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

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

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.