How to Profit From the Fed's New Moves

Post date: Nov 07, 2010 11:3:15 PM

Ben Bernanke hopes his new $600 billion bonanza will help unemployed machinists in Toledo and building contractors in Spokane.

But so far the biggest winners have been condo-flippers in Shanghai, stock market traders in Hong Kong and speculators in commodities like cotton, silver and sugar everywhere.

Prices have skyrocketed since Mr. Bernanke first unveiled his plans two months ago. Commodities have surged. Emerging markets are booming.

Is it too late for ordinary Americans to get in on all this action? Maybe. Jumping on a bandwagon that's been running a long time is always risky.

European Pressphoto Agency

A new Petrobas oil rig in Angra dos Reis, Brazil: Emerging markets are booming, but jumping on a moving bandwagon is always risky.

But there are ways of doing it that minimize the dangers. Among them: call options—simple, if misunderstood, derivatives that can be bought through any broker.

But first, you need to understand why the assets described above stand to benefit from the Federal Reserve's new plan to buy up bonds.

There are three reasons, say economists.

For starters, by flooding the world with extra dollars, the Fed is effectively devaluing all dollars. That reduces their value against other currencies. But emerging economies like China insist on keeping their own currencies cheap against the dollar, to help their exports. So if the Fed devalues the greenback, they have to follow suit.

Brett Arends explains how he thinks you can profit from the Federal Reserve's latest quantitative easing plan.

Net result: These countries are flooding their own economies with extra liquidity at a time when many of them are already in danger of overheating. There are real estate bubbles and other speculative surges bursting out all across emerging markets.

There's a second way Mr. Bernanke is fueling the emerging-markets boom.

The Fed is pumping all those dollars into the banking system. But the banks aren't lending them out here in the U.S. (Why would they? The banks are already sitting on record excess reserves. Demand and expected returns are low.) Instead, the money just ends up chasing the "hottest" speculative boom—and that, of course, is emerging markets.

"When the Fed provides liquidity for U.S. markets, it provides liquidity for the world," says Milton Ezrati, senior economist at fund company Lord Abbett. Emerging markets, he says, are simply "the most popular destinations" for money right now.

And there's a third way the Fed is helping emerging markets. As the Fed devalues dollars, commodities priced in dollars gain in comparison. For many investors, they start to look like a hedge against inflation. And that, in turn, is good news for those emerging economies that export a lot of commodities, from sugar to cotton.

So what does all this mean for you?

Investors have been pouring money into mutual funds that invest in emerging markets all year. According to Financial Research Corp., which tracks fund flows, investors have been stepping up purchases lately.

Those looking to invest in emerging markets have a wide variety of choices. Among the simplest, iShares MSCI Emerging Markets Index is a low-cost exchange-traded fund that invests across a basket of markets. And Guggenheim Frontier Markets, another ETF, invests across newer, even riskier "frontier" markets like Chile, Colombia and Egypt. It's gained 17% since late August.

The danger is that everyone is already in emerging markets. How crowded is this trade? Here's an anecdote. A short while ago I met a "market technician," a chart reader. I wanted to talk about stock-market moving averages, Bollinger Bands, stochastics, waves and so on.

But he didn't want to talk about any of that. He wanted to about emerging markets. Apparently "Peru is the next Colombia," which itself was the next Brazil, oh, about two months ago. I forget the details. It was all there on his iPad.

This is the kind of stuff you encounter late in a mania. Are the taxi drivers into this stuff yet?

Maybe this boom will run and run. I don't know. Nor does anyone else. Emerging markets are not cheap. But if you think it has room to keep going for months more, and you figure it's a bubble, the way to play it isn't to run away from risk. It's to embrace the risk.

Make a smaller bet, so you're gambling less money. But make those bets in the riskiest, most volatile assets. They'll run the most on the way up (and fall the most on the way back down).

And one way to do that is through call options. These are a simple way of investing in a boom without risking too much money. You can buy them through any decent broker.

Call options are like a down payment you can walk away from. For a small amount of money, you lock in the right to buy an asset at a fixed price later on.

If the asset booms, you can make the trade and collect the profit. If the asset tanks, or even just hangs around, you can walk away. All you lose is the down payment.

Options aren't the same as shares. There is a very real chance of losing your entire stake. That's why one only wagers a small amount.

While emerging markets are hot, Dylan Grice, a strategist at SG Securities, says the call options on those markets are surprisingly cheap. There are technical reasons for that, things to do with market volatility and the way options are usually priced.

Look at the iShares emerging-markets ETF. Since late August it has rocketed from around $40 to nearly $49. At the depths of the crash, nearly two years ago, it was below $20.

But if you don't want to risk $49 a share this late in the game, you can get in for a fraction of that. For $7.35 a share, you can buy $45 call options that will last until January 2012. (Note: Options trade in round lots of 100.) If the markets rocket higher, those options will gain in value. But your total risk comes to $7.35 a share.

The $60 call options cost just $1.43 a share. If emerging markets skyrocket into a bubble—as some smart people predict—you'll make out fine. And if it all goes south, you'll lose a grand total of $1.43 a share.

Write to Brett Arends at brett.arends@wsj.com

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