 The Relative Dollar and Gold 3
Adam Hamilton
Archives
December 10, 2004
The global currency markets boiled this week with all the fury
of a raging storm-driven sea, leading to some of the biggest
daily swings in months.
On Wednesday alone, the galloping
euro fell 0.7%, the perpetually manipulated yen bled 1.1%, the
much-maligned US Dollar Index surged 0.8% higher, and the ultimate
currency gold plunged 3.3%. It was definitely one of the most
interesting currency days in recent memory, since the currency
markets typically meander slow enough to make a glacier look
swift.
While unique and unprecedented
factors were probably responsible for the gold slide in particular,
which I discussed in a Zeal
Speculator Update published Wednesday evening, all the exciting
action this week got me thinking about probabilities again. Probabilities
are truly the bread and butter of speculating.
We live in a world where nothing
is certain and anything can happen. Physicists, especially
the quantum variety, express this mathematically by saying there
is nothing with a probability of 1, certain to happen, or 0,
impossible to happen. While a particular probability may be very
large or fleetingly small, it can never hit certainty or impossibility.
In life we tend to ignore this
universal truth although we all intuitively understand it. Next
time you hop in your car to head to work or get groceries, there
is a tiny chance you are going to burn to death imprisoned in
the twisted-metal wreckage of your ride courtesy of a blistering
gasoline-fed inferno. Yet, since the risk of dying in an automobile
accident is so very small relative to the number of car trips
made a day, we all consider this risk acceptable and are willing
to bear it.
And if probabilities with no
certainty permeate our regular lives, then the financial markets
are possibly the purest study in probabilities imaginable. Every
single decision to buy or sell in the global markets, whether
consciously or not, is not made without the buyer or seller first
gaming the probabilities. A market participant must weigh risks
and potential rewards, and somehow handicap when the odds are
in his favor and when they are not.
Investors and speculators get
themselves into the most trouble when they become so enamored
with a particular trade that they momentarily forget that nothing
has a probability of 1. Contrarians express this in terms of
bullish or bearish sentiment, when the majority of traders crowd
onto one side of a trade. These very moments when folks feel
like a trade is a sure thing are among the most dangerous in
the markets. Nothing is certain and the risk of losses, even
total losses, always exists.
When a given trade is hot and
everyone is talking about it, our natural tendency is to mentally
extrapolate it out into infinity. We fall into the deadly trap
of linear thinking, assuming the future will conform to only
the most recent past. This behavior becomes most pronounced
during popular manias, such as the NASDAQ
madness of early 2000. While common in the markets since
greed and fear blind so many, similar assumptions seem absurd
in normal life.
For example, if you saw a child
blowing up a balloon that was getting larger and larger, what
would you assume? Obviously, the more stretched the balloon grows,
the more air it contains, the higher the probability it
will suddenly burst. Yet, using typically flawed market logic,
the average trader sees a linear trend, like a balloon being
inflated, and assumes it will run out into infinity. The trader
wrongly assumes that the bigger the balloon grows, the lower
the probability it will suddenly burst!
The longer the market has moved
in one direction, the more traders think betting with it is a
sure thing. It is like betting the larger a balloon swells the
larger it is likely to get. Instead, in reality, the longer a
particular trend has been in force the higher the probability
grows that it will reverse. Nothing moves in the same direction
forever and periodic reversals are evident at every scale, from
intraday to decades, even in strong primary trends.
At an intermediate time-scale,
considering several months, the currency markets seem to be stretched
like our proverbial balloon. Dollar
shorts are multiplying like rabbits as pretty much everyone
expects the dollar to continue lower in the weeks ahead. Before
Wednesday's startling events, gold sentiment was waxing pretty
bullish as well, although the gold
stocks have been stubbornly reluctant to follow.
Thus, I would like to discuss
the current dollar and gold scene in terms of probabilities this
week. Not you nor I nor anyone knows the future in advance, but
we mere mortals can certainly analyze probabilities and attempt
to trade only when our odds of winning seem the highest.
In speculating, probabilities
are best defined by using a time scale at least an order of magnitude
greater than the period of time over which you are interested
in trading. In this case, we are interested in the probable behavior
of gold and the dollar over the next several months so we should
consider a time scale of 10x that, at least 30 months. By considering
the perpetual ebbing and flowing of the markets on a 10x greater
time scale than the one over which we seek to trade, we can gain
a better understanding of when our odds for success are particularly
high.
Our first chart compares the
US Dollar Index and gold over the past three years or so, relative
to each other and to their own respective 200-day moving averages.
The negative correlation between these two competing currencies
is an astounding -0.95, among the highest I have seen in the
markets over several years. This inverse relationship is to be
expected though, especially in Stage
One of a secular gold bull.
Besides the striking symmetry
between the dollar and its arch-nemesis gold, the distinctive
X in this chart presents an ideal study in probabilities. By
considering the behavior of the dollar and gold over several
years, we can gain an excellent idea of when probabilities swing
wildly in our favor for being long or short one or the other
for the next few months. Since we can't see the future, the best
we can hope for is to trade only when the odds seem to
be massively in our favor.
The probability analysis begins
with identifying the primary trends. While both the dollar and
gold oscillate all over the place from week to week, over the
last several years the dollar's secular trend has been bearish
while gold's secular trend has been bullish. The dollar's top
resistance line is drawn above in red while gold's lower support
line is rendered in blue.
Now realize these linear technical
lines are virtually never mathematically precise. Technicians
today generally draw in support and resistance lines framing
prices by hand just as they did a century ago. Drawing straight
lines is certainly easier with a computer, but technical lines
are just as subjective as ever. If you had drawn the lines above
instead of me, you may have chosen a different slope for the
red dollar resistance and blue gold support lines.
Thankfully though, there are
also technical lines that are absolute, without the slightest
sliver of subjectivity. Both of the 200-day moving averages rendered
above, for example, are precisely defined mathematically. If
you, I, and 100 other people compute gold's 200dma, we are all
going to get the same number and the same chart line. Since the
simple 200dma is absolutely defined and utterly unambiguous,
it is a great base from which to launch into probability analysis.
In multi-year charts with trending
markets, 200dmas tend to run parallel with the primary trend.
This is obvious above with both the dollar and gold. The dollar's
absolute 200dma roughly follows its subjective resistance line,
and gold's 200dma runs impressively parallel with its subjective
support line for years. Thus the mathematically precise 200dmas
unmask primary trends and can be used as a reference point from
which to judge the soundness of hand-drawn technical lines.
Because of their very mathematical
nature, 200dmas lag behind trending markets. A 200dma is computed
by adding up today's close with the previous 199 closes and dividing
by 200, so it is past-biased and generally lags prices by many
months. Thus a secular bear market like the dollar tends to sell
off and continue lower after it nears its 200dma, while a secular
bull market like gold tends to rally higher after it approaches
its 200dma.
The ongoing interaction between
a trending market and its 200dma is quite telling, regardless
of if the trend is bullish or bearish. Prices tend to diverge
away from and then revert back to their own 200dmas over time.
If you look at enough charts and consider enough historical markets,
it gradually becomes evident that this perpetual flow and ebb
away from and back to 200dmas is universal. Indeed it pretty
much has to be this way due to the very mathematical nature
of the 200dma!
The distance between a price
and its 200dma allows us to define probabilities. In both the
dollar and gold above, when they are close to their respective
200dmas they are likely to pull away and when they are far from
their 200dmas they are likely to revert back. Gaming the 200dmas
creates an analytical framework from which we can define high-probability-for-success
opportunities for a particular trade.
If you want to short the dollar,
the best time is when it is near its black 200dma line shown
above. Bear to date the closer the dollar was to its 200dma,
even over it briefly, the higher the probability its next major
move would be a bearish downleg. Conversely if you want to be
long the dollar, your best bet is to wait until it is far below
its 200dma, like today. The most powerful bear-market rallies
bear to date always erupted when the 200dma divergence of the
dollar was greatest. As long as the secular dollar
bear remains in force, these odds should remain similar.
If you want to go long gold,
you have the best chance of winning if you do it when it is near
its white 200dma line rendered above. All of the biggest uplegs
in our gold bull to date launched when the metal was meandering
near its 200dma. Conversely the best time to short gold is when
it ventures far above its 200dma, like today. Just like the dollar,
as long as this secular gold
bull persists the odds for multi-month speculations are likely
to remain similar.
Since any trending price tends
to run away from and revert back to its 200dma periodically,
the distance between a price and its 200dma is a good proxy for
probabilities of reversal. Even with long-term trends short-term
reversals are likely when a price either nears its 200dma or
runs too far away from it. This idea is very simple, yet it proves
quite effective in practice.
The primary problem with using
it for active speculation lies with the problems in visually
estimating a particular 200dma divergence. As a chart scale grows
larger it skews percentage changes. In the chart above a $25
gain in gold from $250 looks the same as a $25 gain in gold from
$450, yet in percentage terms the former is almost twice as large
as the latter. All visual estimates are subjective anyway, lacking
precision.
In order to precisely measure
200dma divergences, I developed the tool of technical Relativity.
It takes a price and divides it by its 200dma. The result is
a number that expresses where a price is relative to its
200dma as a ratio. When a price is 25% above its 200dma,
it has a relative reading of 1.25. When it is 10% under, it has
a relative reading of 0.90. This ratio approach ensures that
percentage changes over time are considered in constant terms
and eliminates all visual skew and subjectivity.
Our final chart graphs these
relative dollar and relative gold indicators. Imagine if the
conventional X chart above was somehow flattened like opening
a scissors all the way up. Both the dollar's and gold's respective
200dmas are flattened on the x-axis along the 1.00 line below
while the price data is also flattened onto a horizontal constant-percentage
scale as a ratio. This tool allows us to define the probabilities
that can guide our tactical dollar and gold trades looking out
a few months.
When the dollar and gold prices
are flattened along a horizontal 200dma proxy and their prices
are expressed as ratios to their respective 200dmas, we can finally
clearly understand intermediate-term trading probabilities. Both
the rDollar and rGold form well-defined ranges which have held
solid for years now in their secular trending markets. These
ranges of interest are defined above by the red and blue transparent
zones collaring both series.
In the dollar's case, it has
tended to oscillate between 0.92 and 1.00 relative in its secular
bear to date. When it falls down under 0.92, like it did last
Friday for the first time since January 2004, a major bear-market
rally grows highly probable. In fact, almost a year ago I used
this very analysis
to warn our subscribers of a highly-probable imminent major dollar
bear-market rally and major gold correction. Probabilities are
simply not in favor of being short the dollar when it is already
stretched far below its key 200dma resistance like today.
Gold, on the other hand, has
tended to meander between 0.99 and 1.14 relative in its secular
bull to date. When it gets high above its 200dma, like last Friday's
1.121 reading 12.1% above, the probability increases that a major
correction is looming. Periodic corrections are absolutely necessary
in bull markets to bleed off speculative excesses and keep the
bull healthy. Like a balloon being blown up, the higher gold
stretches above its 200dma the higher the probability for a major
correction grows.
Thus, just as during the times
my first two rDollar and rGold essays were published, early
January 2004 and late
April 2004, today the probabilities are swinging in favor
of a major intermediate trend change, temporary multi-month reversals,
in both the dollar and gold. The farther the dollar and gold
stretch away from their respective 200dmas, the greater the odds
grow that the next several months will hold a major dollar bear-market
rally and a major gold correction.
As a hardcore gold investor
and speculator myself I fully realize this analysis is not what
folks want to hear, but nevertheless I must share it. Periodic
multi-month reversals within secular trends like the dollar's
and gold's are quite common and very healthy. Without the reversals
general sentiment would wax too extreme which would threaten
to prematurely end the dollar bear and gold bull. So far at least,
200dma divergences have been one of the best ways to identify
these reversals early.
The relativity-based interpretation
of the wild currency action of the past week or so is that these
extreme 200dma divergences today are just not sustainable. Rather
than worrying about the inevitable flowing and ebbing of the
markets away from and back to their 200dmas, we can harness this
behavior to help us multiply the capital in our portfolios.
For example, if you are a dollar
speculator, don't short the dollar today while everyone else
is and it is already so far under its 200dma. Odds are you are
going to get slaughtered in a bear-market rally so it doesn't
even make sense to accept this enormous risk. Instead throw long
or get out.
For gold investors and speculators,
the best time to go long gold and deploy capital is not when
gold is stretched far above its 200dma like today, but when it
retreats back down to kiss it. We had such a glorious opportunity
last spring and we will almost certainly have many more in the
future. Today's big 200dma divergence demands neutrality at least,
although aggressive speculators can short it.
Going long gold when it is
low relative to its 200dma is a high-probability-for-success
trade, not to mention the ideal time to buy long-term investments
when they are low. But going long gold when it is high relative
to its 200dma like today is a low-probability-for-success
trade, a gamble. Heeding the relativity signals thus far
has led to excellent realized profits in each upleg in this gold
bull to date, not to mention helping speculators profit on the
short side during the periodic corrections.
Now we began with probability
theory and should end with it. Anything can happen in
the markets at any time. While the odds are small, the
dollar could still plummet, even from here, on some catastrophic
news. And at some point gold is going to leap out of its
Stage One currency bull into a Stage
Two investment bull, radically changing its slope in the
process. Relativity works best in trending markets and works
worst when secular trends change, either reversing outright or
merely accelerating in the same direction.
Relativity too is ultimately
a linear assumption, along similar lines to those I warned about
above where traders think the current short-term trend can be
extrapolated into infinity. Interestingly though, the longer
the period of time the less risky linear assumptions get. A several-year
secular trend is much more likely to persist for several more
years in the future than a several-day trend is for several more
days.
The greater the length of market
time considered, the less that random noise affects prices and
the more meaningful their trends. Once a trend runs for years,
it is highly unlikely to cease until the underlying fundamentals
driving it also fully run their courses.
If you are interested in seeing
how we apply this relative currency analysis in terms of real-world
speculation, please
subscribe to our acclaimed Zeal
Intelligence monthly newsletter today! The current issue
discusses actual trading strategy based on relative analysis
and we will certainly point out in the future when the odds once
again swing wildly back in our favor for deploying new gold and
gold-stock speculations.
We are already hard at work
analyzing stocks for potential recommendation in the next major
gold upleg. In addition our subscribers gain Web access to relative
dollar, relative gold, and relative euro charts updated weekly
so you can easily monitor these important developments.
Like a balloon stretching,
the farther away a price pulls from its 200dma the higher the
probability grows that it will temporarily reverse to revert
back to its 200dma. While not exceedingly extreme yet, both the
dollar and gold are getting relatively far from their respective
200dmas so we must be very vigilant for the increasingly probable
reversals.
A major dollar bear-market
rally and major gold correction lasting for a few months are
nothing to worry about for those prepared for the risk, but for
those who aren't their capital can evaporate rapidly. Please
be careful here!
December 10, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
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