driven. TheLFB service offerings include a mix of complimentary and subscription-based products that cover trade signals, professional grade currency and commodity analysis, comprehensive charting overviews, as well as daily trade desk video reviews. The trader news feed is a proprietary offering that gauges 24-hour market sentiment, guiding all levels of traders on the nuances of each new trading day.

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