By Evaldo Albuquerque, Editor, Exotic FX Alert and Currency Capitalist
When you play roulette in a casino, you can choose between two colors: red or black. If you bet on red, and the ball falls into a red pocket on the wheel, you win. If it falls into a black pocket, you lose.
It’s simple. For most of this year, the financial market has been just one huge roulette casino, with two options: “risk on” and “risk off”.
In roulette, sometimes the ball falls into a black pocket. Sometimes, it falls into a red one. If you always bet on the same color, you will lose a lot of times.
Throughout the year, the market also alternated constantly between “risk on” and “risk off”. The constant shift in sentiment made this year very difficult for long-term investors.
The bad news is 2012 is likely to be another casino.
The good news is there are simple ways to make money in this market.
Pick Your Color: Black or Red
Investing has become a binary decision, much like the roulette’s black and red options. You have to choose between “risk on” and “risk off”.
When sentiment is good, risky assets such as stocks and commodities rally. When sentiment turns sour, safe-haven assets, such as the dollar and Treasury bonds rally, and risky assets plunge.
The constant cycle of hope and anxiety is a nightmare to long-term investors.
When “risk off” dominates, the whole market goes down. Even stocks of great companies with a bright future suffer. The baby is thrown out with the bathwater.
According to Bianco Research, in the entire history of the S&P 500 there have been 11 days when more than 490 stocks that compose the index moved in the same direction. Of those 11 instances, six have occurred since July 2011.
Volatility is the Name of the Game
2011 will go down in history as one of the most volatile years ever, with the stock market having more ups and downs than a roller coaster.
The S&P 500, for example, has travelled the distance between 1,100 and 1,200 seven times just in the second half of the year. The constant swings in market sentiment were very frustrating for most investors.
Hedge funds, for example, had the worst year since 2008. Even star investors, such as John Paulson and Bill Gross, have not done well this year.
Paulson, who made billions of dollars by betting against the U.S. housing market, saw his two largest funds drop by 29% and 44%. Gross, arguably the best bond investor ever, had one of the worst years of his career.
What’s Causing so Much Volatility?
Policy makers are behind a lot of this volatility.
In the U.S., the debt ceiling debate, not only resulted in the U.S. losing its AAA debt rating, but also increased the risk of a recession. That sent the markets into a wild ride.
In Europe, leaders can’t reach an agreement on how to solve the crisis. They have mastered the art of kicking the can down the road. So there’s still a risk of a full-blown European crisis, which could bring down the global financial system. No wonder markets go schizophrenic every time there’s news out of Europe.
In China, policy markets are trying to prevent a real state bubble from popping. If they fail, one of the main engines of global growth will face a major crisis. No country will be safe. So investors are nervous about that as well.
When the Market Gives you Lemons,
2011 was a pretty volatile year. Since none of our global problems have been resolved, we’re in for more of the same in 2012.
We’re likely to see another macro-driven and highly correlated market. There will be little regard to individual company fundamentals.
While this risk on/risk off market is a nightmare to long-term investors, it’s the perfect environment for short-term traders.
There’s no place better to explore macro ideas than the currency market. Emerging market currencies offer the best opportunities, because they are very sensitive to changes in sentiment.
When risk is on, emerging market currencies rally against the dollar, which is viewed as safe-haven. So you can easily profit in a “risk on” mode by buying currencies such as the Mexican peso, the South African rand, or the Hungarian forint.
When risk is off, you do the opposite. It’s as simple as that.
There will be a lot of market volatility next year. You can do nothing, and just watch markets go up and down in wild moves. Or you can use those moves to profit in the Forex market.
The market will give you lots of lemons next year. Make sure you make lemonade!
Editor, Exotic FX Alert and Currency Capitalist