The U.S. dollar’s downward spiral continued Thursday, driving the PowerShares DB US Dollar Index (UUP) to a new three-year low. The greenback’s latest descent accelerated following Bernanke and Co.’s mid-September decision to hold off tapering their asset purchases. While the buck’s support breach certainly isn’t helping traders who were betting on higher interest rates and a stronger dollar, it is boosting foreign funds like the iShares MSCI EAFE ETF (EFA).
Over the past few decades, a strong link has existed between the U.S. dollar and foreign markets. As shown in the accompanying chart, a decline in the buck from 2002 to 2008 accompanied relative weakness in the S&P 500 (shown by the falling SPX:MSWORLD ratio). In contrast, since the dollar began strengthening over the past five years, the S&P 500 has outperformed the rest of the world.
Said another way, a weak dollar has helped foreign stocks on a relative basis; a strong dollar has hurt them.
With this big picture in mind, let’s know zoom in to discover what has happened this year.
This time, we’ll look at the S&P 500’s performance relative to the iShares MSCI EAFE ETF, which represents foreign stocks in Europe, Australasia and the Far East.
For the bulk of the year, the SPX:EFA ratio was rising as U.S. stocks bested the performance of their overseas counterparts. However, the tides began to turn in July, and in early September the trend of the ratio reversed lower (blue arrow). As suggested by the positive correlation between the dollar and SPX:EFA ratio, the recent outperformance by EFA is in part a byproduct of the weakening greenback.
If you think the dollar will remain under pressure and, more importantly, that EFA will continue to outperform, consider entering a Dec 63-66 bull call spread by buying the Dec 63 call and selling the Dec 66 call for $1.49 or better. The max risk is limited to the initial debit of $1.49 and will be lost if EFA sits below $63 at expiration. The max reward is limited to the distance between strikes minus the net debit, or $1.51, and will captured if EFA can climb above $66 by year’s end.
By using December options, we give ourselves plenty of time to weather any short-term volatility associated with the daily drama from D.C. We’re also well-positioned to profit from any type of stock surge in the seasonally strong fourth quarter.
At the time of this writing Tyler had no positions on any of the aforementioned securities.