Short the Euro

I have a philosophy on shorting.  Unlike buying and holding a stock because its cheap - if your analysis correct, valuation will always bail you out if you are patient enough - shorting is more complex.  High valuation is not enough to short, in my opinion.

Shorting is the process of borrowing a security then selling it in the hopes it will fall in value so you can buy it back at a lower price before returning the security to its rightful owner. 

In theory, losses from shorting are limitless, since the price of a security can theoretically rise forever. Practically, this does not happen since no stock rises to infinity.  However, a shorted stock price can rise enough to wipe you out.

Those shorting the ridiculously over-valued Talking Sock Puppets in 1998 based solely on valuation were harshly taught this lesson, as many short sellers were wiped out during the Tech Bubble as valuations grew from the merely ridiculous to the idiotically insane.

Thus valuation is not enough for me to short, though valuation is a critical component.  When stocks break, over-valued stocks will usually fall much farther than under-valued stocks.

Along with valuation, there are two other factors I look for when shorting - fundamentals that are or about to deteriorate, and a breakdown in the technicals.

Fundamentals are the foundation of a security's ascent.  Securities that are supported by strong fundamentals have a strong foundation.  However, like a house, deteriorating fundamentals are tantamount to the rotten foundation of a physical structure.  When the foundation collapses, so does the price of the security.

Technicals are a clue that buying power is exhausted.  When charts are rolling over, it is a sign that all the buyers have bought and there is no one left to support the security.  Deteriorating technicals are the safest sign that it is time to short, in my opinion.

A while ago, I called the bottom of the dollar.  I was wrong.  It still had another leg down.  However, I was close to the lows, which I believe are now in place.  I believe the dollar is about to strengthen appreciably against the other developed currencies, in particular against the euro. 

Over the next few weeks, I intend to get short the euro, though the currency is extremely oversold at the moment.  Thus, I will wait before entering my position.

A euro short satisfies all three factors of my shorting criteria.

Valuation
The euro is overvalued against the dollar.  Interest rate differentials are fairly benign for long-run instruments, though short-term rates are much higher in Europe.  However, inflation is peaking, which means that with economic growth slowing, interest rates will come down in Europe, and short-term interest rate differentials will narrow.

Based on purchasing power parity, the dollar is worth $1.10-$1.20 against the euro, according to several investment banks.  Having last been in Europe in March - when the dollar was hitting all-time lows and dropping over a penny a day - this seems about right to me. 

Fundamentals
Growth is slowing in Europe and business conditions are deteriorating.  The Spanish banking system is under extreme duress, having funded the housing bubble to excess which is now collapsing, Spain's banks are as bad, if not worse, than America's.  Ireland is also in trouble for similar reasons, and home prices are generally over-valued on the continent.  Meanwhile, German business confidence is eroding, hitting lows not seen in decades, the economy contracted in Italy during the second quarter, and France is, well, France!

Things are not necessarily worse in Europe than they are in America, but Europe has not yet experienced the significant deceleration already experienced in the US, and the currencies do not yet reflect the disparities in the growth curves.

And decoupling is sheer nonsense.

Longer-term, despite the slower growth that will occur in America over the next several years as excesses work through the economy, America's economy is more structurally sound as the US is more dynamic and pro-growth than Europe. 

Also, the demographics work against Europe as the rate of population growth is slower in Europe than in America.  Social Security and Medicare liabilities are enormous.  However, they are peanuts compared  to the future public pension and healthcare liabilities in Europe as the welfare state is far more generous on the other side of the pond. 

In Europe's favour is the inclusion of the former Warsaw Pact countries into the union.  This should not be underestimated as the cost structures are significantly lower in Eastern Europe, which will force radical restructuring on the continent.  This restructuring will be bitterly opposed in the political arena, but it is inevitable, and ultimately will lead to higher rates of economic growth.  This, however, is many years into the future.

Technicals
The euro is rolling over.

The huge move down on Monday was significant.  I think the chart is broken.

I will look to get aggressively short the euro in the not too distant future.

Comments

[A von Altendorf]

The implications are enormous, if you're right.

[Geldpress]

Better late than never. You may have been early, but the Euro collapse party is only just beginning. I completely agree with your justification. I assume you are shorting the Euro in the forex. I can't trade currencies in my IRA, so Im forced to use the ETF's and ETN's.

http://www.geldpress.com/2008/11/short-the-euro-without-playing-the-currency-market/