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June 03, 2005

Foreign Stock Investors: Beware the Double-Whammy
by Chip Hanlon

For U.S. investors, there's no such thing as a conservative foreign stock investment.

Given the beating many foreign equity investors have undoubtedly taken in 2005 thanks to the rally in the U.S. Dollar, this may not exactly sound like news, but I still suspect the impact of currency fluctuation isn't well understood, so let me say this again: if you're a U.S. citizen living here in America, there's no such thing as a low-risk, conservative foreign stock investment.

This doesn't mean that in the proper balance some measure of foreign equity exposure isn't right for many investors - heck, my own firm is quite unique in providing such trading access to international markets and many of my own clients maintain some exposure to such holdings, albeit less than normal - but it does mean it would be the height of foolishness and arrogance to bet the farm on non-Dollar exposure and that individual foreign equities typically aren't appropriate for Grandma's portfolio.

The Powerful Case for Understanding Currency Risk

The best way I can illustrate and defend the comments above is with a couple of real-life examples I experienced earlier this year with my own clients. On April 15th, for instance, a client I've worked with for 10 years was considering the sale of a foreign holding that had performed admirably, one he had held for 2 years. When I reviewed the stock's performance with him, he was shocked to learn that despite the fact he was sitting on a capital gain of 35%, the stock itself had increased by only one cent! There's no trick answer here, like this was a penny stock for which a one-cent move accounted for a large percentage gain; this was, in fact, one of the largest-cap stocks traded on the New Zealand market! The huge move in the Kiwi had simply carried the day.

Another client, one that had held a different foreign equity for approximately 18 months, was surprised to learn even earlier this year that the share price of the restaurant operator he was about to sell for an 11.5% gain (excluding dividends, which in this case were substantial) was actually down 4% in its local market!

That is how powerful, indeed crucial, it is to get currency movements right when looking to invest abroad.

Imagine, then, what investors experienced in recent years from their foreign stock holdings that actually increased in value! Truly, it's not hard to achieve huge returns when you have the following trend moving in your favor:

4-year Aussie Dollar chart:

Think how intoxicating such returns must have been to investors who were exposed to the proper currencies over the last few years! Just holding shares in a simple, predictable business like a utility can provide internet-type returns if held in the right foreign market with a currency that's flying your favor; in fact, investors probably hadn't seen anything like it since, oh, I don't know, say their prevalent use of margin during the tech boom.

And that is the way to think of foreign equity investing: for American investors, it carries volatility risk that can at least be roughly equated to the use of margin leverage here at home. The problem is, most investors started to forget that such risks are a two-way street, as a 10-year chart of the same Australian Dollar shows:

When a foreign currency is on the rise, it's hard for American investors holding stocks in that market to go wrong. Likewise, it'll be very difficult for American investors to make much headway in foreign markets at times when the U.S. Dollar is rallying. Knowing when to over- or under-weight your foreign equity exposure based simply on the currency outlook is of vital importance to investors, something most people (and some advisors) don't seem to understand well enough.

Investors, then, need to seriously consider the potential double-whammy of a simultaneous decline in their foreign stocks and currencies, realize how deeply such a combination could cut into their portfolio's value and carefully re-evaluate their exposure to such risk.

Don't Let the Dogma Bite You

Just as it was easy to get caught up in the new era promises of the dot-com boom, it has been tempting, especially for investors that experienced at least a taste of recent foreign equity market success, to get caught up in recent promises of the end of American Empire or the supposed risk of waking up one day soon to find the Dollar worth literally nothing. Indeed, part of the reason for my own confidence late last year in calling for a reversal in the US Dollar was the fact many of my own clients had quite clearly fallen in love with their foreign equity holdings, an awful sign from a contrary standpoint.

To highlight how such investment dogma can be a killer, however, I refer you to a recent article from the thoughtful Peter Brimelow at CBSMarketwatch: http://www.marketwatch.com/news/story.asp?dist=morenews&param=archive&siteid=mktw&guid=%7B75E85C53%2DABE3%2D4171%2DA952%2D4FD0E72968C0%7D&garden=&minisite

The focus of Mr. Brimelow's article is on an advisor whose recent track record has been outstanding, but who presents a conundrum for the newsletter-rating service at Marketwatch because the same manager's track record is absolutely abysmal in the longer run. The only part of the article that baffles me is why this might confuse the folks at Marketwatch; the article seems to make the story quite clear, that as a perma-bear on the stock market, this newsletter writer's performance stunk when the U.S. was experiencing a bull market and shined when the bear came to visit.

Isn't this precisely the outcome one should expect from a stopped clock?

Here I feel the need to repeat the same analogy I have used before: just as Henry Blodget was merely at the right place at the right time, an internet stock analyst in the internet era, today's Dollar perma-bears are merely having (or, if my suspicion is correct, have already had) their day in the sun. Unfortunately, unwitting investors have simply found some of today's anti-Dollar Blodgets too recently to know that many of them have been promising the demise of the Greenback almost since the dawn of time, dangerous stuff for shareholders in the wrong currency climate.

In fact, getting wildly over-concentrated is simply one of the silliest things an investor can do. And if one's portfolio has reached that state due to the advice of a "professional," it's even more unforgivable. Think I'm over-stating things? This is what the excellent site, SecuritiesSleuth.com, has to say about what it calls this basic "broker fraud:"

Over Concentration. "Over concentration has been a big problem. Many brokers acted like lemmings and put their customers in high tech's only. When the market crashed the brokers want(ed) to shirk responsibility. A prudent advisor would have suggested a mixture of investment sectors such as consumer goods, energy stocks, and not just high tech."

My suggestion: substitute the words "non-dollar holdings" in place of "high tech" in the paragraph above and re-read the passage. You get the picture... those that advocate nothing but non-Dollar investments are doing investors no service, something that only becomes visible when the trend turns against them.

Think about it: would you, as an experienced investor, allow a broker or newsletter writer to convince you to put all of your assets into tech stocks? Not after witnessing the dot-com bust, to be sure. Many of you reading this essay are do-it-yourself types of investors; if the passage above represents one of the most frowned-upon practices in which an advisor engage, why, then, would you do it to yourself in any asset class?

About a Dollar Pullback

Moving to the subject of a possible correction in the U.S. Dollar, here's one last thought that some might find valuable: it's simple, S-I-M-P-L-E, to see that the Dollar's surge is now very extended, anti-Euro sentiment is running red hot and the Dollar is being embraced in a way it hasn't in quite some time. Now, I'm still a bit different because most analysts continue to see this as a counter-trend rally in an ongoing bear market for the Greenback, whereas I suspect that perhaps something has changed and we may actually be in the early stages of a Dollar bull market. That being said, however, some counter-trend (I.E. non-Dollar) trading moves should be ripe for the picking at the moment. For those who might try to nibble at such opportunities, allow me to make the following suggestion: gravitate toward strength.

When trading, my anecdotal experience suggests that assets that hold up best when their sectors are falling tend also to rally the most when the trend turns their way. As I'm currently sizing up trading opportunities, I'm personally looking at silver (with its notable, downright suspicious recent strength) as more attractive than gold and the Canadian Dollar as preferable to the more obviously oversold Euro, as examples. Again, it would be my broad generalization that for traders, this is a savvy way to go about searching for possible short-term winners.

As for the rest of you who aren't going to try and aggressively trade a short-term pullback in the U.S. Dollar: tune out the dogma, learn exactly how much currency gains have contributed to your recent foreign equity success and be prepared to protect yourself should the U.S. Dollar give you a break and pullback, as it seems poised to do.

*The essay above is an extended excerpt from the one that will available later today at our website, www.deltaga.com.

Chip Hanlon
President
Delta Global Advisors
800-485-1220
info@deltaga.com
www.deltaga.com

Currently the President of Delta Global Advisors and the founder of Green Faucet, Chip Hanlon is regularly featured in the national media for his global economic viewpoints and is a contributing writer for Real Money, the subscription service from TheStreet.com. Previously, Hanlon has served as the C.O.O. at Euro Pacific Capital, as the President of Unfunds, Inc., and as Vice President of Investments and Syndicate Manager with Sutro & Co.

Copyright © 2005-2008 Chip Hanlon

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