Rumors of dollar’s death greatly exaggerated

Sentiment is still very anti-dollar (though not as extreme as last February-April), but the index is no lower than a few months ago, nor even a few years ago. Despite all of the dollar-crash and hyperinflation hysteria in recent years, early 2008 still marks the bottom.

MACD and RSI also seem to back up the case that the next big move is more likely up than down:

3 year daily chart:

stockcharts.com

5-year weekly chart:

bigcharts.com

10-year monthly:

futures.tradingcharts.com

The 10-year chart says it all: the dollar has already crashed, and as is typical in the financial markets, few noticed or attempted to take action until the move was already over.

The dollar’s going to crash, the dollar’s going to crash!

Uh, it already has. The time to be shouting about a crash was 2000, but the dollar-crash meme only got mainstream in late 2007. As you can see in this 10-year chart of the trade-weignted dollar index, the dollar had by then already fallen, and is no lower today than 3 years ago. It may be putting in a triple bottom prior to a secular bull market. The sentiment has certainly been negative enough for long enough to set up a lasting upturn, and the price action in recent years is similar to that of the late 80s to early 90s.

-

EDIT: Here’s a 30-year dollar index chart.

-

A secular bull market in the dollar would coincide with more unwinding of risk assets, since the buck has been a favored short for the carry trade (it is weak vs. other currencies, and has very low borrowing costs).

It would also make sense for US Treasury rates to finally put in their secular bottom during the dollar’s bull market, but not in the first phase. Interest rates follow a very long cycle, with the last top in the early 1980s and the last bottom in the early 1940s. Sentiment is still too anti-bond, and there is still too much credit unwinding to come for me to believe that bonds are ready to start falling. Bonds, after all, are hard cash for big players, and people reach out the curve for yield as short-term rates compress during credit stress.

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.
-
source: futures.tradingcharts.com
-
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.

VIX & Put:Call starting to make puts attractive again

A fair degree of complacency has snuck back into markets over the last month.  We don’t have a strong sell signal in stocks yet, but if April marked the high in US and European markets and economic indicators are turning down again, this could be a good spot to start building short positions again:

-

Here’s the equity put:call vs the 20 day moving average, back to one standard deviation under its mean. Dipping lower would require the kind of extreme complacency that we’ve only seen twice in the last decade, so I wouldn’t count on it:

-

The dollar has also corrected its overbought condition (and is actually very oversold), which is key for a resumption of the deflation trade:

Week in review and intermediate-term thoughts

Today I’m going to lay out what I’m watching for clues about the intermediate-term prospects. The action of the last 4 weeks has been more suggestive of a reversal than any we’ve had since the March 2009 lows. However, even if a top is in hand and we are finally at our spring 1930 moment, I’m not willing to throw caution to the wind and discount the possibility of another few weeks of rally.

Let’s start with the 5-day average equity:put call ratio, which has nailed so many intermediate-term tops, not least of which this last, which it suggested would be followed by a serious decline:

Indexindicators.com

The put:call ratio could use a bit more of a reset, which could be achieved by just a few more days of calmer or rising markets. Nothing major required here, just a pause.

This break has shaken up a few traders, but judging from interviews this week, the majority remain fairly sanguine about a continued bull phase and consider this a healthy correction, much as they did the first declines off SPX 1550 in late 2007 and early 2008. Also, the past year has established a very clear pattern of modest declines followed by new highs on extreme bullishness. Traders and their machines may be programmed to buy this dip, but with the recent technical damage (we busted the last low for the first time in the whole rally and experienced a mini-crash) I’d expect any rally to be relatively shallow.

There is a pattern of reduced oomph on each subsequent rally phase, which you can see in the diminishing slopes of each rally. You can also see the weakening of the larger trend in the angles between subsequent lows.  (Click to enlarge the image.)

TD Ameritrade

I’ve drawn those ovals on RSI to show a technique I have for picking bottoms. It gets most intermediate term bottoms, and perhaps more importantly, it has a low false-positive rate. A rally becomes likely when you get a double bottom in RSI. This works on any scale you chose, from 1-minute to daily or higher. The likelihood of a rally increases if the second bottom on RSI is higher than the first. This is common because the middle wave of a decline is usually more intense than the final wave.

Now, this current juncture has such a double bottom signal, though the second RSI bottom is not higher than the first. It is also trickier because the first was formed by the latest black Thursday, May 6. I’m not sure how such an event should factor in, but it throws off our analysis somewhat. Perhaps the May 6 event should be discounted (it was really just 1 hour of trading that produced the reading) so that we can’t actually count this RSI bottom as a 2nd.

In terms of time, we’re just over 4 weeks into the decline, which is approaching the average for an intermediate-term decline over the last 3 years (the last one was very short at 3 weeks, and others have lasted up to 8 weeks).

Also of consideration is the extreme complacency that we are correcting. Look again at CPCE in the first chart above. From what I can tell, it set a record for complacency going back to at least the year 1999. This suggests we may have more decline ahead before an extended relief rally. Sentiment has turned negative, but not overwhealmingly so, and it has only been negative for a couple of weeks, so this is not a contraint to a further decline.

One more consideration is the 1930 parallel. Once stocks broke that April after their rally from the crash of ’29, they failed to rally hard for years. The decline was steady all the way down to the bottom in July ’32. In this analalogue, we would have another week or so of choppy and weak rally, followed by the bottom falling out, an outcome that would elegantly resolve our situation. The dip-buyers pile in, but the oomph is gone, momentum weakens and RSI turns down, then BAM, we’re back to SPX 750 this summer.

Prophet charts

I am approaching this situation by being neutral on stocks at the moment. I am holding a core position in December 2011 and 2012 SPY puts and some calls I’m short on IYR and GDX, though I sold a portion of the puts on Tuesday morning and and the rest are hedged with a short in VIX futures (I do this because spreads on options make them costly to trade in and out of). Essentially, I’m flat on equities.

I closed a ton of shorts from last Thursday to Tuesday morning, and went long SPX, ASX and Nikkei futures (and long CHF, EUR, GBP and short JPY and VIX) early this week when I saw divergences in the VIX, currencies and commodities (ie, stock indexes made a new low that was not confirmed with new extremes elsewhere, a buy signal) as well as a glaring RSI divergence on the hourly scale. Those “long risk” positions I closed for profits on Thursday and Friday, since we’ve already corrected the extreme short-term oversold condition and are in neutral territory. Equity-wise, I ended the week where I was on Tuesday morning, since the drop in volitility hurt my puts as much as my various longs made me money. Vol is a bitch that way — sometimes you time prices right, but it’s not enough.

Speaking of the VIX, I think it could settle down for a few weeks, though to a higher level than in April, before the next decline pushes it up again. I think it will remain elevated (as from Oct 2007 onwards) for many more months or a couple of years:

Prophet charts

In the commodity space I’m even more convinced that a major top is at hand, since some trendline breaks have been decisive (platinum, palladium, oil) and the declines have been so violent all around. Commodities tend not to rally as hard as stocks once the trend changes to down, so I entered shorts on oil, silver, gold, palladium and copper near their highs late in the week. The precious metals are looking particularly suspect to me here, and I still think my July 2008 double top analogue is in play.

The euro, Swiss franc and British pound are still looking very weak. Sentiment has been in the dumps for four months now, which is a set-up for a spectacular rally, but judging from their heaviness this week as stocks and commodities and CAD and AUD rallied, I think they may slide to one more low before that rally.

Some highly scientific projections

S&P 500:

That’s not a projection for a final bottom, by the way… that would be lower.

Gold, from 1971 (Richard ”I am now a Keynesian in economics” Nixon):

Note: Under Bretton Woods, the dollar of course was pegged at 35 to the ounce from 1933 to 1971.

Gold has been in a parabolic move since ’04, and the degree of speculative interest got high enough to call it a mania, just like every other asset class this past decade. It is money, though, so although I expect some frightful drops, on the whole gold will preserve your capital through the mayhem. The high inflation that everyone has thought is right around the corner since 2007 could actually happen several years from now after enough debt has been wiped away to end deflation. In that case, history says the best assets could instead be real estate (leverage!) and agricultural commodities (government-induced shortages). *Professor Jastram showed that gold, as a form of money, doesn’t do as well in real terms in inflation as most people think, though it sure beats paper money during high inflation.

Remember, 1980 – 2001 was an inflationary period. So was 2001-2008, so go figure — I figure gold did well in the latter inflation because there was a commodity mania. Since 2008 you could say it has been strong for the “right reasons” – financial panic and deflation. That said, it still gets ahead of itself and does tend to fall with other commodities when the margin loan department calls.

US Dollar Index:

More deflationary panic ahead — what’s so great about all the other fiat currencies? Why is everyone so afraid of the dollar? Answers: nothing, and because it fell for 7 years.

-

*Here is a free paper by Jastram I found on Scribd: The Behavior of Gold under Deflation