It is an oversimplification to summarize George Soros' investment philosophy based on the theory of reflexivity into a single sentence, but it is useful to think of the theory as telling us that a trend will continue until it reverses.
Reflexivity also points out the direction of the trend can be influenced by underlying economic factors and the perception of traders and policy makers about the trend. That makes analyzing trends more complicated because we need to consider what policy makers might do and how traders will react in addition to prices.
The entire global economy might be thought of as a group of trends under the theory of reflexivity. What happens in the U.S. impacts Japan, for example, just as policies in Japan have an impact on the U.S. These impacts can be seen in exchange rates, a market in which Soros has demonstrated mastery. His most famous trade -- a bet against the Bank of England -- made him $1 billion in one day.
Recently, Soros said that after a period of remarkable stability in currencies, he expects to see "more fireworks, more volatility." Traders benefit from volatility because volatile markets are the ones that offer large gains in short periods of time.
Soros also noted that there are limits to how far one currency can move because other nations can change their policies to influence their own currency. In the case of Japan, he said a limiting factor in how low the yen can fall is how much of a decline the U.S. is willing to tolerate.
After an extended decline in the yen, it could be time for that trend to reverse. The monthly chart below shows how far the yen has dropped and also shows that it has reached its downside target.
After falling almost 24% in the past two years, the yen has found support during the past four months.
Fundamentally, the yen seems like it should fall further. The Bank of Japan intends to double the supply of yen within the next two years, and increased supply usually results in lower prices. However, the price of any currency depends on the prices of other currencies. The Federal Reserve and the European Central Bank can also increase their money supply, and their actions could offset the impact of more yen in the global financial system.
Reflexivity tells us that market trends will influence behaviors and those behaviors will also influence prices. In Japan, we may be seeing signs that the downtrend in the yen is starting to have an impact on corporations that will lead to a strengthening of the yen.
As one example, a cheaper yen has allowed Toyota Motor (TM) to build up more than $37 billion in cash, which it will use to reinvest in its business and increase its dividend. These actions should help fuel growth in the Japanese economy. Increased growth will lead to an increased demand for yen and allow the Bank of Japan to increase the money supply without sparking inflation or devaluing the yen.
In other words, Soros is right that the direction of the trend itself is a factor that leads to the reversal of the trend.
Timing is an important decision for traders, who make the largest gains when they catch the beginning of a trend. In the yen, the time to buy could be now. The monthly chart above showed that we have reached the downside price target. The weekly chart below shows that the momentum of relative strength (RS) has turned up, a signal that the yen should outperform other investments during the next few months.
The Momentum of Comparative Strength (MoCS) indicator has just turned positive on CurrencyShares Japanese Yen Trust (FXY), an ETF that tracks the yen. MoCS converts relative strength to a Moving Average Convergence/Divergence (MACD) style indicator that can offer timely signals when the trend changes.
In testing on yen futures, this signal is accurate about 61% of the time with the average trade delivering a gain of more than 11% over the next four months. This system exits when the MoCS turns negative or after four months, whichever comes first.
Soros believes that currencies will be more volatile in the future, and the theory of reflexivity points to a possible trend reversal in the yen. Traders can take a low-risk position with FXY or a more aggressive position with yen futures.
Recommended Trade Setup:
-- Buy FXY up to $103
-- Set stop-loss at $98
-- Set initial price target at $114 for a potential 11% gain in 3-6 months
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