Currency ETFs Are Giving Advance Stock Market Signals (BZF, INR, CEW, EEM, INDY, EWZ)

Scott Martin: Asset class correlation is rarely an exact science, but traders have found that some indicators are still invaluable triggers for timing entries and exits on countries such as India and Brazil.

Stock ETFs like (NYSEARCA:INDY) and (NYSEARCA:EWZ) have tracked the rupee and the real extremely closely in recent months.

This has been especially noticeable in Brazil, where every recent short-term peak in the value of the real compared to the U.S. dollar has foreshadowed a follow-up lift in the Brazilian stock market a day to a week later.

And Brazilian stocks haven’t made any appreciable moves up lately without the real strengthening first.

Taken together, these signals haven’t been a perfect skeleton key to trading the Bovespa, but they’ve given traders plenty of warning when it’s time to take profits or dive back in.

This isn’t surprising given the relationship between emerging stock markets and prevailing supply and demand for currency. A Brazil-focused investor who wants to double down, for example, needs to buy more reais first, and foreigners who sell out of a stock position generally repatriate their profits in their native currency.

In the former case, demand for reais rises, and then that Brazilian currency is put to work buying stocks. When demand for reais levels off, it’s been a good indication that the flow of money into the stock market pipeline is faltering. People make their buys, stock prices climb and then run out of fuel to go higher.

Naturally, when foreign traders sell out of real-denominated stocks, the opposite relationship emerges. Once-inflated demand for reais declines, depressing exchange rates and, again, leaving Brazilian stocks starved for the foreign capital they need to move up.

A similar pattern has ruled in India as well, only with a few key twists. Because India is still relatively closed to many forms of direct foreign investment, the relationship between stocks and currency is less immediate — domestic investors can pump Bombay for weeks after the rupee starts a downward move.

However, it still takes that initial burst of juice from overseas to get either India or Brazil moving. Right now, we see the rupee moving higher — as you can see from the performance of the currency fund (NYSEARCA:INR) — so there’s hope for another bounce brewing for Bombay.

The real, on the other hand, still points straight down as Brazilian central bankers keep guiding local interest rates lower, taking the fundamental value of the real and funds like (NYSEARCA:BZF) down along with them.

But can we extrapolate this indicator to the emerging markets in general?

WisdomTree’s emerging currency fund (NYSEARCA:CEW) is designed to mirror a broad basket of exchange rates in Brazil, Chile, Mexico, Poland, Russia, Turkey, South Africa, China, India, Malaysia, Indonesia and South Korea.

The fund weighs each of these 12 currencies equally, so it won’t be a perfect match for global emerging stock ETFs like (NYSEARCA:EEM), which will reflect higher exposure to China, Korea and Brazil — not to mention Taiwan, which doesn’t appear in CEW at all — and a lot lower exposure to everything else.

Still, line up the CEW and EEM charts, and you’ll find that most of the peaks and valleys have coincided over the last four months. This demonstrates the depth to which binary “risk on / risk off” mentality has taken root in market psychology: when traders are buying risk, everything with “emerging” in the description does well, but otherwise all these assets are for sale.

Unfortunately, the relationship has been too perfect to be much help to casual traders. Once CEW peaks, the odds are good that EEM has peaked as well — which means it’s too late to trade the signal. And when CEW bottoms, EEM has bottomed too.

Written By Scott Martin From Emerging Money

Emerging Money provides insightful and timely information about the increasingly important world of Emerging Market investments. CNBC Emerging Markets Contributor Tim Seymour leads the team of Emerging Money to bring you cutting edge global news and analysis.

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