May 23, 2009

Market Insights 23 May 2009

Weekly Snapshot
• Auto lender GMAC receives additional $7.5 bn in bailout money from US government
• Standard & Poor's warned that UK debt could rise to 100% of GDP by 2013
• UK's credit rating could be downgraded from current 'AAA' status
• US Volatility Index dropped to a low of 26.57 on Wednesday
• Japan’s GDP shrank by 4% in the first quarter compared with Q4 in 2008
• BofA raised $13.5 bn since May 8th by issuing additional shares
• Brazil & China plan to use their own currencies in trade rather than the US$
• The Euro’s share in Russia’s forex reserves increased to 47.5%, overtaking the dollar’s, which is now 41.5%
• U.S. housing starts fell 12.8% to a seasonally adjusted annual rate of 458,000 units, the lowest since 1959

Recommended Read
Why Britain has to curb finance - By Martin Wolf

Will new targets for CAFE be effective?
You may have caught a glimpse of this week's "CAFE" meeting in Washington when the US administration announced the new plans for Corporate Average Fuel Economy. The CEOs of the major car manufacturers stood right beside Mr. Obama when the announcement was made to increase CAFE targets for passenger cars to 39 miles per gallon by 2016.

How effective will these new targets be? John Gapper predicts that "Detroit will dodge Obama’s fuel rules"

He believes that there are several flaws with the idea of imposing these standards and I would agree with some aspects of his arguments. Fuel efficiency standards were introduced in the mid 70's with a CAFE for passenger cars at 18 mpg and again in the mid 80s at 27.5 mpg. As Mr. Gapper notes, CAFE standards brought an end to the huge passenger cars of the 1970s but they also paved the way for the production of Light Trucks, Mini Vans and SUVs, all of which were bigger, heavier and consumed even more gasoline.

Instead of imposing new standards which may or may not be met by 2016, Mr. Gapper suggests that a higher tax on gasoline may be a much more effective solution, particularly in terms of achieving immediate changes in consumer behavior. US federal gasoline tax is currently 18 cents per gallon and overall gasoline taxes in the US amount to less than 20% of the actual price paid at the pump. Compared with the rest of the world that is incredibly low. Many European countries have gasoline taxes between 60%-70% of the gasoline price listed at the pump.

Raising taxes on gasoline may be a politically difficult move but it could be explained by stating that all other industrialized nations have gasoline taxes in multiples of those imposed by the US government. It would also have the immediate effect of helping to reduce the nightmarish US budget deficit (wouldn't it be nice for a change to see some positive effects on the US budget?). Nobody likes to pay taxes, but that is one tax increase I would favor over any increase in personal income or corporate tax.

More on ETFs
Last week, we looked at some specific examples of Oil ETFs and found that the real returns of an ETF can be much less than the price performance of the underlying asset, commodity or index which is tracked by the ETF. This week, we turn our attention to a set of currency ETFs examining the same correlation and returns.

First Currency ETF: CurrencyShares Euro Trust (Symbol: FXE)

Second Currency ETF: WisdomTree Dreyfus Euro Fund (Symbol: EU)

Looking at comparative charts, we noticed that the price of the underlying currency, in this case the spot price of Euro, moves essentially the same way as the two ETFs (tickers: FXE & EU) tracking the currency.

Euro (Spot price) versus FXE (ETF)

Euro (Spot price) versus EU (ETF)

We performed the same correlation analysis for both ETFs and found that FXE had a positive correlation of 99.96% whereas EU had a positive correlation of 99.65%. In terms of some specific trading examples, we ran some hypothetical trades again looking at the very basic comparison on a trade basis. As you can see from the tables below, these ETFs reflect the underlying asset much more accurately.

This is encouraging but let's examine a few more parameters before making a judgment call on these ETFs. In terms of the expense ratios, they are higher than the traditional index trackers but slightly less expensive than the Oil ETFs we examined last week. Expense ratios are 0.40% for FXE and 0.35% for EU.

On first glance then, these two ETFs provide pretty good value in terms of matching the underlying asset, but what are the caveats?

Liquidity may be the main issue to note here. If you were to trade Euros versus US$ with a broker or bank, there is literally never any issue with liquidity. According to the most recent figures by the Bank of International Settlements (BIS), the global forex market has a daily trading volume of over $3.2 trillion and Euro versus US$ accounts for about 27% of that volume, nearly $1 trillion daily. By contrast, FXE has a Net Asset Value (NAV) of only about $600M and with an average trading volume of 472,000 shares, the notional volume is just $66M. Our second ETF is even smaller by comparison. EU has an NAV of only $9M and an average trading volume of only 4,600, giving it a trading volume of just over $100,000; not nearly enough to be considered a sensibly liquid investment.

Another potential concern for the active trader is the fact that Forex is typically traded 24 hours across all time zones. Comparing the trading hours of the ETF versus the spot currency, a trader would loose out on 16 hours of additional market action, which would be an issue for professional traders or trading teams. But for a smaller investor who is not too concerned with daily price fluctuation, the ETF solution would be a sensible way to gain some currency exposure. We will continue to examine more currency ETFs in upcoming newsletters.

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Good luck & good trading!

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