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Investing in an Economic Downturn or Recession

It has been known for many moons, and over many business cycles, that during every economic downturn, or recession, things follow a similar path. One of the first things we see is a bear market in equities. Short-selling in the stock markets is a bit tricky, however, particularly with regulators around the globe deliberately trying to curtail it, so this is not the equivalent of going long in a bull market. So it came to be known that during recessions, cash is king. This is particularly true of our current situation because the credit contraction this time around is particularly severe, making cash that much more attractive. OK, so cash is definitely king, but cash in itself does not constitute returns unless you use it to buy equities on the cheap, at which point it is no longer cash. You could also argue that during a deflationary period such as this, cash does constitute returns because it gains purchasing power. The jury is still out on how deflationary this recession is going to be however. In the meantime, what do you do with your cash (if you have any)?

The answer is simple. Change it to a different form of cash. By far the best investment one can make going into a recession is to enter some smart positions in the currency market, or forex. If you look at a daily or weekly chart of the S&P 500 or Dow Jones Industrials, or just about any index out there, and compare it to most Japanese Yen (JPY) charts, you will see a striking resemblance – they are in fact almost mirror images of one another. In financial markets, this is known as an "inverse correlation". There are several reasons for this correlation. One of them is something known as the carry trade. During the strong economic expansion over the past few years, investors have been seeking high yields by borrowing currencies with a low interest rate (such as JPY), and buying currencies with a high interest rate (such as the Australian Dollar, or AUD), and pocketing the difference. This works great because interest is risk-free, and if you highly leverage yourself, it can bring in amazing returns. This also worked even better because it became a self-fulfilling prophecy: The more investors bought these higher-yielding currencies, the higher its value went, so you could profit not only from the interest, but now even more so from the fact that the currency you are buying is going up in value. This worked so well for so long, that investors started to forget about a little thing called “risk”. It seemed like this was a risk-free way to make money. This is a tell-tale sign of a financial bubble in the making. Risk appetite grew until it came to a point where investors were acting irrationally. Alan Greenspan’s term “irrational exuberance” comes to mind.

As the US economy began to enter an economic downturn, and then a recession, investors began to feel their appetite for risk decreasing dramatically, and they began to exit these positions. This is called the “unwinding” of the carry trade, which put pressure on the high-yielding currencies like AUD, and since everyone who traded their JPY in for high-yielders now had to buy JPY again, it drove the value of JPY up. JPY has also historically been known as a “safe-haven” currency because it is backed by a large, mature, and stable economy. This added its appeal as the economic downturn became more serious. Add to that the large volume of speculative investment, and you have a recipe for a very strong move up in the JPY. The Swiss Franc (CHF) is another good example of a low-yielding currency reaping the benefits of the recession.


SP500 vs AUDJPY comparison

The nice thing about all this is that the currency market is an unregulated, over-the-counter market, which means there is no ban on any type of short-selling (there couldn’t be anyway, since selling one currency always entails buying another). Knowing what we know about cash being king, about the strong inverse correlation between equity markets and the JPY, and the ability to trade whenever, wherever and whichever way you want, we have a strong case for the currency market being the best possible option for investors seeking a good return in a bear market, or an economic downturn, or even an outright recession. Just a word of caution however: in uncertain times such as this, volatility tends to rise sharply, so make sure you don’t over-leverage your forex account. High leverage is normal in forex to make up for its relative lack of volatility. There seems to be no such lack during this recession, so please be careful. If you would like to know more about that, please read our “How to Calculate Leverage” article from a few weeks ago.

(Just to be clear, this article is for information purposes only and is not a recommendation to buy or sell any particular currencies)

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