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US Dollar Bear Market 5

Currencies / US Dollar May 11, 2007 - 12:43 PM GMT

By: Zeal_LLC

Currencies

Adam Hamilton writes : With the headline US stock indexes doing so well this year, they are understandably absorbing trader attention and news coverage like a black hole. It is always exciting to see major new round numbers achieved and new highs carved. But other markets outside of this limelight are not frozen in stasis.

In particular the US dollar, seemingly totally forgotten in the dark shadow the stock markets are casting, has been exceedingly interesting. While you wouldn't know it from the mainstream financial media thanks to very little commentary on it, the US dollar's secular bear market is very much alive and well. In fact today it is on the verge of testing major major new lows.

If the dollar indeed continues on its stealthy downward trajectory and hits these new lows, the implications will probably be profound. Especially for American investors and speculators, the dollar is the linchpin of everything financial. When foreign investors see new dollar lows, will the massive inflows of capital they pump into our financial markets waver? What would this mean for US stocks, bonds, and interest rates?


As always in financial-market analysis, perspective is everything. In order to really understand just how critical the US dollar's technical position is today, it is best to start with a tactical view and then zoom out to the little-considered strategic view. The precarious levels at which the dollar trades today are remarkable to ponder in historical context.

The most popular way to track the dollar's fortunes is via the NYBOT-traded US Dollar Index, or USDX. It has been around since the early 1970s and measures the US dollar against a trade-weighted basket of major world currencies. Today the USDX is dominated by the euro, with a 58% weight. The Japanese yen weighs in at 14%, the British pound 12%, the Canadian dollar 9%, and then the Swedish krona and Swiss franc round out this geometrically-averaged index.

The actual USDX number shows where the US dollar is trading today relative to a March 1973 indexed base value of 100. Thus if this index is above 100, then the dollar is relatively more valuable today than it was in 1973 compared to these major currencies. If it is below 100, then the dollar is relatively less valuable. Today it is challenging 80, a hyper-critical number I'll discuss later.

In addition to the USDX and its assorted technicals, the charts in this essay also include the relative dollar. Based on my Relativity trading theory , the rDollar is computed by dividing the USDX by its own 200dma. The daily result is then graphed over time and it effectively condenses the dollar's behavior relative to its 200dma into a horizontal constant-percentage band. Eventually the rDollar forms a trading range within this band, granting traders excellent insight into high-probability-for-success long and short points.

Since it is not in Wall Street's best interest to publicize dollar weakness, as it leads to lower foreign investment in US stocks and bonds, I don't think a lot of investors are aware of the dollar technical scene today. This first chart, although short-term at only 19 months or so, shows a very definite downleg. Despite excellent US stock-market performance which should attract foreign investment, the dollar is being sold on balance worldwide.

Since its latest interim high in November 2005, the US Dollar Index has relentlessly ground 11.8% lower. Over an identical span of time, the S&P 500 rose 20.4%. Thus if you were a foreign investor buying US stocks in late 2005, about 6/10ths of your stock gains since then have been erased by your dollar losses. Such a big negative swing in a currency's value is not going to inspire foreign confidence in US markets.

And when a trend develops over 18 months like the dollar downtrend rendered here, there is a very high probability that fundamentals are driving it, not sentiment. The dollar has been falling in value for 18 months because global dollar supply exceeds global dollar demand. When such a structural surplus exists in any market, the only possible resulting price action is continuing declines on balance.

Technically this latest US dollar downleg has carved a fairly sharp and well-defined channel. Except for a month or so last spring when the dollar fell sharply and briefly traveled under this downtrend, it has generally bounced between channel support and resistance without incident. Indeed a new tactical support line can be drawn from these lows to today's, and savvy traders are anxiously watching it and wondering if it will hold.

Now an orderly downtrend over this length of time virtually has to be fundamentally driven, and some key technicals confirm this bearish structural-surplus thesis. Note above that the dollar's latest downleg has been trending parallel to its 200-day moving average. And the dollar was also repelled at its 200dma late last year and early this year. Such technical signatures are only witnessed in real bear markets.

One of the great strengths of 200dmas is they are like big road signs illuminating primary paths. Averaging the last 200 daily closes on a rolling basis obliterates all random daily and even weekly noise and distills out the true essence of a price trend. With the dollar's 200dma pointing steadily down again like a big bearish arrow for a year now, there should be no arguing regarding whether or not the USDX is in a bear market.

And bear markets ebb and flow, just the opposite of bull markets. Prices fall down two steps in downlegs and then climb back up one in bear rallies, and this cycle repeats. Just as a trending bull periodically returns to its underlying 200dma in corrections, a trending bear periodically returns to its overhead 200dma in bear rallies. Just as the 200dma is primary secular support in a bull, it is primary secular resistance in a bear.

This is sure the case today with the dollar being repelled at its 200dma during both of its last two approaches. Technically there isn't even a chance that a bear market is over until a price can climb back up over its key 200dma and stay there . The dollar valiantly tried such a bold gambit in 2005 as this next chart shows, but it clearly failed. Even the sentiment-driven massive bear rally that lasted for nearly a year was not enough to overcome its bearish fundamentals.

In order to keep our perspective as we zoom out to a more strategic scale, realize that the relatively tiny area of the previous chart is shaded below in the lower right. This dollar bear market is certainly nothing new as it started way back in the summer of 2001. Since then, the US dollar has lost fully one third of its value in the international marketplace. Foreign investors in US assets have really absorbed huge dollar losses.

The dollar's secular bear got off to a slow start initially in mid-2001, but by mid-2002 it had started falling with a vengeance and plunged. It soon stabilized into its original secular downtrend rendered above and carved a series of five major new bear-to-date lows over the next several years that are marked above. Note that during this original secular downtrend the dollar's bear rallies were consistently repelled near its 200dma.

By late 2004 the dollar carnage was incredible. The world's flagship currency had plunged from 120% of its 1973 value to 80% in just under three years. Dollar sentiment was naturally horrendous at the time and calls for new lows abounded. Great fear existed then, a classic bottoming characteristic that is conspicuous by its absence today. As the dollar tests these same lows again, now apathy reigns. Without any fear yet, odds are we haven't even seen a short-term sentiment bottom.

Due to the great fear in late 2004 and the ubiquitous calls for the dollar to continue plunging, I thought a major bear rally in the currency was due at the time. I explained why in an essay the month the dollar bottomed. The red rDollar had hit the bottom of its relative trading range and such ugly sentiment couldn't be sustainable for long. I was right on the major bear rally being due but its duration and magnitude far exceeded my initial expectations.

Rather than just a major bear rally like we'd seen many times before in this bear, the dollar started a truly massive bear rally. It was epic! The dollar surged back above its 200dma in mid-2005 and lingered there long enough to start dragging its 200dma higher again. Technically at least, with its 200dma climbing, by late 2005 strong arguments could be advanced making the case that the dollar's secular bear was over.

While I studied the bear-market rhythms of the dollar in great depth during its original secular downtrend years, my trading interest was never in shorting the dollar. I was using the dollar as a contrary indicator to know when to buy gold and gold stocks. In the early years of today's secular gold bull, gold was simply trading as an alternative currency and hence could only rise when the dollar fell. These two competing currencies moved in opposing lockstep .

But during the dollar's massive bear rally in 2005, a wonderful thing happened. Instead of falling on the dollar strength as it had done in previous years, gold simply remained flat while the dollar rallied. It was an awesome show of defiance. Investment demand for gold was finally materializing that was independent of the dollar's fortunes. The gold bull's Stage Two was dawning, when the metal's investment role superseded its currency role in importance.

With gold holding strong in 2005 despite dollar strength, gold bulls started to forget about the dollar. As gold's bull had grown powerful enough to overcome its old dollar nemesis, contrarians shifted their focus away from the dollar. Gold truly established its independence when the biggest upleg of its bull launched well before the dollar's late 2005 top. And gold continued higher while the USDX held above 90 in early 2006 until the dollar's April plunge that year helped catapult the metal to a major new bull-to-date high.

Although there was a fantastic fundamental reason for the gold price to rise, its global demand growth exceeded its global supply growth, this was not the case for the dollar. While gold is finite and very hard to mine so its supply only historically grows about 1% a year or less, the US dollar has a potentially infinite supply. The Fed creates more and more of these faith-based fictions out of thin air everyday. So it was hard to imagine the dollar's bear being over with dollar supply exploding up in excess of 7% annually.

By late 2005, the dollar had rallied enough to obliterate the hyper-bearish sentiment of late 2004. But without fundamental support, an actual supply-demand deficit, the dollar had no choice but to roll back over into bear mode once its oversold sentiment buying of 2005 was exhausted. And so it did slump which brings us to today. The dollar is now right on the verge of making a fresh new bear-to-date low.

Such a new low would be the sixth of its bear so far, and I suspect it would really rattle the confidence of foreign investors with capital deployed in the States. Since all paper currencies are ultimately confidence games, any waning of faith in Washington 's ability to manage the dollar could have huge implications.

Imagine if foreign central banks, for example, grow weary of six years of huge dollar losses so they start to diversify out of their dollar-heavy holdings. They would have to first sell their US assets, primarily US Treasuries and other high-grade bonds, to get dollars. This first act alone would drive down bond prices and drive up interest rates. It doesn't take much imagination to spin all kinds of ugly scenarios if long rates rise in these precarious times for mortgages and other US debt markets.

After the foreign central banks sold their US bonds, they would sell their US dollars and buy other currencies like the euro. This would drive the dollar even lower, exacerbating its new lows. The worst-case scenario is a vicious circle forms. Enough foreign investors sell US assets then dollars to drive prices low enough to scare even more, who then sell and scare still more into selling, etc. A plunging dollar in such a scenario would wreak untold havoc on US stocks, US bonds, US interest rates, and import prices.

Everything I've discussed up to this point is certainly sobering for us American investors. If anything resembling a dollar panic starts when new bear-to-date lows are carved, all of our assets have the potential to get hurt. Unfortunately though, we aren't even to the scariest part yet. If we zoom out one more time, to the full history of the USDX, a terrifying truth emerges.

As from the first to second chart, the area of the second secular-dollar-bear chart above is shaded in the lower right corner of this final grand strategic chart. This ultra-longview clearly shows that we are not just on the verge of new bear-to-date dollar lows, but all-time dollar lows! What will happen to foreign confidence in owning dollars and US investments if the dollar starts plunging into uncharted territory below 80?

In my opinion even the concept of an all-time low is hard to wrap our minds around. Thanks to dollar inflation most investment assets appreciate in nominal value over time, so for example there is never a danger that a stock index will hit an all-time low. So who knows how traders will react to such an exceedingly rare event? When the dollar grinds under 80 and the fact that the dollar is at all-time lows becomes widely known, it will probably inflict tremendous damage to sentiment.

The last time the US Dollar Index approached this all-important 80 line-in-the-sand was in late 2004 at the previous bear-to-date lows. And as you can see above, there were only four other times before that, spread across decades, when the dollar even challenged 80 briefly. If the USDX falls under 80 soon with conviction, technically-oriented dollar traders may panic and we could see serious acceleration lower.

Now dollar bulls, Wall Street types, obviously do not like the ugly implications of such a downward spiral of selling that new all-time lows will probably spawn. So when they see a chart like this, they tend to see the glass as half full rather than half empty. “Well, 80 has held rock solid as support for three decades now so I don't see any reason why it won't hold today. Technically 80 is unassailable.”

From a pure technical perspective, I can't argue with these bullish arguments. 80 has indeed held since the late 1970s and it may very well hold again today. But the problem with pure technical arguments is that they risk getting dashed against the rocks by the fundamentals which ultimately drive secular-trending markets. It is not lines on a chart that drive the dollar or any asset higher or lower, but their underlying economics.

If worldwide dollar supply growth continues to exceed worldwide dollar demand growth, then the dollar price on the international markets simply has to fall regardless of where it is technically today. Unfortunately for us American investors, this is the case on both the dollar supply side and demand side. Pretty much all arguments and scenarios point towards soaring dollar supplies and waning dollar demand.

On the supply side, the US Fed continues to create dollars out of thin air like there is no tomorrow. This inflation is relentless and has tended to run 7%+ annually over the long term. This means that all other things being equal, global dollar demand has to grow by 7% a year just to keep the dollar's international value stable . Since the only thing any central bank can ever accomplish is growing money supplies, there is literally zero hope of global dollar supply declining.

With dollar supplies growing perpetually until everyone eventually just gives up on it and the currency utterly collapses like every other pure fiat currency in history, the dollar price will be determined by demand. Unfortunately global dollar demand is waning. Foreign investors can invest in better-returning stock markets than the US and they can buy bonds in countries with higher interest rates than the US . And these superior returns are available in major nations, so why mess with dollars and US investments?

And central banks in particular, the world's biggest dollar investors, are far too heavily concentrated in dollar holdings. Even if they thought the dollar was in a secular bull, which they sure won't after it breaks 80, it would still be prudent to sell vast quantities of dollars to reduce their dollar holdings to more reasonable levels. Even Alan Greenspan recently publicly said that it isn't prudent to have too much exposure in any one currency, including the dollar. Diversification out of overweight dollar holdings will hurt overall demand.

And finally, and perhaps most troublingly, all over the world investors are extremely angry with Washington 's aggressive foreign policies. Regardless of what we Americans think, Washington 's actions in recent years are largely seen as meddling imperialism by most of the rest of the world. Just as Americans aren't likely to invest in Iran (and we can't legally), foreign investors are less likely to buy Washington 's paper dollars if their blood is boiling thanks to Washington 's actions. This too will hurt demand.

In light of all these fundamental truths today, as far as I am concerned the USDX breaking below 80 to new all-time lows is all but a fait accompli. It is inevitable. Investors not ready for it could really be hurt, especially if dollar and US-asset selling intensifies under 80. One of the best defenses in such a scenario lies in hard assets, especially gold and gold stocks. The gold price will shine during any currency crisis and rise more than enough to offset dollar losses and create real gains.

At Zeal we have been aggressively investing and speculating in gold and elite gold stocks since their respective bull markets began in the early 2000s. While gold will rise for its own fundamental reasons independent of the dollar, any dollar panic will spark huge additional interest and new gold buying worldwide. As such, our existing and future gold-stock trades should benefit tremendously in a sub-80 USDX world.

If you are interested in adding elite gold and other commodities stocks to your portfolio during opportune times of temporary technical weakness, please subscribe to our acclaimed monthly newsletter . In it we are constantly analyzing the thriving commodities bulls and other factors likely to affect them including the dollar breakdown. We've already earned amazing realized profits but the best is likely still yet to come.

The bottom line is the US dollar bear is alive and well, despite its vacation in 2005. While Wall Street has tried to ignore the renewed grinding lower of this currency, once it falls below 80 and hits new bear-to-date and indeed all-time lows it will become front-page news worldwide. Such an event can only lead to more selling as global investors start to grow scared of even more dollar weakness.

To thrive in such a hostile environment, investors and speculators should focus on hard assets like commodities. Commodities prices are determined by global supply and demand and are therefore immune to weakness in any particular currency, even the once-mighty US dollar. Commodities prices will simply adjust higher if the dollar continues falling, more than making up for dollar losses.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2007 Zeal Research ( www.ZealLLC.com )


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