Oscar Wilde, the 19th century poet and playwright, once said: “Everything popular is wrong.”
The Irish wordsmith wasn’t referring to the financial markets, but he may as well have been. That’s because investors should be very wary of the popular stocks, sectors, and exchange-traded funds (ETFs) du jour.
While it’s true that momentum can persist, more often than not, popularity is the kiss of death.
In finance, the degree of popularity is typically referred to as sentiment.
Fundamentals matter in the long term, but sentiment is what really drives short- and intermediate-term moves in the financial markets.
Caution is, therefore, essential when sentiment reaches a bullish extreme.
The Texas Hedge
It was a no-brainer, can’t-lose trade.
Pundits on CNBC and Bloomberg TV were supremely confident in the outcome.
Fund flows poured in to take advantage of its inevitability.
This was a “layup” – a sure thing.
The Bank of Japan (BOJ) was going to depress the value of the Japanese yen, and Japanese equities would rise due to exporters benefiting from a cheap currency.
Naturally, everyone wanted to be long Japanese stocks, but short the yen, and the WisdomTree Japan Hedged Equity ETF (DXJ) provided an easy way to do just that.
Except now investors are realizing that they aren’t hedged at all.
Ironically, the yen has gone through the roof ever since the BOJ implemented a quasi-negative interest rate scheme.
The U.S. dollar/Japanese yen exchange rate (USDJPY) recently hit its lowest level since October 2014 (a decline in USDJPY represents dollar weakness, yen strength).
Thus, anyone betting on a decline in the yen is getting bludgeoned in the market.
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Not only that, Japanese equities are, unsurprisingly, falling in tandem with USDJPY.
This is a lose/lose situation for DXJ holders.
Since April 2015, when I warned that investors in currency “hedged” ETFs were essentially speculating on currency movements, DXJ has lost 26% of its value (including distributions).
Going back even further to early 2014, DXJ has produced a total return of negative 6%.
Alas, it was so popular!
Over the same time frame, the S&P 500 has returned a positive 16%.
To be sure, DXJ now offers a far better risk-reward proposition than it did a year ago.
Basically, the fund may excel because the trade is not nearly as popular.
We’re even seeing currency futures speculators, in aggregate, bet on yen appreciation.
The last time this group had a net long position in the yen was 2012, right before the yen plummeted as “Abenomics” was introduced. In other words, the sentiment of this crowd is a contrarian indicator.
Sentiment notwithstanding, the fundamentals for Japan, in general, remain poor.
Japan has a shortage of the most precious natural resource on the planet: children.
Do the central planners really think that burning their currency at the stake is going to solve anything? Well, they certainly shouldn’t.
Nonetheless, the short-term swings will continue, as prices are determined – at the margin – by human behavior and emotions.
This is why serially buying the most popular investments is a great way to destroy wealth.
Meanwhile, the fundamentals for U.S. Treasuries remain strong. The real trick, however, will be knowing when they, too, have become overly popular.
Safe (and high-yield) investing,
Alan Gula, CFA