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Currency Countertrends

Adam Hamilton
January 31, 2005

The recent technical reversals in the dollar, euro, and gold are spawning a lot of discussion in the markets these days. Sizable currency moves broadly impact most major countries and markets in a myriad of interrelated ways, so investors and speculators really need to pay careful attention.

These reversals now underway are all countertrend moves. In each case the currencies are moving opposite to, or counter to, the direction their primary long-term trends have traveled over the last few years.

The mighty US dollar is in a primary bear market. From July 2001 to December 2004 it has fallen by an amazing 33% bear to date. It is appalling that the average American who pays no attention to these things has no idea that the international purchasing power of his income and wealth has been cut by a third in only the past few years. Ouch.

The main beneficiary of the dollar's bear has been the euro, which is enjoying a powerful primary bull market. From October 2000 to December 2004 the once ridiculed composite fiat currency has powered a dazzling 65% higher! This bull provides a compelling disincentive for savvy European investors to buy dollars to invest in the States, since the falling dollar can be repatriated into fewer euros with each passing year.

The dollar's weakness is also driving the initial currency stage of our primary gold bull. From April 2001 to December 2004, gold in US dollar terms soared by a breathtaking 77%. This number alone is interesting as it far exceeds the dollar's 33% drop and should help put to rest perpetually popular ideas among fringe gold investors who believe gold will just tread water relative to the dollar's fall without earning real gains.

Now these respective dollar, euro, and gold primary trends are all over three years old, which puts them solidly into the fabled annals of seculardom. A secular trend is a powerful long-term market movement driven by underlying fundamentals. Once secular trends start, they can run anywhere from a half decade to nearly two decades so they must be respected. Only radically changing fundamentals can end a secular trend.

Since last month, we have witnessed countertrend reversals running 4.2%, 4.8%, and 8.1% respectively in the dollar, euro, and gold. Compared to their secular trends to date, these reversals represent relatively trivial retracements of small fractions of their entire secular moves. In addition, these countertrend reversals have only run for an average of 5 weeks compared to an average of 45 months for the primary trends.

Which trends are more important and likely to persist? The 5-week countertrend reversals or the 45-month primary secular trends? Obviously the longer a trend lasts, the higher the probability it is being driven by powerful underlying supply-and-demand fundamentals which are very slow to change. Conversely the shorter the trend, the more likely it is little more than fleeting technical noise.

Countertrend moves, whether they arrive in the form of corrections in secular bulls or bear-market rallies in secular bears, are necessary to rebalance sentiment. In bull markets popular sentiment periodically waxes too ecstatic, so a correction bleeds off the speculative excesses to keep the bull healthy. In bear markets speculators periodically grow too pessimistic and scared, so bear-market rallies are necessary to rebalance sentiment to neutral.

Temporary countertrend reversals are completely normal and should be expected in all markets dominated by secular trends. These moves lead to common mistakes made by speculators who haven't conditioned themselves to expect the periodic countertrend reversals.

Some speculators don't take the prospect of countertrend reversals seriously enough, so when they inevitably happen these speculators grow flustered. When they see their primary trend not running arrow straight into infinity, they assume that they were wrong and they exit a secular trend too early, often leaving in disgust. Some even blame others for these inevitable reversals, assuming some shadowy syndicate of insider traders is out to personally destroy them.

This leads to another mistake, taking a temporary countertrend reversal too seriously. If speculators don't expect these moves, their arrival can lead to deep worries that their primary trend is over. They assume the worst, that a major secular reversal is underway. But secular bulls and secular bears don't end very often, and when they do it is always on major changes in underlying fundamental conditions. Technicals alone won't do it.

The happy medium navigating between these mistakes is just to expect periodic countertrend reversals in any secular trending market. Corrections in bulls and bear-market rallies in bears are inevitable and healthy, so the wise course of action is to expect them, ride them out, and continue betting with your primary trend until its driving underlying fundamentals radically change.

As a gold investor, I find myself particularly interested in how our current countertrend moves are affecting the gold market. Gold is money, the ultimate historical currency over six millennia, so it does tend to move in parallel to other major currencies. In fact, in Stage One of a major secular gold bull, fiat currency devaluations are its major driver.

Since the dollar, euro, and gold are so interrelated as competing currencies these days, I don't think they can be studied independently. If you want to know how long their current countertrend reversals are likely to last and at what levels they are likely to end, you really need to study all three at once. This holistic approach is as important to dollar or euro speculators as it is to gold speculators.

Our three charts this week should all be viewed at once as they compare the dollar, euro, and gold over the past 17 months or so. During this time each currency has witnessed three major reversals, two countertrend and one ending a temporary countertrend move to rejoin the primary trend. The fascinating thing to observe is the timing, as all three currencies tend to reverse at roughly the same times. Vertical blue lines through each chart highlight these reversals so they are easier to compare among the charts.

These charts also highlight the Relativity analysis for each currency, or the absolute distance away from their respective 200-day moving averages that they tend to stretch. This also gives us important clues as to when countertrend reversals are likely to end so the primary trends can reassert themselves. Relative extremes almost always match major interim highs and lows that mark short-term turning points.

As you examine all of these charts at once, there are a few things to note. First, the dates of the last three reversals are nearly identical in all but one case where they were merely similar, which I will discuss below. Neither the dollar, euro, nor gold can be studied effectively from a trading standpoint by ignoring the other two currencies. They are all interrelated.

Second, when a currency is moving with its primary secular trend, bull or bear, it tends to diverge away from its black 200dma. But when it enters a temporary countertrend reversal, either correction or bear-market rally, it tends to converge back to its 200dma. The raw degree of these periodic 200dma divergences and convergences is noted by the red relative readings that show each price as a constant multiple of its 200dma over time.

Finally, while each of today's countertrend moves is well underway, they tend to struggle a bit when they hit the first support or resistance line extended from the last move with the primary trend. In the dollar's case above, the dollar bear rally is now struggling to get over its lower support line established in the second half of 2004.

Not surprisingly, the peaks and troughs of this euro chart match the dollar's almost exactly. Just as the dollar is now struggling with an extended support line from its last downleg, so is the euro now bouncing off of an extended resistance line from its last upleg. Once these key technical levels are overcome, the countertrend moves should continue until they fully run their courses with each currency back near its respective 200dma.

The January and May gold reversals perfectly match those in the euro and dollar above, but the December one arrived a few weeks early. I suspect this was because of the gold ETF-driven selling panic that hit gold early last month. The gold ETF's competitors launched a preemptive strike across its bow by actively undermining its reputation via strategically released half-truths and exaggerated conclusions designed to scare away investors.

If you are interested in understanding the ETF-driven gold selloff in detail, I discussed it extensively in the current January issue of our Zeal Intelligence newsletter. Without the surreal ETF-driven events of early December, I suspect gold would have rallied right into the end of the month and hit its relative neutral signal above 1.14 within days of the reversals in the dollar and euro. The ETF mini-panic just accelerated the inevitable reversal ahead in time by a few weeks.

Once its countertrend reversal commenced though, gold, like the dollar and euro, initially bounced off of its extended resistance line from its previous upleg in the second half of 2004. After this zone failed, gold soon fell down to its extended support line from the last upleg, where it is struggling along today. It will probably have to converge even closer with its 200dma now near $411 before its current temporary correction ends.

Looking at these three currencies primarily from the perspective of a gold investor and speculator, when they are all considered together they seem to paint a much clearer picture of what to expect in the next couple months than gold alone. This is easiest to understand if we study the last major countertrend reversal in the currencies, from January 2004 to May 2004.

A year ago this month, the dollar, euro and gold were all stretched far away from their respective 200dmas. The dollar, since it is in a primary bear market, was stretched way below its 200dma, actually approaching only 0.90x this key technical line. Meanwhile the euro and gold, both in primary bull markets, were stretched far above their respective 200dmas. The euro traded over 1.11x its 200dma while gold went 1.15x as high.

But, as is no surprise for diligent students of the markets, any secular trend can only diverge so far away from its 200dma before a temporary countertrend reversal to rebalance sentiment becomes inevitable. On the very same day last year, January 9th, the dollar, euro, and gold all reached their 200dma divergence limits simultaneously and began converging with their 200dmas in unison.

If you strive to look for these reversals in advance so you can trade them profitably, the interesting thing to note is that these currency countertrend moves were anticipated. I wrote an essay published the same day of this reversal last January that warned, "The US Dollar Index really looks like a major countertrend rally is imminent and due. And if a bear-market rally in the dollar launches, for any reason, odds are that gold is going to get hit over the short-term. Get ready!"

These normal, healthy, and expected countertrend currency moves ran about four months into May before they reached maturity. By early May the dollar, euro, and gold had all converged with their respective 200dmas, signaling that their reversals were nearing an end. This too was expected, as I wrote in late April, "Another major gold upleg appears to be on the very verge of launching, but only the decisive and brave will seize today's awesome opportunity to saddle up and ride it. Get long now!"

Once again the dollar, euro, and gold, as competing global currencies, all exited their countertrend reversals of early 2004 within one day of each other in May. Their respective sentiment-neutralizing 200dma convergences complete, their 200dmas began to diverge again as their primary secular trends reasserted themselves. The dollar's primary bear market continued to new bear-to-date lows while the euro and gold bulls marched right on to fresh new bull-to-date highs.

Now in light of this strong recent, and indeed long-term, precedent of the dollar and euro/gold to move in resolute lockstep opposition, doesn't it make sense to expect this relationship to hold for this current countertrend reversal? I don't know of any reason to expect it not to hold, unless gold suddenly launches into Stage Two and decouples from the dollar on global investment demand.

This Stage Two transition we have so eagerly awaited certainly could happen at any time, but betting on this inherently unpredictable event happening in any given month is a low-probability-for-success gamble. Yet, I hear many gold investors and speculators who are making this very bet. They are continuing to try and call an interim bottom in gold, and the end of its countertrend reversal, before the dollar and euro reversals fully run their own courses. Possible, but not probable.

Since the last major gold shifts from upleg to correction mode or vice versa have usually happened to the day that the dollar and euro made their own reversals, it seems prudent to look for this same simultaneous currency convergence to again come to pass before gold is ready to enter its next major upleg. Until the dollar, euro, and gold all complete the necessary convergences with their own 200dmas, it makes little sense to get excited about a major interim bottom in gold.

Today's currency 200dma convergences are all progressing nicely, but to different degrees. The dollar has traded as high as 0.964x its 200dma so far, but as our red short band in the first chart above shows it should exceed 1.00x, or travel above its 200dma, before its bear rally is ready to give up its ghost. In terms of its Relativity band defined by the green and red Relative Dollar long and short indicators on its chart, the dollar bear rally is barely halfway into its relative channel, or halfway complete.

The euro is in the same boat, about halfway through its relative channel with a correction-ending relative target just at its 200dma, or 1.00x. Correction to date the euro has traded as low as 1.039x its 200dma, so it still has a ways to go to hit it. With both the dollar and euro only halfway through their expected countertrend reversals, odds are gold still faces some weakness or at least continuing consolidation ahead.

Gold, however, thanks to the ETF-driven selling panic in early December, is probably 80% through its expected correction in relative terms. Its red rGold line above has fallen most of the way through its relative trading channel, but it still has a little ways to go yet as gold should bottom under 0.99x its 200dma before launching a dazzling new upleg. Correction to date the lowest it has traded is 1.019x its 200dma.

With gold's correction already so advanced in expected 200dma-convergence-distance terms, it is easy to understand why gold investors and speculators are chomping at the bit to call a gold bottom and throw long with a vengeance again. Yet, the parallel dollar and euro countertrend reversals are not that far along yet leading me to believe we are in for more dollar strength and euro weakness, which is not favorable for gold.

Gold will probably grind sideways and a bit lower to its 200dma while the dollar bear rally and euro correction continue in the next couple of months. I fully realize this is not what gold investors want to hear, but the currency connection remains so strong in gold trading that probabilities favor this course of action. Gold's next major upleg will inevitably come, but probably not until all three currency countertrend reversals fully converge with their 200dmas.

If you are interested in deploying capital in this next gold upleg when the time looks right, please consider subscribing to our acclaimed monthly Zeal Intelligence newsletter. Over the last couple months we have painstakingly researched all of the major gold mining companies as well as over 50 juniors so far. In the upcoming February issue to be published on February 1st, I am wading into analysis of the majors to uncover the ones with the highest potential for big gains in the next gold upleg.

In addition, and maybe more importantly, this blue-chip major analysis sets the stage for extensive junior-gold analysis in future issues of ZI, laying down performance standards by which we can judge the most fundamentally-promising juniors. After all, since juniors are far more risky than established majors, we need to have expected returns above and beyond the best of the majors to compensate for the added risks.

By the time to redeploy into the best big and small gold stocks arrives, you will be up to date on the highest-potential picks and ready to roll. In addition, our subscribers gain exclusive web access to large private versions of these relative currency charts that are now updated every few trading days. You can watch the 200dma currency convergences unfold with your own eyes and be ready to jump on the next great long gold opportunity when it arrives.

The bottom line is temporary currency countertrend moves are necessary, healthy, and should be expected periodically. They deftly bleed the air out of sentiment imbalances that breed when secular trends diverge too far from their anchoring 200dmas.

Once these countertrend reversals are underway though, they tend to run until all three major currencies fully converge with their own 200dmas. The dollar bear rally, euro correction, and gold correction are likely to persist until all three currencies reach the fully converged point where they can majestically launch back into their primary secular trends.

And since gold still seems to remain firmly entrenched in the Stage-One currency-devaluation phase of its secular bull, it seems prudent to not expect a major interim gold bottom totally independent of a major interim dollar top and euro bottom. All three currencies must be considered together as long as they continue to trade in lockstep with each other.

January 28, 2005
Adam Hamilton, CPA
email: zelotes@zealllc.com

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