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.
Adam Hamilton, CPA
Zealllc.com
Mai
11, 2007
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