After tumbling some 21 percent in the four months from May to September last year, the Indian rupee has made an impressive about-face – climbing 14 percent in the last six months.
But this recent rise in value seems very odd. While its tumble was triggered by the U.S. Federal Reserve’s announcement last May that stimulus reductions would begin before the year was out – strengthening the U.S. dollar and sending emerging market currencies reeling – the actual stimulus reductions themselves which began in January haven’t harmed the rupee at all. It seems the U.S. Fed’s tapering bark was more menacing than its bite.
While all that was happening, India’s Sensex stock market index followed the rupee in tandem, falling some 14 percent as the rupee fell, and rising some 28 percent as the rupee rose.
Do you notice the profit opportunity in that? During the fall, both the rupee and the Sensex tumbled together, which made Indian stocks even cheaper as you get extra rupees for your USD and extra shares for your rupees – a double discount.
During the rise, both the rupee and the Sensex have risen together, giving you extra rupees when you sell your shares and extra USD when you sell your rupees – a double profit.
The rupee’s move amplified the gains in Indian equities, allowing investors to buy cheap stocks for less, and sell expensive stocks for more. Sound enticing? The only problem is there are a lot of moving parts. Not only can the stock market move against you, but the currency exchange could too.
Yet India just might be a good candidate for this combo equity-currency strategy, given the government’s commitment to keeping its markets strong while not tampering too much with its currency. Let’s note what the Indian central bank has been doing lately, and the effect it has had on the Sensex and rupee. Then we’ll consider how we might take advantage of that.
India Saves the Rupee
When the rupee fell to multi-decade lows by September of last year, India was on the brink of crisis. Foreign investments were fleeing India and other emerging markets, leaving gaping holes in their current accounts, widening budget deficits, and making interest payments on foreign debt more expensive to cover.
Normally, a central bank would raise interest rates to strengthen its currency, which the Reserve Bank of India did from September to January, increasing its rates from 7.25 to 8 percent. But it was reluctant to do more, since high rates slow commerce and growth by making business loans and mortgages more expensive.
So the RBI supplemented its modest interest rate hikes by buying U.S. dollars. After all, since U.S. Fed tapering strengthens the USD over time, India would gain a boost on the back of a rising dollar. As a result, India’s foreign reserves have climbed to over $298 billion, their highest level since the end of 2011.
Increasing foreign reserves not only gives the rupee a more solid backing from more USD in the RBI’s vaults, it also allows the central bank to stop raising interest rates, enabling Indian companies and their stocks to flourish once again. The RBI seems to have found a perfect balance between rupee strength and stock market growth.
Sensex and Rupee – Joined at the Hip
In fact, India has maintained a rather tight relationship between its currency and stock market for years, as the graph below shows.
Sources: Xe.com, Marketwatch.com
For the most part, the Indian rupee and Sensex index have risen (green) and fallen (red) noticeably closely. Not always perfectly in tandem down to the day or week, but on a monthly scale at least.
How might a trader take advantage of this tandem movement between the rupee and Sensex?
Sources: Xe.com, Marketwatch.com
When both the rupee and Sensex are at recent lows – as noted in late June, late August, early November, and late January in the graphs above – converting USD into rupees will get you extra rupees at a lower price – there’s your first discount.
Those rupees would then be used to purchase Indian stocks, preferably the broader market index for better diversification, getting you extra shares at a lower cost – there’s your second discount.
When you are satisfied with the Sensex’s next upward move, the process would simply be reserved, selling your stock at a higher price, and converting your rupees back into dollars at a lower price for an extra profit.
But we must be aware of what can go wrong. Notice the middle of September in the graph above? The Sensex fell almost 5 percent, while the rupee actually rose a tiny bit. An exit out of your positions at that time would have cost you a chunk of your profit.
For this relative value trade to work, you will need to use your calculator to work out two transactions – stock sale and currency conversion back to USD – before you know if there is sufficient profit to justify closing the trade.
Since stock markets can decouple from their currencies, you must be careful to pick a foreign market that has some true growth potential, so that over time your stock position will rise and provide you with enough appreciation to offset any currency loss should the exchange rate move against you. This is where India’s equity market comes through with very high scores.
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India’s Remarkable Momentum
When both legs of the strategy described above move in tandem – both stocks and currency – you’ll do just fine. But for those times when the two legs move in opposite direction, your focus should always be on picking the right market, since equities will move more than currencies over time.
As can be seen in the first graph above, while India’s rupee has lost 24 percent against the USD over the past 10 years, its Sensex index has gained an incredible 285 percent. Hence the importance of picking the right market.
Compare that to the S&P 500’s gain of 64 percent over the past 10 years and we can say with confidence the Sensex was indeed the right market.
But in picking the right foreign market for this strategy, there is more to consider than just recent stock market history. The economy’s growth history and future projections are also important to note.
As noted above, since India’s independence in 1950, its GDP annual growth rate has averaged 5 percent in the front half and some 7 percent in the back half, while U.S. GDP annual growth has averaged 4 percent in the front half and some 3 percent in the back half over the same period.
As for GDP contraction, U.S. growth has crossed solidly into negative territory (shrinkage) at least 8 times over the period, compared to India’s 3 times.
What about the future, though? Aren’t emerging markets in for a very rough go over the next few years?
Yes, they likely are. But emerging markets are like small cap stocks, while developed markets are like large cap stocks. Just as the small caps collapse harder than large caps in bear markets and rebound faster in bull markets, so too emerging markets will fall harder during global recessions and spring back faster during expansions.
According to future projections, India is due for some pretty robust growth going forward, as compiled by Trading Economics.
Where the U.S. GDP annual growth rate is expected to clock 3 percent, 3.2 percent, 2.8 percent and 2.7 percent in the four quarters of 2014 and average 3 percent across 2015, India’s GDP annual growth rate is anticipated to average 4.81 percent, 4.82 percent, 4.79 percent and 4 percent in the four quarters of this year and 5 percent throughout 2015.
But there is one more forecast to note, which takes us back to the U.S. Federal Reserve’s stimulus tapering. As the termination of its monthly bond buying program by the end of this year strengthens the USD relative to the rupee and other currencies, investors will be able to purchase Sensex stocks more cheaply on the dips, adding an exchange rate bonus to Indian stock appreciation over time.
Yet as attractive as this and other similar foreign investment strategies are, one must always remember that only a fraction of a portfolio should ever be diversified into foreign markets.
Just as one would spread his holdings across large caps as well as small caps, so too the safety and stability of American markets should always be the bulk of any portfolio. India could well be a cheetah springing to action in the field, but America will always be the elephant in the room.