Major dollar rally coming soon, to a trading screen near you.

Sorry for my long hiatus from blogging. I’ve been trading very little over the last six months, demoralized and righly so due to chronically awful trade execution and overreaching. I have a highly valid reversal strategy, but it is not a trend strategy, and I need to keep my bearish macro views out of the equation (though I suspect that they would be better suited to the next 2 years that the last 2 – but I need to forget about that and keep such discussions academic, for risk of corrupting a perfectly good trading model).

I’ve done some soul-searching and review of my trading history and this blog, and come to the conclusion that I should not abandon this pursuit but instead work to remedy my fatal flaws. A review of my history shows that I am able to identify turns in markets with a very high degree of probability. The fatal flaws are not analytical, but as is usually the case, emotional and procedural. This blog actually has a very good record of both initiating positions and closing or reversing them. As a trader, I would have done well to follow its advice, but I would often revert back to my bear bias, and way too soon, as when I shorted risk last March-April, booked huge profits and went long (including buying bottom tick in EUR and CHF) in June, only to reverse and go short again in July on bias alone without my proven criteria for a valid set-up.

My basic methodology as it has evolved here since August 2008 when this blog began, is to use sentiment and technical data to identify oversold and overbought conditions that are long in the tooth and due for clearing reversals.

The classic set-up is like this:

  • DSI sentiment has plateaued or bottomed at an extreme (<20% or >80% for at least 5 weeks, the longer the better – this can go on for 6 months at the outside, more commonly 4-12 weeks if we are talking <20% or >80% readings).
  • A major move comensurate with that sentiment has occurred (the market is trading at highs or lows), which to the mass of traders seems totatally justified by fundamentals.
  • Price action shows weakening momentum. This is indicated by a diverging trend in oomph indicators MACD and RSI. This usually means that the rate of change is slowing and that each new little push is slower and on lower volume, even as new extremes in price are reached.
  • A loose stop-loss level can be identified (a level that should it be broken decisively, would indicate that the prevailing trend still has legs). This is a mult-week strategy, so stops should use daily or even weekly levels — no use for 5 minute charts here.
  • Markets are highly coordinated in recent years. E.g., if the dollar is looking like it is going to rally, don’t be long stocks or commodities or short bonds.
  • Adjust stops downward to breakeven after the reversal, and tighten stops to a gain as DSI data reaches 40-60% middle ground.
  • Tighten stops much more or close positions after DSI data approaches the opposite extreme (e.g., if you shorted SPX when DSI bulls were 90%, prepare to close and consider the trade finished once DSI reaches 25%).
  • This is not a trend system! Repeat, this is not a trend system! Trade reversals only, as those have the highest probability. Once the oversold/overbought condition is cleared, the probability of the market continuing in your direction is vastly lower, and does not justify the risk (no matter your opinion of the longer-term situation or fundamentals). This last point was my fatal flaw.
So, we have a classic long-dollar set-up developing right now. I give it strong odds that we experience a major dollar rally within 2 months, with all of the de-leveraging that entails in other markets. This is not the place to put on a heavy position if you are not willing to accept big drawdowns, since this market could easily trend for a while yet, with the stock markets holding up as well.
Note that this trade is confirmed by the opposite in the stock market. Plateau in DSI and other sentiment indicators at a high level of bullishness for several weeks. This condition will be cleared to the downside as the dollar breaks upward. Copper, oil, etc will also correct hard down, and the anti-dollar currency pack (CAD, GBP, EUR, AUD and probably CHF) will fall as well. Not sure about JPY – it often trades up with the dollar during these little episodes of risk unwinding.
As always, the timing is the most uncertain factor here, but the longer the dollar sentiment stays low, the less risk there is in this trade and the stronger the resulting rally will be. I can’t say whether this will come next week or in early June, but we are at the point where traders should be nervous about short-dollar, long-risk positions, because that trade is running on momentum alone and meets the requisites for sudden reversal.
The archetypal set-up was long-dollar in fall 2009, after dismal trader sentiment since early June 09. The set-up was in place by late August, but the dollar continued to drift down through November, helped along by small clearing rallies and brief upticks in sentiment. Because average sentiment was low for an extraordinarily long time (6 months), we had a very powerful rally, from 74 to 88, over the following 6 months. This time, sentiment has been low for two months so far, certainly enough for a good rally, but not necessarily for the same killer trade. On the other hand it is somewhat better because the readings are more extreme.
The clearing episodes are the wall of worry or the slope of hope that keep the trend going.  A smoothy trending market with a flattening slope is more dangerous for followers and better for reversal traders. So far we have such a market, but if it gets choppy, with little sell-offs in stocks and small dollar rallies, it can last longer, and if the clearing events are big enough, it would cancel this trade. There will be others.
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6 thoughts on “Major dollar rally coming soon, to a trading screen near you.

  1. Good to have you back. Was wondering what happened … How long can the market go up? I say Liquidity / Money printing is going to continue through June … but most will start to unwind their positions in May … QE3 will follow … Bernanke is insane .. some insight from Bill Fleckenstein:

    Failing the Sniff Test
    Now it seems Bill Gross may have joined the same camp, though for some slightly different reasons. In his Investment Outlook article published yesterday, headlined, “Skunked,” he details the staggering size of the financial burden of our unfunded liabilities. As he points out, this is not some theoretical estimate of future spending, but rather, “The discounted net present value of current spending, should it continue at the projected demographic rate.” The sum total is around $75 trillion. As he points out, if you use the CPI plus 1% to calculate the interest rate on the debt (which is the rate he used to discount back the government’s future liabilities), interest expenses would equal $2.6 trillion, which is about ten times higher than the current level of $250 billion.

    The bottom line is he feels the size of unfunded liabilities (a consequence mainly of entitlements) means we are headed to an increased use of the printing press. Gross suggests that, when it comes to the size of our real off-balance debt, as opposed to the size of the $9.1 trillion on-balance-sheet national debt ($11-$12 trillion counting agency debt), we are “out-Greeking the Greeks.”

    He sums up by saying, “the only way out of the dilemma, absent very large entitlement cuts, is to default in one (or a combination) of four ways: 1) outright via contractual abrogation — surely unthinkable, 2) surreptitiously via accelerating and unexpectedly higher inflation — likely but not significant in its impact, 3) deceptively via a declining dollar — currently taking place right in front of our noses, and 4) stealthily via policy rates and Treasury yields far below historical levels — paying savers less on their money and hoping they won’t complain.”

    No One’s Default But Our Own
    And finally, “Unless entitlements are substantially reformed, I am confident that this country will default on its debt; not in conventional ways, but by picking the pocket of savers via a combination of less observable, yet historically verifiable policies — inflation, currency devaluation and low to negative real interest rates.”

    Those, of course, are exactly the policies we are pursuing now, which is why we are where we are. Inflation has become the order of the day and it will only intensify. Exactly when I can’t say, but it is worth pointing out that, since QE began, for about eighteen months the monetary base did not really percolate. But so far in 2011 it has exploded by 20% or so. I think that is a sign that inflation is likely to begin accelerating.

    Of course, inflation is impacted by expectations. If people think prices are going to climb, they buy in advance, and vice versa. Thus, psychology plays a large role. However, as I pointed out not too long ago, the mindset is changing and the genie is out of the bottle.

  2. Thanks for posting this – I’m making a short post in response, about where we sit in the debt cycle and what’s happening with inflation.

  3. I think the dollar has a hugh rally……..there could be a flaw in that everyone expects the ECB to raise rates on Thursday. Watch out, it is a day of volatility.

    Firstly, it has already been priced in, so even if they do raise it, there could be a “what next reaction”.

    If they do not raise rates…….. the dollar will almost certainly rally

  4. good to hear from you again – have followed you for quite a bit and find that your timing of turns in the market are is rather good – and couldnt agree more about the highly probable turn in the dollar – looking forward to reading more posts… peter – copenhagen, denmark

  5. Welcome back Mike. Indeed, markets have been very harsh on us realists, but we are all learning the lessons, and this is the only way to get better…
    Looking forward to reading your posts!

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