Here's How You Can Still Profit From Declining European ETFs

 

NEW YORK (Fabian Capital Management) -- European exchange-traded funds have experienced a difficult summer amid a faltering currency and central bank that is scrambling to implement looser monetary policies.

On the surface, the recent announcement of further rate cuts and asset purchases to stimulate economic growth seems like a step in the right direction for the European Central Bank. However, reaction to the news by shares of European companies has been less than stellar.

The Vanguard European ETF  (VGK) recently fell back below its 200-day moving average and is now nearly 6% off its high established in July. Despite a brief rally attempt in August, this index of over 500 Europe-based stocks is now fighting to regain its uptrend.

It may face additional technical damage if the 50-day moving average crosses below the 200-day moving average. This is known as the "death cross" in technical parlance and appears to be a near-term event on the horizon.

That stands in sharp contrast to major equity indices of domestic and emerging market countries that are within 1% of their 2014 highs. The SPDR S&P 500 ETF  (SPY) and iShares MSCI Emerging Market ETF  (EEM) are showing much greater relative strength than Europe. In fact, VGK is clinging to the flat line this year while SPY and EEM are diverging upward.

Another consideration is the sharp decline in the CurrencyShares Euro Trust  (FXE) , which has fallen more than 7% since hitting a high in May. This devaluation of the euro is not surprising considering that quantitative easing measures have been expected to be announced for a number of months. However, it may be adding to the anxiety of international investors and globally-based companies that would like to see stabilizing factors take hold.

So what does this mean for your international stock allocations?

The easy move is to sell European-based indices and move to the safety of cash or reallocate those proceeds to other regions that are showing better relative strength. However, I would caution against a complete abandonment of European equities without taking several factors into account.

Ultimately, the ECB is committed to implementing measures to counteract deflationary forces throughout the Euro-zone region. As the asset purchase strategy takes shape and additional data is accounted for, we may reach an inflection point that morphs into a counter-trend rally.

In addition, the recent fall in the euro currency may be stretched to the point of short-term exhaustion. Conversely, the rally in the U.S. dollar index is likely due for a breather as well. If that takes place, it should play a role in steadying European markets.

Lastly, chasing performance in domestic stocks and abandoning international diversification this late in the game may have its own set of consequences. Selling one investment low and buying another near the highs is not a successful strategy to generate wealth.

While there is certainly a case to be made for shifting assets to undervalued emerging market nations, many European regions are becoming more attractive as well. France, Germany, Italy, and Spain have all fallen 10% individually from their highs.

One potential investment alternative to consider if you are focused on further devaluation of the euro is the WisdomTree Europe Hedged Equity Fund  (HEDJ) . This ETF invests in a diversified basket of 125 European equities while simultaneously shorting the euro. The goal is to increase returns versus a basket of non-hedged stocks when the U.S. dollar is increasing in value relative to the euro.

So far this year, HEDJ has gained 5.79% and recently picked up a great deal of steam as a result of euro weakness. This ETF has now accumulated more than $2.5 billion in total assets, with more than $1.7 billion of inflows this year alone. Clearly larger and sophisticated investors are implementing strategies to hedge their currency risk, while still remaining allocated to liquid overseas equities.

No matter how you ultimately play the European theme, remember that implementing risk management measures is important to protecting capital. If the Euro-zone does slip into a deflationary environment, it will be imperative that a disciplined approach overrules conviction of any specific outcome. Remaining nimble and alert to these developing themes will allow you to traverse the stormy seas and emerge in a more prosperous position.

At the time of publication, the author was long DVY, although positions may change at any time.

Follow @fabiancapital

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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