US Dollar Bear Notoriety
Adam Hamilton November 12, 2004 3068 Words
The very foundation of contrarian investing is the premise that the crowd is always wrong near major market turning points. Contrarian investors carefully watch the thundering mainstream herd, noting the dominant popular trading bias, and then consider taking the opposite side of these trades.
The legendary Warren Buffett, the premier contrarian of our time, summed this up beautifully with his famous words, ďBe brave when others are afraid, and afraid when others are brave.Ē I have been thinking about this timeless wisdom a lot lately as I ponder the US dollarís behavior since the elections.
Since early November, the popular notoriety of the ongoing dollar bear has exploded. The fact that the US dollar is in a secular bear market is certainly nothing new. I first wrote about the coming dollar bear in the summer of 2001 a month after the dollarís secular top, and have been analyzing this dollar bear periodically ever since.
Back in the early days of this dollar bear, this whole idea was an incredibly heretical thesis. Outside of the small band of hardcore contrarians and battle-hardened gold investors, few believed a dollar bear was even possible since the mighty dollar was the worldís reserve currency. Surely no foreigners would ever be so brazen as to actually sell the dollar, right? Wall Street and the mainstream scoffed at the mere suggestion that the dollar was rolling over into secular bear mode.
How times have changed three years later! Now you canít even open a financial newspaper or watch a financial news show without hearing about the dollar bear. My desk is literally covered with various dollar-bear articles from Bloomberg, Reuters, and major US newspapers, all published this week alone. Even the US Treasury was trotting out a parade of toadies in recent days to solemnly reassure the world that ďthe strong dollar policy of the United States remains unchangedĒ.
The dollar is definitely in a secular bear, but the popular notoriety surrounding this event is certainly in a bull market these days. As a belligerent contrarian, few things make me more nervous than suddenly finding myself in a position where the mainstream starts to agree with my trades. Buffett warned us to be brave (buy) when others are afraid (selling), and popular fear surrounding the dollar bear is surging.
In light of this latest market fashion of jumping on this dollar bear bandwagon, I would like to update my dollar analysis this week. Even with the dollar bearís immediate notoriety growing, examining the perpetual greed and fear cycles in the dollar is always complex. Long-term and short-term sentiment waves cascade into each other and overlap, sometimes leading to very different outlooks over various future time frames.
Weíve built two new dollar bear charts this week, the first strategic and the second tactical in focus. On both charts the usual US Dollar Index data is superimposed over the Relative Dollar, or the dollar divided by its 200-day moving average. This rDollar indicator has been remarkably accurate in calling major interim bottoms in this dollar bear so far and it offers many insights into the probability of another major bottom brewing today.
By considering the dollar in both strategic and tactical technical terms in light of its recent surge in popular notoriety, contrarians can gain a much better idea of its most probable future course lying ahead over the short, intermediate, and long terms.
As this secular trend indicates, the dollar bear is certainly nothing new. While mainstream investors start paying attention thanks to the exploding news coverage of this long-underway event, contrarians and gold investors have already been earning big profits for years by betting with this primary trend. Indeed this dollar bear is one of the key components undergirding the powerful Stage One gold bull.
Interestingly, as contrarian theory predicts, the notoriety of the dollar bear is heavily dependent on its price. The dollar bear weighs heavily on investorsí minds when the dollar has been weak for a month or two and it trades near its lower support line rendered above. But once the dollar rallies back up towards resistance and has a strong month or two, the notoriety of the dollar bear evaporates like a desert mirage.
It is a natural human tendency to extrapolate immediate market conditions out into infinity. When prices rise people feel good and greedily expect farther rises. But when prices are falling people feel bad and grow fearful of additional drops. It takes a lot of time and effort to overcome this psychological tyranny of the present to develop a resolutely contrarian focus. Considering markets within their long-term contexts is an important first step.
The secular dollar bear shown above has had five distinct downlegs, including our current specimen. Each major downleg lasted several months or so and dragged the US Dollar Index down to fresh new bear-to-date lows. With the dollar breaking 85 in recent weeks we already have a marginal new low on this current in-progress dollar downleg. Peak to trough, the US Dollar Index has slumped 31% bear to date.
Interestingly though, even in light of the growing media frenzy surrounding the dollarís latest slide, the currency doesnít look anywhere close to carving a major interim bottom yet, let alone ending its secular bear. There are a couple key technical reasons that a major interim bottom isnít likely here and many fundamental reasons why this secular dollar bear is probably not yet approaching its ultimate end.
As this chart reveals, major interim bottoms in the dollar, the kind that precede powerful multi-month bear-market rallies, generally happen only when the dollar is near its lower support line. The last two major downlegs, labeled 3 and 4 above, both failed to bounce higher until the dollar solidly slammed into its support. The downlegs before that, 1 and 2, didnít travel quite as low but they still were in the lower half of the downtrend channel approaching support when they finally gave up their ghosts.
In contrast the dollarís fifth major downleg today is nowhere near support. At best it is still in the upper third of the dollarís downtrend channel, and it probably has to grind way down into the lower quarter or so of this downtrend in order to find strong enough support to attempt a major bear-market rally. As long as the US Dollar Index continues to trade high up in its downtrend near resistance like today, odds are we arenít going to see a major interim bottom.
The Relative Dollar concurs with this simple trending technical analysis. Note above how the dollarís black 200dma line runs parallel with the dollarís downtrend channel. In any secular bear market, a price gradually marches lower by falling below its 200dma (a downleg) before periodically retreating back up to its 200dma (a bear-market rally). The red rDollar line precisely quantifies this key ongoing relationship between the dollar and its trailing 200dma.
So far in this dollar bear to date, major dollar downlegs have tended to end when the currency was trading between 0.90x and 0.92x its 200-day moving average. The first and fourth major downlegs both bounced when the rDollar hit 0.905. The third ground a little lower to 0.903 before soaring higher in a spectacular bear-market rally in mid-2003. The only major-interim-bottom outlier was the second major downleg which ended a bit higher at 0.922 in relative terms.
This remarkably consistent dollar-bear performance is the primary reason why I donít consider a major bear-market rally to be highly probable until the rDollar trades under 0.92 or so. As this graph indicates, the lowest the rDollar has traveled so far in our fifth major downleg today is only 0.949 carved on November 5th. If the dollar was to turn around here and enter major bear-market-rally mode, it would be the highest such interim bottom in relative terms in this entire bear to date. While a major bottom here is possible, it is just not very probable in light of precedent.
Thus, from a pure technical perspective the dollar ought to head lower in the intermediate term before we see another major multi-month bear rally. The dollar will probably head down near its lower support line as well as slumping down under 0.92x its 200dma before todayís fifth major downleg fully runs its course. With its current 200dma, this would yield a major interim bottom in the US Dollar Index under 81, or at least 4% lower from here.
And if we consider fundamentals, the long-term outlook remains bearish just like the intermediate term. The goofy US Fed continues to create fiat dollars out of nothing at a relentless pace. As this printing-press inflation leads to relatively more dollars chasing relatively fewer goods, services, and investments, the value of the dollar falls. The Fed is also encouraging foreigners to sell dollars by keeping US interest rates artificially low to subsidize wanton American debtors. All of the Fedís current policies are virtually assured to continue weakening the dollar.
Not wanting to be outdone by the Fed, the Washington bureaucrats are also doing everything in their power to weaken the dollar. The US government continues to spend far more than it can steal from Americans via brutally excessive taxation levels. The huge structural deficits Washington insists on running are eroding Americaís credit and standing in the world. In addition, Washingtonís newfound love of imperialism is spawning great antipathy worldwide. Until these fundamentals change, the dollar bear will likely remain in force.
Furthermore, in the past few decades secular bulls and bears in the dollar have tended to run for 5 to 7 years before maturing and reversing. Our current specimen remains quite young by this standard, barely three years, so duration precedent also supports the bearish fundamental outlook on the dollar in the years ahead.
In light of these intermediate-term technical and long-term fundamental situations facing the mighty US dollar, it looks like the dollar shorts still have the upper hand in probability terms. Yes, the dollar bearís notoriety in the mainstream is growing, but apparently not enough mainstreamers are ready to put their money where their mouths are on this so far. The popular noise on the dollar bear ought to get a lot louder before a major interim bottom materializes.
In early 2004, near the last major interim low in the dollar after downleg 4, the raw level of dollar bear notoriety greatly exceeded what we have seen in the recent weeks. In early January I wrote, ďThe 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. ... With the dollarís 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.Ē
We havenít yet reached the everyone-shorting-the-dollar stage this time around, but odds are we will before the fifth major interim bottom of this secular dollar bear is carved. When the growing media hype surrounding the dollar bear is eventually backed by a massive surge in dollar-short plays by Wall Street and the mainstreamers, then contrarians will really have to take note. For now though, this fifth downleg does not appear to be in jeopardy of spiraling out of hand.
With the probable intermediate and long-term scenarios addressed, that leaves the short-term. Our next chart encompasses just the past year or so, the small blue-shaded area in the lower right corner of the graph above. Interestingly, while the dollar looks bearish in the months and years ahead, the outlook over the next few weeks actually looks bullish.
Like pretty much everything else having to do with the markets, dollar sentiment is fractal in nature. In addition to episodes of popular bullishness and bearishness at the major interim tops and bottoms on a strategic scale, there are also miniature sentiment waves that cascade through the dollar over the short term. I suspect the current notoriety of this dollar bear is a product of a short-term sentiment wave rather than a long-term one.
In this tactical chart we can see the end of the fourth major dollar downleg and the beginning of the fifth. Just as general dollar sentiment was rotten and everyone was shorting in January (except us contrarians), dollar sentiment was positively glowing at the currencyís latest major interim top in May. I was watching this top very closely and went long gold stocks again after their early 2004 correction so I paid careful attention to what was said about the dollar.
After that May top, big Wall Street brokerages were predicting additional serious moves higher in the US dollar. I remember reading a couple reports calling for a target level of 100 in the US Dollar Index before 2004 ended. This dollar-bullish noise grew so intense and loud that even some analysts who usually traffic in contrarian circles were sucked in. To their credit the ďcontrariansĒ werenít as bullish as Wall Street, but I saved contrarian newsletter reports from this summer calling for 95 to 96 in the dollar index by autumn.
Dollar bullishness also exploded again in late August as the dollar threatened to break out from both its short-term and long-term resistance lines. If you compare this tactical graph to the earlier strategic one, you will note that the dollar hugged both key resistance levels for a couple months. This was a particularly rough time for gold investors, as dollar strength usually translates into gold weakness. If I had an ounce of gold for every e-mail I received on this between late July and early October, I could start my own central bank.
The point of all these observations is to illustrate that the noisy majority is always wrong near market turning points. Dollar bears came out of the woodwork last January as bearish media coverage exploded, but they were wrong. Only contrarians predicted a major bear-market rally in the dollar. Similarly, in May and later last summer, dollar bulls multiplied along with bullish media coverage. Only contrarians predicted that the fifth major dollar downleg already underway would accelerate into autumn.
By the time any market event becomes mature enough or prominent enough to dominate the major news outlets, odds are that the vast majority of that move is past. If you buy when others are brave and sell when others are afraid like a mainstreamer, perverting Mr. Buffettís brilliant advice, sooner or later you are going to lose all your trading capital in the markets. If you want to consistently win, you have to force yourself to adapt a contrary focus to mainstream investing popularity.
And this thought brings us to today. The intermediate-term and long-term outlook on the dollar remains bearish, but short term a bounce is certainly possible. By a bounce I donít mean a massive multi-month bear market rally like the first half of 2004, but a sharp move higher over a couple of weeks or so. Two previous bounces are labeled above, in June and July, which each carried the dollar higher for a short spell.
Technical bounces are totally normal during major downlegs, they help bleed off temporarily excessive fear and rebalance sentiment. Todayís soaring media coverage and the resulting growing notoriety of the dollarís weakness is both a result of growing fear and a catalyst for even more fear. Unless the dollar bounces briefly, fear could get out of hand. Bounces solve this sentiment problem.
These technical bounces generally occur when the dollar hits its tactical support line, just as it did in June and July before the previous two bounces. As you can see in this chart, the US Dollar Index just slammed into this same support line again for a third time in early November, and a minor bounce may already be in progress.
If this fairly-high-probability bounce indeed materializes in the coming weeks, it could carry the dollar back up as high as 86+, up to the same upper resistance line at which the currency lingered last summer. But, even if the bounce does run all the way back up through the dollarís tactical downtrend channel, odds are it will be short-lived. With strongly bearish intermediate and long-term outlooks, any dollar strength on a minor technical bounce will probably be fleeting at best.
The bottom line is the dollar bearís notoriety is growing, which naturally causes concern among contrarians. A contrarian wants to buy when others are afraid and sell when others are brave, so contrarians short the dollar today are wary that the mainstream is growing too fearful of the falling dollar. But, thankfully for contrarians, the technicals and fundamentals only seem to support a short-term dollar bounce at best, not a major bear-market rally and certainly not the end of the dollarís secular bear.
If you are interested in trading this potential dollar bounce, please consider subscribing to our acclaimed Zeal Intelligence monthly newsletter. In the current November issue I discuss how we are planning on playing a dollar bounce in terms of the primary beneficiaries of dollar weakness, gold stocks and gold-stock options.
While such a minor dollar bounce would probably hurt these speculations short-term, it would create some excellent buying opportunities if the dollar does head up to its own resistance for a short time. We are currently screening various gold-stock options as well as junior gold miners for potential purchase if the dollar does indeed challenge its resistance again before its downleg resumes in earnest. It would create the first good buying opportunity for leveraged gold plays since last summer.
Our subscribers also have exclusive access to a new subscriber-only charts section on our website, which among dozens of other charts includes a high-resolution Relative Dollar chart updated at least weekly so you can monitor the ongoing progress of this major dollar downleg. This is especially important for gold investors since goldís next major correction will probably commence the moment this fifth major dollar downleg ends.
The dollar bearís notoriety is certainly growing, but so far the popular fear doesnít look great enough to do anything besides spawn a minor dollar bounce at best. Contrarian investors and speculators directly or indirectly short the dollar probably have nothing to fear in the intermediate and long-term time horizons.
Adam Hamilton, CPA November 12, 2004 Subscribe at www.zealllc.com/subscribe.htm