The Relative Dollar
and Gold
Adam Hamilton
Archives
January 9, 2004
The relentlessly
plunging US dollar is the primary topic of some of the most widely
played financial-news stories these days. This once mighty American
currency is rapidly falling from international grace, and even
conventional media outlets are focusing more and more on the
enormous implications of the down-spiraling dollar.
It's not only
the financial markets that are nervously pondering this troubling
development, I suspect that all of the major governments on Earth
are burning the midnight oil trying to decide how to address
this issue. The farther the dollar falls, the more difficult
it is for other countries' exporting industries to sell their
products into the largest consumer market in the world, the United
States.
European officials
seem to be pretty calm about the dollar rout so far, but European
exporters are growing increasingly vocal as the young euro soars
to all-time-record highs. Europe is a major exporter to the US
and for the last four months or so the plunging dollar has ratcheted
up the pressure on European exporters. Every fresh new dollar
low relative to the euro makes European goods more expensive
for Americans.
In the past
couple weeks I have seen more and more European financial analysts
suggest that the probability of public official European intervention
in the currency markets approaches very high levels if the euro
continues rocketing up to US$1.35, only about 6% higher than
today's stellar levels. Aggressive European foreign-exchange
manipulation would certainly be a big shock to the currency markets,
as it is pretty rare.
The frightened
Japanese, on the other hand, can't seem to last one single trading
day without actively attempting to manipulate the foreign-exchange
markets. As the euro has continued to slam into new highs, massive
yen sales and dollar purchases by the Bank of Japan have so far
held the dollar above Y106 or so. Last year the Japanese government
spent a record Y20t (trillion!) trying to retard the yen's export-crushing
rise relative to the US dollar!
Japanese exporters
are growing increasingly nervous now as this Y106 level is challenged.
The Japan Business Federation, Japan's largest business lobby,
is loudly asserting that the Y105 line is absolutely vital to
Japanese corporations and must be held at all costs. So, the
relatively continuous unannounced Bank of Japan manipulation
in the currency markets is almost certain to continue and indeed
accelerate.
With the dollar's
plunge now headline financial and even general news across the
globe, one of the most popular bets around these days is to short
the US dollar. As contrarians, however, this rising crescendo
of dollar-short noise and coverage ought to trigger loud warning
klaxons in our skulls.
Markets are
not linear, they do not move in a straight line forever. They
perpetually rise and fall with the ebbing and flowing tides of
circumstance and herd psychology. As soon as one trade becomes
too popular and lopsided, when either greed or fear waxes too
extreme, a mean reversion back in the opposite direction is inevitable.
These timeless market truths apply not only to stock markets,
but to currency markets as well.
While there
is no doubt that the US dollar is in a long-term bear market
for all kinds of structural and fiat-currency-fragility reasons,
short-term countertrend rallies do indeed happen from time to
time. Just as there were mighty bear-market rallies in the US
stock markets after the tech bubble burst, most quite sharp and
extraordinary, similar bear-market rallies have happened and
will continue to happen in the US dollar.
As the US dollar
appears to be so short-term oversold today, this sharp countertrend
bear-market rally in the American currency could launch at any
time. Global public sentiment against the dollar is unbelievably
negative at the moment as the widespread media coverage attests,
and the financial markets abhor extreme situations where everyone
piles on one side of a trade. The contrarian play these days,
the bet that very few are willing to make, is that a dollar bear-market
rally is approaching.
The implications
of such a short-term dollar mean reversion are very obvious for
currency traders. Dollar shorts can cover and realize their profits
and they can go long the dollar or short other competing currencies
that are near long-time or record highs, like the euro. The professional
forex folks are well aware of this and I suspect that a short-covering
frenzy will be the initial buying spark that ignites the coming
countertrend dollar bear-market rally.
There is an
entirely separate class of "currency" traders as well
though, and many of these may not recognize the considerable
dangers that a dollar bear rally poses to their short-term positions.
Through six millennia of human history the ultimate currency
has been gold, a rare and precious metal of indisputable intrinsic
value in all times and all places. Just as the euro and dollar
have an inverse relationship, so do the dollar and gold.
As the dollar's
exchange value falls, it takes more dollars to buy gold so the
dollar gold price rises. Conversely, when the dollar's exchange
value rises, due to a bear-market rally or any reason, it takes
fewer dollars to buy gold so the dollar gold price falls. A short-term
countertrend dollar rally portends a short-term bearish omen
for the price of gold denominated in US dollars!
This strategic
inverse relationship between gold and the US dollar is quite
obvious on a longer-term chart. Our first graph this week shows
the most popular measure of the US dollar, the US Dollar Index,
with the gold price in US dollars superimposed on top. The key
long-term 200-day moving averages of the dollar and gold are
also rendered below, as they offer many insights into the timing
of an oversold dollar bear-market rally.
There is no
better mathematical way to quantify long-term strategic trends
in progress than through 200-day moving averages, and the black
and white 200dmas above beautifully illustrate the strategic
antipathy between the US dollar and gold. In general, if the
dollar is up gold is down and vice versa, and the near mirror-image
cross of their respective 200dmas really drives home this core
point.
Please note
that this dollar/gold relationship is strategic, but not necessarily
tactical. If you look at long periods of time, dollar weakness
will almost always translate into gold strength and vice versa.
But the shorter the time frame that you consider, the less this
relationship will necessarily be true.
For example,
if both the dollar and gold are down on one particular trading
day, it is no big deal. Markets do all kinds of anomalous things
over the short-term while they tend to behave quite rationally
over the long-term. I bring this up because fretting and woe
is a gold-forum staple these days whenever the dollar is down
and gold does not soar. I also tend to receive more concerned
e-mails from my consulting clients on curious trading days when
the dollar and gold move in the same direction.
Single-day
moves, merely considered in isolation, are all but totally meaningless
though. Now if the dollar fell for six months and gold fell for
six months right along with it, that would be a different story
entirely and cause for much concern. But over an ultra-short-term
span of time these strategic relationships don't always hold.
While what gold and the dollar will do in the next 60 seconds
is essentially random and not tradable, what gold and the dollar
will do in the next 60 months is anything but random and eminently
tradable!
One of the
core axioms of all speculation is that the shorter the period
of time that one considers, the less rational that the markets
should be expected to be. So ultra-short-term dollar/gold decouplings
are actually fairly common and absolutely nothing to worry about.
Personally, I wouldn't even start pondering a dollar/gold decoupling
until it lasted at least a month!
When considered
over years, however, as in the chart above, the dollar/gold inverse
relationship is as rock-solid as anything in the markets can
be. After all, gold and the dollar are competing global currencies
just like the dollar and euro, so it makes great sense that weakness
in one will translate into strength in the other. Even more revealing
is carefully studying both the dollar and gold relative to their
key long-term 200dmas.
While the primary
secular dollar trend is down while gold's is up, the role of
the respective 200dmas in each case is incredibly consistent.
Over the long-term, regardless of bull or bear-market conditions,
any given market periodically retreats to its 200dma on short-term
countertrend moves. Thus, if you know that a certain long-term
trend is in place, and you witness a countertrend move back to
its 200dma, then you can once again bet with the long-term primary
trend with high confidence.
Starting with
gold, since it is easiest to think in bull-market terms, there
have been several times in the past few years where gold has
touched its white 200dma line above. Not surprisingly, all of
these gold 200dma encounters proved to be absolutely outstanding
buying opportunities, for both gunslinging speculators and long-term
investors alike. If you see gold approach its 200dma while the
long-term fundamentals supporting its Great Bull remain steadfastly
entrenched, then you can buy gold and gold stocks with reckless
abandon.
The dollar
bear, on the other hand, exhibits the same behavior even though
it is inverted. The closer that the dollar retreats to its overhead
200dma during its countertrend rallies, the higher the probability
that a fantastic moment to add new dollar short positions has
arrived. While there has only been one major 200dma kiss in this
dollar bear so far, early September 2003, it proved to be a phenomenal
time to short the dollar and ride this recent brutal dollar downleg
that is utterly dominating financial news today.
So, in bull
or bear alike, if you witness a price retreat away from its primary
trend in a countertrend rally or correction and once again approach
its 200dma, then you should not hesitate to bet with the primary
trend once again, as long as you believe that the fundamentals
supporting this primary trend remain firmly in place.
While 200dma
convergences are excellent opportunities to deploy capital with
the primary trend, the obvious and important corollary is that
200dma divergences are excellent opportunities to bet against
the primary trend.
In both the
dollar and gold lines shown above, each time that either currency
pulled too far away from its 200dma, a short-term countertrend
move back towards its 200dma was inevitable. To put it bluntly,
your probability of short-term speculation success is very low
if you go long gold when it is way above its 200dma or if you
throw short the dollar when it is way below its 200dma!
These 200dma
divergences are the very moments when popular market sentiment
waxes too extreme in one direction, virtually assuring that a
short-term mean reversion is inevitable. And if the financial
media constantly trumpets only one side of a trade and extrapolates
a current short-term trend into eternity, like today's plunging
dollar, it is a telltale warning sign for contrarians that we
should really tread cautiously and prepare for a mean reversion
back to the 200dma.
While this
200dma convergence/divergence thesis is very easy to understand,
it is difficult to quantify precisely. For example, if you just
look at the chart above, how do you know when either the dollar
or gold are farthest from or closest to their respective 200dmas
in percentage terms? How do you compare a 200dma convergence
or divergence today with one that happened three years ago, at
very different price levels?
We had to address
these very visual-skew and time-comparability problems last year
while analyzing market volatility via the flagship VIX implied-volatility
index. The concept of the Relative VIX was born, dividing the
VIX by its 200dma to make it perfectly comparable in magnitude
over time. I have since applied this Relativity construct to
the HUI gold-stock index and silver as well, with promising results.
By creating
a Relative Dollar and Relative Gold, merely dividing the daily
gold price and dollar price by their respective 200dmas, we can
greatly increase our insight into the critical interrelationship
between these two competing currencies. The graph below, introducing
both the Relative Dollar and Relative Gold, suggests key levels
at which short-term 200dma divergences grow so great that speculators
should start expecting a short-term countertrend mean reversion
back to the 200dmas.
Since Relativity
is calculated by dividing a price by its 200dma, it is most useful
to think of these resulting numbers in percentage terms. A Relative
Gold reading of 1.15, for instance, indicates that the gold price
is 15% above its 200dma at any given moment in time. A Relative
Dollar level of 0.90, likewise, tells us that the dollar is trading
at 90% of its own 200dma. A 1.00 Relativity reading, of course,
indicates that either price is trading right at its respective
200dma.
The true nature
of the inverse strategic relationship between the dollar and
gold is even more apparent in relative terms. In the past couple
years especially the negative correlation between these two competing
currencies has been really strong and rock solid. As the vertical
yellow lines above indicate, interim dollar lows in Relativity
terms tended to coincide rather well with interim gold highs.
Today the Relative
Dollar is approaching 0.90, an incredibly strong support line
as the chart above reveals. This level where the current US Dollar
Index price trades at 90% of its key 200dma has been challenged
three times in the dollar bear market to date, but this support
has not yet fallen. Back in mid-2002 the Relative Dollar briefly
hit 0.905, and in mid-2003 a Relative Dollar depth of 0.903 was
plumbed, but so far this heavy 0.90 line has not been pierced.
Today the Relative
Dollar has closed as low as 0.908, right above the major short-term
countertrend reversal level that has been so consistent in its
bear thus far. While anything can always happen in the markets,
speculation is primarily an exercise in probabilities, an odds
game. If the Relative Dollar 0.90ish levels held in earlier dollar
downlegs, shouldn't speculators at least give this support the
benefit of the doubt today?
I would not
want to be short the US dollar over the near-term right now,
even being well aware of all of its terrible fiat failings and
long-term structural problems, since it is currently trading
near technical levels that have heralded a bear-market rally
in recent years. In Relative Dollar terms, the high-probability
bet now is to go long the dollar on this 200dma divergence. Once
its oversold bear-market rally ends and the dollar converges
with its 200dma, then it will be another great opportunity to
short, as it was in September 2003.
The ominous
implications of this potentially imminent dollar countertrend
rally are great indeed for short-term gold speculators. If you
look at each Relative Dollar interim low above, and follow the
straight yellow lines up, you will note that Relative Gold interim
highs tended to happen near Relative Dollar interim lows. Indeed
today we have a high Relative Gold reading of 1.153, the second
highest interim extreme achieved in gold's bull market to date.
But in the
past couple years, right after these interim Relative Dollar
lows and Relative Gold highs were reached, in the months following
the gold price made a sharp pullback. Gold entered countertrend
corrections, bleeding off overbought short-term speculative excesses
by heading back down to converge with its own 200dma. If you
bought short-term speculative positions in gold near any of these
Relative Dollar lows and Relative Gold highs, you would have
lost money over the short-term.
Now today gold
speculators face these same short-term bearish omens once again.
Gold has soared in recent months while the dollar has plummeted.
Gold is approaching high levels relative to its 200dma while
the US dollar is approaching low levels relative to its own 200dma.
In recent years these very Relative Dollar interim low levels
have heralded the negative short-term-sentiment extreme that
sparked a strong countertrend bear-market rally in the dollar.
But when the
dollar rallied off its interim lows to converge with its 200dma,
gold was naturally hit hard and mean-reverted back down towards
its own key 200dma. As the chart above reveals, both gold and
the dollar are stretched almost as far away from their respective
200dmas as they have been in their entire major long-term trends
to date, and a temporary mean reversion and short-term countertrend
move is inevitable sooner or later for both of these elite currencies.
For my fellow
gold and gold-stock speculators, I would be really cautious here
and not add new positions. You also probably ought to ratchet
up the trailing stop losses on your existing positions. The next
great buying opportunity to ride another glorious gold upleg
will probably not occur until gold converges with its 200dma,
until Relative Gold once again approaches 1.00 parity. If the
past is any indication, this countertrend move could take a few
months to fully play out.
We are aggressively
gearing up and preparing for the next major gold upleg at Zeal.
In the January issue of our acclaimed Zeal Intelligence newsletter
just published for our subscribers, there are a couple points
of interest for gold and gold-stock speculators.
First, we started
officially tracking the Relative Gold series shown in the graph
above in our Zeal Contrarian Speculation Matrix. Based on this
chart, I am interested in an initial general long-to-short range
of less than 1.020 to greater than 1.110 or so. In other words
I would be enthusiastically buying gold stocks when gold is within
2% of its 200dma but I will be short-term cautious as I am today
whenever gold trades more than 11% above its 200dma. We may as
well seek to launch high-probability trades only, as there is
no reward or glory for becoming martyrs in the financial markets!
Second, the
January ZI details fundamental analysis of a half-dozen of the
most promising elite blue-chip gold and silver stocks. We ran
a technical screen of every gold and silver stock of the elite
HUI and XAU indices in the December issue, and then analyzed
the six most promising technical winners in fundamental terms
in this month's January issue of ZI. I am really thankful and
thrilled that this new issue has already become one of our most
popular issues of ZI to date.
If you are
interested in gold-stock speculation, please honor us with your
subscription
today! We are working hard preparing for the next major gold
upleg, both in identifying the legendary buying opportunity when
it arrives and in picking the right horses to run the next race
up. What an exciting time to be a gold-stock speculator!
For now though,
the oversold dollar levels and overbought gold levels in Relativity
terms are troubling. The US Dollar Index really looks like a
major countertrend rally is imminent and due. And if a bear-market
rally in the dollar launches, for any reason, odds are that gold
is going to get hit over the short-term. Get ready!
The contrarian
bet today is not to run with the popular short-term media prognostications
of dollar doom, but to anticipate a near-term countertrend 200dma
convergence for the mighty US dollar.
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
January 9, 2004
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