 US
Dollar Bear 4
Adam Hamilton
Archives
October 27, 2006
At any given moment in time there are broad strategic themes
exerting tremendous influence on the financial markets behind
the scenes. Students of the markets call these themes secular
trends. They are long-term supply-and-demand-driven forces that
cause a particular price to move in one direction on balance
for many years.
Although these secular trends can certainly seem to be failing
from time to time during their periodic countertrend reversals
to rebalance sentiment, they often run for over a decade.
Both the secular great
commodities bull and the secular general-stock
bear, even though they have been running countertrend lately,
are likely to last about seventeen
years each. Secular trends tend to run for an awfully long
time!
As such, investors can only ignore secular trends at their own
great peril. If you are a long-term investor and you are not
aware of both the secular trends dominating the markets as well
as their relative stages of maturity, you risk getting caught
up in a temporary countertrend move and taking large losses once
the primary secular trend resumes.
And these countertrend moves can be incredibly convincing if
you haven't steeled yourself with the requisite market knowledge
to prevent them from seducing you in. The current US stock markets
are a perfect example. Even though a vast array of evidence
suggests the Dow 30 is still in a secular bear market
with a decade or so to run yet, the index's recent record highs
have convinced many investors that the bull is back. When this
temporary countertrend move inevitably ends sooner or later,
they will be slaughtered like sheep.
Like avoiding most pitfalls in the financial markets, the only
way to radically lower the probability that you will succumb
to the temptations of temporary countertrend moves is to maintain
a strategic perspective. If you can always keep the long-term
market picture in focus no matter how alluring short-term moves
become, your lifetime investment gains should be at least an
order of magnitude higher than those of fickle investors blown
about by every market whim.
It is in this spirit that I would like to reexamine an important
secular trend that hasn't garnered much attention lately, the
secular US dollar bear. I used to discuss the dollar quite a
bit in past years, as during the early stage-one gold bull the
dollar's fortunes were the primary driver of gold. But now with
the stage-two
gold bull upon us where gold demand is investment-driven
and independent of the dollar, the dollar's usefulness
for commodity trading has waned. Nevertheless, the dollar
remains very important.
For Americans, our whole world is dominated by the dollar. As
the dollar's value fluctuates in the global currency markets,
our costs for importing and profits from exporting can change
dramatically. And for investors outside the US, the dollar remains
the world's reserve currency despite its well-known faults. Yes
it is just a promise to pay printed on fiat paper with no intrinsic
value, but it still dominates global commerce regardless.
While the once mighty US dollar fell relentlessly during 2002,
2003, and 2004, since then it has essentially traded sideways.
With the dollar consolidating horizontally in the currency markets
for the better part of two years now, a lot of traders seem to
have lost strategic perspective and are forgetting that the dollar
is deeply entrenched in a strong secular bear.
Before we delve into the last couple years of dollar action to
update this old thread
of analysis on the dollar bear, it is very important to fully
understand where we have been. This busy chart looks at the venerable
US Dollar Index since 2001 superimposed over the Relative
Dollar, or the US Dollar Index divided by its 200-day moving
average. The dollar action over the past couple years has all
been at low levels deep within its bear.
Almost all analysis of the
dollar that I have seen in the financial media in the last year
has focused on looking at the dollar relative to its late 2004
lows, marked by the 5 above. Indeed from this particular reference
point the dollar has been impressive. The US Dollar Index rose
14.6% from its December 2004 lows to its November 2005 highs.
And even though the dollar is back down near its latest support
line today, it still remains up 7.3% from those bear-to-date
lows.
But if you zoom out beyond the last couple years to fully consider
the big strategic picture, the dollar is still bleeding badly
deep within a powerful secular bear. From its peak
in mid-2001 to its trough in late 2004, the US Dollar Index
lost a staggering 33.3% of its value in the world currency markets!
A dollar spent internationally in late 2004 would only have purchased
two-thirds of what the same dollar spent in mid-2001 would have
commanded.
Since currencies usually move with all the sound and fury of
a glacier, this is a staggeringly large move, especially for
the world's reserve currency. In order to function as a reserve,
an asset should be stable and maintain its value. Foreign
investors and central banks who trusted Washington's endless
"strong dollar" propaganda have watched the currency
losses on their utterly massive investments in the US fall by
a third. If I was them I wouldn't be very happy!
Lest you think a peak-to-trough measurement is a little too aggressive,
the results are similar measuring from mid-2001 to today. This
week the once mighty US dollar was down 28.5% from its levels
of only six summers ago. There is just no escaping the fact that
despite the dollar's sideways trading range of the last couple
years it remains mired deep within a secular bear market.
Wall Street loves a strong dollar since it tends to boost the
US stock markets in a variety of ways. When the dollar is rising,
foreign investors are more likely to buy US stocks since their
currency gains will add to their overall gains from investing
in the US. A strong dollar also makes imports cheaper, and since
the US populace is so heavily dependent on imports a strong dollar
leads to more buying power for Americans which translates into
more profits for US corporations since Americans can afford to
buy more of their products.
Thus, it is not surprising that Wall Street always tries to paint
the US dollar price action in the most bullish possible light
since it brings more capital into the US markets to drive up
stock prices and simultaneously leads to higher profits which
also attract more capital. The mainstream financial media has
been acting accordingly since the late-2004 lows, proclaiming
that a new dollar bull has been born.
One of the key evidences in favor of this new-dollar-bull thesis
is technical. Back at the end of Q1 2005, the US Dollar Index
broke out of its secular downtrend that started in mid-2002.
Once the dollar broke out of this long-oppressive trend channel
near 84, it was off to the races. The dollar continued rallying
sharply and ultimately carved its biggest and longest rally of
this entire bear market. With the secular downtrend broken, Wall
Street reasoned, that must mean the secular bear was defeated
as well.
As students of the markets know though, technicals alone are
never a reason to declare that a secular trend has given
up its ghost. It is supply and demand, underlying fundamentals
that actually drive secular trends. While technicals reflect
these fundamentals for most of a secular trend, there are certainly
times when sentiment gets unbalanced one way or the other and
drives technical prices to temporarily diverge away from the
primary secular trend. Sentiment can never trump fundamentals
for long though.
Another key observation is that secular trends tend to have multiple
independent price-trend channels over their long lives. No matter
which secular trend in history you examine, they all have changes
in trend-pipe slope gradients midstream. This secular dollar
bear is no exception. Originally in 2001 and 2002 the dollar's
downtrend was modest, it was in a high consolidation. But then
the dollar collapsed in Q2 2002 and soon entered a much steeper
downtrend that ran for several years.
Just as the end of its original high-consolidation moderate downtrend
did not mark the end of the dollar bear in early 2002, it is
unlikely the end of its steep secular downtrend in early 2005
will prove any more decisive. While the dollar has largely traded
sideways since then and taken a temporary breather from falling
on balance, this certainly does not mean its bear is over. Secular
trends often see plateau periods where they regroup for a year
or more before their primary trend resumes.
A recent example of a secular price trend running opposite to
its primary trend for over a year before its primary trend
resumed occurred in crude
oil. Oil prices bottomed in late 1998 and then ran relentlessly
higher into late 2000. Then oil slumped throughout 2001 in a
countertrend cyclical bear that caused many to question the secular
oil bull's very existence. But once early 2002 rolled around
oil started marching up again and has done so on balance ever
since.
In oil, as in all secular-trending markets, a temporary countertrend
reversal and trend change will never last unless the underlying
fundamentals support it. Traders who sold oil near the end of
its 2001 countertrend move in the midst of its secular bull at
$20 a barrel missed the ensuing massively profitable run from
$20 to $75+. So a trend change considered alone, a purely technical
development that can be driven by short-term sentiment, is never
adequate reason to declare a secular trend over.
Nevertheless, the dollar's trend change in early 2005 from a
steep secular downtrend to a low consolidation with rising support
is quite interesting. Now that we understand the strategic big
picture in which the dollar's action of the past couple years
occurred, we can zoom in to it alone and analyze it within the
context of its ongoing secular bear. This next chart encompasses
the light-blue shaded area in the lower-right corner of the chart
above.
The dollar's steep secular
downtrend culminated in late 2004 with a blistering plunge that
led to the fifth major interim low of the entire dollar bear
up to that point. This slide was so sharp and extreme that sentiment
looked really unbalanced to the fear side and it was getting
obvious a couple weeks before
the lows that a major bear rally was due.
Just as periodic corrections are common and necessary within
secular bulls, so are periodic bear-market rallies within secular
bears. In both cases sentiment gets too unbalanced after a price
moves in one direction for too long so a temporary countertrend
reversal is needed to rebalance sentiment. In secular bears fear
becomes too extreme at major interim lows so sharp rallies periodically
erupt to moderate fear and build up some greed before the next
major downleg can commence.
The interesting thing about bear-market rallies is they tend
to be the sharpest and fastest rallies a market ever sees. Since
these rallies occur off of deep oversold lows on a big sentiment
imbalance of far too much fear, they can rocket higher at an
amazing pace. As of mid-2002 in
the NASDAQ, for example, 14 of its 15 biggest daily percentage
rallies between 1990 and 2002 happened after its March
2000 bubble top. Bear-market rallies are supposed to be
fast and convincing, just like what we saw in the dollar in early
2005.
And a couple interesting things happened when the dollar started
rallying in its fifth major bear-market rally of its bear. First,
while the dollar's absolute gains in this rally were larger by
far than its previous major bear rallies, this fifth rally took
an inordinately long time to reach maturity in late 2005. Although
major bear rallies 3 and 4 marked on the first chart averaged
progress of 0.14% and 0.13% per day respectively, due to its
long duration bear rally 5 was much less impressive. It only
averaged progress of 0.07% per trading day.
So even though this fifth major bear rally had the biggest absolute
gains of the dollar's bear, this rally took so long that its
progress per day averaged about half of the dollar's previous
two major bear rallies. This could be interpreted a couple ways.
The dollar bulls would probably say that the slower rally was
more in line with a new bull than a sharp bear rally. They have
a point as its signature is not quite right for a typical bear
rally.
But the bears can counter and assert the dollar's extended rally
was a technical fluke. After all, the dollar initially peaked
right at the middle of 2005 before starting to decline sharply.
The secondary mini-rally from mid-Q3 2005 to mid-Q4 2005 that
extended the duration of the entire fifth bear-market rally should
probably not be included in the initial bear-rally's measurement.
Considering the fifth major bear rally from December 2004 to
July 2005, in its initial sharp phase only, the dollar soared
12.2% in 128 trading days. Thus it averaged 0.10% per day, much
closer to bear-rally territory.
And indeed the dollar's incredible surge in Q2 2005 shown above
was practically vertical, a telltale sign of a bear rally that
is not usually witnessed early on in a major bull. Early on in
bulls the greedy sentiment necessary to drive vertical moves
just doesn't exist yet as most traders remain bearish. And it
is interesting where this entire bear rally eventually topped.
In Q4 2005 the dollar failed right at its previous major
interim high. This failure to make a decisive new interim high
above the previous interim high deep within the bowels of the
bear really calls into doubt the technical validity of the new-dollar-bull
thesis.
Not long after in Q2 of this year the dollar fell sharply again,
a bear-market-style plunge after the greedy sentiment that drove
the initial bear rally in early 2005 finally faded. Today the
dollar is once again scraping support and remains lower than
it was a couple years ago. Will this new support line hold?
If it doesn't, if the dollar falls below it, technically-oriented
traders will probably dump the dollar aggressively and its next
major bear-market downleg will probably ensue.
Over the last couple quarters the dollar has inched closer and
closer to breaking below its latest support line, which is relentlessly
rising. Today it is just above 85 and rising at a slope of about
1 dollar index point per quarter. So in the coming quarters if
the dollar doesn't rally from here it is going to break this
key technical line by default. Provocatively the dollar's 200dma
is already pointing sharply down once again which is the
best price clue of where a primary trend is headed.
But it is ultimately fundamentals that drive great secular trends,
not technicals. On the US dollar's fundamental front there is
really only one major positive but a broad array of major negatives.
I believe the fundamental negatives far outweigh the positives
suggesting that dollar supply will exceed dollar demand in the
coming years forcing its secular bear to resume. A dollar oversupply
relative to demand ensures falling prices.
The one big dollar-positive development is the rising US interest
rates. The higher rates go, the more attractive dollar-denominated
debt investments like US Treasuries become to investors around
the world. But since debt-laden Americans and Wall Street fear
high interest rates so much, the Fed can't keep raising them
indefinitely without triggering a massive economic slowdown eventually.
So higher rates are a self-limiting positive factor.
And even if the Fed could continue ratcheting short rates much
higher, I doubt the relative merit of higher-paying dollar debt
would outweigh the considerable negatives facing the dollar.
First, and most importantly, is the Fed's relentless debasement
of our currency. Each year it grows the total dollars in circulation
globally by 7% to 8%+ without fail. For every new paper dollar
conjured into existence, dollar supplies grow relative to demand
and lead to lower prices. The Fed's red-hot printing presses
alone are enough for the dollar bear to continue.
Exacerbating matters is the fact that while dollar supplies are
relentlessly rising thanks to the Fed's unacceptable money-supply
profligacy, demand is falling for a variety of reasons. Higher
supplies and lower demand inevitably lead to falling prices on
balance. Really the US dollar doesn't stand a chance of escaping
its bear in this environment.
The biggest source of dollar demand which could raise its price
is the foreign investors. But there are multiple problems on
this front. Foreign investors, from individuals to central banks,
are already up to their ears in dollar exposure. Rather than
increasing their dollar investments, they are shedding them.
Other currencies such as the euro and gold are gaining ground
as foreign investors reduce their tremendously over-weighted
dollar positions.
And these foreigners have plenty of great reasons to reduce their
dollar exposure besides portfolio diversification. Foreign buyers
of dollars are financing the great American consumption binge.
This was fine when they couldn't find uses for their capital
at home, but with the rapid industrialization of Asia why would
they choose to finance giant houses in suburbia for Americans
when they could instead invest in their own countries' growth?
Increasingly they are doing just this, choosing to invest at
home rather than buying US bonds.
Another problem reducing dollar demand is Washington's increasingly
aggressive imperialism. No one likes a busybody neighbor messing
around in other people's business, and the more countries and
people Washington irritates with its foreign adventures the fewer
investors are going to want to buy dollars.
Incredibly Washington is even biting the hand that feeds, that
keeps our economy afloat, by drawing hard ideological lines.
"If you are not for us, you are against us!"
Such rhetoric is not the way to convince global investors to
continue buying dollars. Increasingly not only are foreign investors
getting irritated with Washington's empire-building behavior,
but they are worried their US assets will be frozen and they
will take a 100% loss if Washington decides they are "not
for us". And even if they don't fear the rising expropriations
in the US, they know that their US investments finance the imperialism
they so hate. So why buy dollars?
Regardless of your opinion on Washington's policies of late,
you have to admit that its chosen course is not winning the hearts
and minds of major foreign investors around the world
who can bid the dollar higher. There are already many reasons
why global dollar demand is waning including portfolio diversification
and competing investments at home, so adding political reasons
to reduce dollar exposure will only deepen and prolong this bear.
Interestingly it is commodities that are the biggest beneficiaries
of secular dollar weakness. The lower the dollar goes in world
markets, the more the dollar-price of individual commodities
rises. This leads to much higher dollar profits for commodities
producers. As such, if you want to avoid suffering in the
dollar bear, the best places to park capital to preserve your
purchasing power and even earn awesome real gains is in commodities
and the elite commodities producers.
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The bottom line is even though the US dollar has traded sideways
on balance for the past couple years, odds are its secular bear
remains very much alive and well. Relentlessly growing dollar
supplies thanks to the Fed's printing presses coupled with a
variety of major reasons why international investment demand
for the dollar is waning point to continuing dollar weakness
in the coming years.
Although we Americans have few refuges from an ongoing dollar
bear since our world is so dollar-dominated, commodities tend
to thrive in such environments. The devaluing dollar raises the
local price of commodities leading to higher profits for producers.
These profits tend to rise far faster than the dollar declines
leading to great outperformance in the commodities sectors.
Adam Hamilton, CPA
October 27, 2006
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!
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