Currency Moves Signal Panic Selling – Use It to Our Advantage

Tuesday, May 25, 2010

Yesterday I discussed how to use currency exchange rates for understanding global economic and financial conditions. Today, let’s look at how the rates can provide a window into emotional investment moves, particularly panic selling, and how we can use the information to our advantage.

Previously, I described the key elements that determine exchange rates (see “Evaluating Global Economic and Financial Concerns – Choose Viewpoints Carefully”). Included are investment flows, and they are the key drivers right now.

Below is the updated exchange rate graph, showing the sharp drops in all the other (i.e., non-Euro/UK) currencies (Australia, Switzerland, Canada, Mexico and India) relative to the US dollar and the Japanese yen.

Currencies, especially those of less developed countries with large amounts of foreign capital invested, can drop significantly when investors from outside the countries sell en masse. Those sales can be anything – bonds, stocks or the currencies, themselves. Also, sales of mutual funds holding such securities eventually lead to such sales. The exchange rates are affected because the asset sales also involve selling those countries’ currencies and buying the investors’ home (or a stronger) currency.

When investors are focused on value (reason), individual countries move separately as determinations are made about each country’s conditions. However, when investors are focused on fear (emotion), the currencies can drop in unison under the weight of widespread selling.

Taking advantage: Two professional investing strategies

When we look back on panicky times, we see many prices reaching attractively low levels. Clearly, then, our best route would have been to buy in those times. But with prices tumbling, how do we act without getting burned?

I previously covered five key considerations (see “Five Keys for Deciding What to Do in This Stock Market – Buy, Sell or Wait?”). Let’s add to that the two main strategies the professionals use:

  1. When opportunities arise in emotional times, buy. This simple sounding approach represents sound and wise investing, and is how skilled investment managers operate. But they don’t act blindly. Superior performance comes from being able to get past today’s emotional rhetoric and concentrate on finding excellent investments whose prices have been dragged down.
  2. Sell short (and incite); then buy. The approach here is to take advantage of a known concern (e.g., Greece’s troubles), using public statements and/or private investment actions to unnerve, even frighten, investors into selling. Then, when the hoped-for panic selling sets in, close out any short sales and go long at cheap prices.

(Does #2 sound distasteful? Well, it is. I’ll have more to say about it tomorrow – what the tactics are, why they’re allowed to exist and what we can do to protect ourselves.)

So… In times like these, we need to act like the professionals (in #1, above), buying sound investments that are temporarily low in price and high in value. This is the first step in achieving “buy low, sell high” superior performance.

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