Long EEM Short IWM-How it Works in 3 Ways

Long EEM Short IWM potentially works in 3 ways:

1) See my last post “Asian Currency Opportunity” where currency undervaluation means potential gain of 20-50% versus the US$ and 50%-100% versus the Japanese Yen.  However, even absent the undervaluation, the spread offers protection against a declining dollar, for which most US bond, equity, and real estate investors are not well enough hedged.

2) If the currency undervaluation is not enough, EEM offers better growth at a far lower valuation on an equity basis.  These are not the best indicators of value, but they are public, so I can share them here

Emerging and US Small Cap valuation from Vanguard

Equity characteristics as of 02/28/2011
	Emerging Mkts Stk Idx Inv	MSCI Emerging Markets Index Net USD	Small-Cap Index Fund Inv	MSCI US Small Cap 1750 Index
Number of stocks	900	796	1722	1716
Median market cap	$18.6 billion	$18.9 billion	$1.8 billion	$1.8 billion
price/earnings ratio	14.5x	14.3x	26.1x	26.1x
price/book ratio	2.2x	2.1x	2.1x	2.1x
return on equity	21.70%	21.00%	10.20%	10.20%
earnings growth rate	14.30%	13.70%	3.80%	4.00%

Emerging and US Small Cap valuation stats from iShares EEM and iShares IWM

Fundamentals & Risk as of 2/28/2011
	EEM	IWM
12-Month Yield	1.41%	1.09%
Price to Earnings Ratio	18.69	27.98
Price to Book Ratio	3.44	3.58

3) The spread offers low correlation versus stocks and bonds in a persistently and dangerously high correlation environment.

From TimelyPortfolio

From TimelyPortfolio

I’m still not exactly sure how this is calculated, but I thought this offered another look at something statistical, and I feel is not very well covered by other examples.  Points closest to each other on the chart are most related.

From TimelyPortfolio

 

 

R code:

require(quantmod)
require(PerformanceAnalytics)
require(fAssets)

tckr<-c("EEM","IEF","IWM","GLD","SPY")

start<-"2005-01-01"
end<- format(Sys.Date(),"%Y-%m-%d") # yyyy-mm-dd

# Pull tckr index data from Yahoo! Finance
getSymbols(tckr, from=start, to=end)

EEM<-adjustOHLC(EEM,use.Adjusted=T)
IEF<-adjustOHLC(IEF,use.Adjusted=T)
IWM<-adjustOHLC(IWM,use.Adjusted=T)
GLD<-adjustOHLC(GLD,use.Adjusted=T)
SPY<-adjustOHLC(SPY,use.Adjusted=T)

EEM<-to.weekly(EEM, indexAt='endof')
IEF<-to.weekly(IEF, indexAt='endof')
IWM<-to.weekly(IWM, indexAt='endof')
GLD<-to.weekly(GLD, indexAt='endof')
SPY<-to.weekly(SPY, indexAt='endof')
EEMIWM<-to.weekly(EEM/IWM, indexAt='endof')

RetToAnalyze<-merge(weeklyReturn(EEM),weeklyReturn(IEF),weeklyReturn(IWM),weeklyReturn(GLD),weeklyReturn(SPY),weeklyReturn(EEMIWM))
colnames(RetToAnalyze)<-c(tckr,"EEMIWM")

assetsDendrogramPlot(as.timeSeries(RetToAnalyze))
assetsCorEigenPlot(as.timeSeries(RetToAnalyze))
mtext("Source: Yahoo! Finance",side=1,adj=0)

chart.Correlation(RetToAnalyze[,1:6,drop=F], main="Correlation since 2005")
mtext("Source: Yahoo! Finance",side=1,adj=0)

#get Rolling Correlations with IEF(bonds) and SPY(stocks)
corEEMIWMtoBonds<-runCor(RetToAnalyze[,6],RetToAnalyze[,2],25)
corEEMIWMtoStocks<-runCor(RetToAnalyze[,6],RetToAnalyze[,5],25)
chartSeries(EEMIWM,TA="addBBands();addTA(corEEMIWMtoBonds);addTA(corEEMIWMtoStocks)",theme="white")
mtext("Source: Yahoo! Finance",side=1,adj=0)

 

 

Disclosure:  AS ALWAYS, THESE ARE MY OPINIONS AND THE FUTURE IS UNPREDICTABLE.  CONDITIONS CHANGE AND I ADJUST POTENTIALLY WITHOUT DISCLOSURE ON THIS BLOG.  YOU ARE ON YOUR OWN MAKING INVESTMENT DECISIONS, AND IN NO WAY AM I ADVISING YOU.  I TAKE NO RESPONSIBILITY FOR YOUR GAINS OR LOSSES.