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US Dollar Bear 4

Adam Hamilton
October 27, 2006

At any given moment in time there are broad strategic themes exerting tremendous influence on the financial markets behind the scenes. Students of the markets call these themes secular trends. They are long-term supply-and-demand-driven forces that cause a particular price to move in one direction on balance for many years.
Although these secular trends can certainly seem to be failing from time to time during their periodic countertrend reversals to rebalance sentiment, they often run for over a decade. Both the secular great commodities bull and the secular general-stock bear, even though they have been running countertrend lately, are likely to last about seventeen years each. Secular trends tend to run for an awfully long time!
As such, investors can only ignore secular trends at their own great peril. If you are a long-term investor and you are not aware of both the secular trends dominating the markets as well as their relative stages of maturity, you risk getting caught up in a temporary countertrend move and taking large losses once the primary secular trend resumes.
And these countertrend moves can be incredibly convincing if you haven't steeled yourself with the requisite market knowledge to prevent them from seducing you in. The current US stock markets are a perfect example. Even though a vast array of evidence suggests the Dow 30 is still in a secular bear market with a decade or so to run yet, the index's recent record highs have convinced many investors that the bull is back. When this temporary countertrend move inevitably ends sooner or later, they will be slaughtered like sheep.
Like avoiding most pitfalls in the financial markets, the only way to radically lower the probability that you will succumb to the temptations of temporary countertrend moves is to maintain a strategic perspective. If you can always keep the long-term market picture in focus no matter how alluring short-term moves become, your lifetime investment gains should be at least an order of magnitude higher than those of fickle investors blown about by every market whim.
It is in this spirit that I would like to reexamine an important secular trend that hasn't garnered much attention lately, the secular US dollar bear. I used to discuss the dollar quite a bit in past years, as during the early stage-one gold bull the dollar's fortunes were the primary driver of gold. But now with the stage-two gold bull upon us where gold demand is investment-driven and independent of the dollar, the dollar's usefulness for commodity trading has waned. Nevertheless, the dollar remains very important.
For Americans, our whole world is dominated by the dollar. As the dollar's value fluctuates in the global currency markets, our costs for importing and profits from exporting can change dramatically. And for investors outside the US, the dollar remains the world's reserve currency despite its well-known faults. Yes it is just a promise to pay printed on fiat paper with no intrinsic value, but it still dominates global commerce regardless.
While the once mighty US dollar fell relentlessly during 2002, 2003, and 2004, since then it has essentially traded sideways. With the dollar consolidating horizontally in the currency markets for the better part of two years now, a lot of traders seem to have lost strategic perspective and are forgetting that the dollar is deeply entrenched in a strong secular bear. 
Before we delve into the last couple years of dollar action to update this old thread of analysis on the dollar bear, it is very important to fully understand where we have been. This busy chart looks at the venerable US Dollar Index since 2001 superimposed over the Relative Dollar, or the US Dollar Index divided by its 200-day moving average. The dollar action over the past couple years has all been at low levels deep within its bear.

Almost all analysis of the dollar that I have seen in the financial media in the last year has focused on looking at the dollar relative to its late 2004 lows, marked by the 5 above. Indeed from this particular reference point the dollar has been impressive. The US Dollar Index rose 14.6% from its December 2004 lows to its November 2005 highs. And even though the dollar is back down near its latest support line today, it still remains up 7.3% from those bear-to-date lows.
But if you zoom out beyond the last couple years to fully consider the big strategic picture, the dollar is still bleeding badly deep within a powerful secular bear. From its peak in mid-2001 to its trough in late 2004, the US Dollar Index lost a staggering 33.3% of its value in the world currency markets!  A dollar spent internationally in late 2004 would only have purchased two-thirds of what the same dollar spent in mid-2001 would have commanded.
Since currencies usually move with all the sound and fury of a glacier, this is a staggeringly large move, especially for the world's reserve currency. In order to function as a reserve, an asset should be stable and maintain its value. Foreign investors and central banks who trusted Washington's endless "strong dollar" propaganda have watched the currency losses on their utterly massive investments in the US fall by a third. If I was them I wouldn't be very happy!
Lest you think a peak-to-trough measurement is a little too aggressive, the results are similar measuring from mid-2001 to today. This week the once mighty US dollar was down 28.5% from its levels of only six summers ago. There is just no escaping the fact that despite the dollar's sideways trading range of the last couple years it remains mired deep within a secular bear market.
Wall Street loves a strong dollar since it tends to boost the US stock markets in a variety of ways. When the dollar is rising, foreign investors are more likely to buy US stocks since their currency gains will add to their overall gains from investing in the US. A strong dollar also makes imports cheaper, and since the US populace is so heavily dependent on imports a strong dollar leads to more buying power for Americans which translates into more profits for US corporations since Americans can afford to buy more of their products.
Thus, it is not surprising that Wall Street always tries to paint the US dollar price action in the most bullish possible light since it brings more capital into the US markets to drive up stock prices and simultaneously leads to higher profits which also attract more capital. The mainstream financial media has been acting accordingly since the late-2004 lows, proclaiming that a new dollar bull has been born.
One of the key evidences in favor of this new-dollar-bull thesis is technical. Back at the end of Q1 2005, the US Dollar Index broke out of its secular downtrend that started in mid-2002. Once the dollar broke out of this long-oppressive trend channel near 84, it was off to the races. The dollar continued rallying sharply and ultimately carved its biggest and longest rally of this entire bear market. With the secular downtrend broken, Wall Street reasoned, that must mean the secular bear was defeated as well.
As students of the markets know though, technicals alone are never a reason to declare that a secular trend has given up its ghost. It is supply and demand, underlying fundamentals that actually drive secular trends. While technicals reflect these fundamentals for most of a secular trend, there are certainly times when sentiment gets unbalanced one way or the other and drives technical prices to temporarily diverge away from the primary secular trend. Sentiment can never trump fundamentals for long though.
Another key observation is that secular trends tend to have multiple independent price-trend channels over their long lives. No matter which secular trend in history you examine, they all have changes in trend-pipe slope gradients midstream. This secular dollar bear is no exception. Originally in 2001 and 2002 the dollar's downtrend was modest, it was in a high consolidation. But then the dollar collapsed in Q2 2002 and soon entered a much steeper downtrend that ran for several years.
Just as the end of its original high-consolidation moderate downtrend did not mark the end of the dollar bear in early 2002, it is unlikely the end of its steep secular downtrend in early 2005 will prove any more decisive. While the dollar has largely traded sideways since then and taken a temporary breather from falling on balance, this certainly does not mean its bear is over. Secular trends often see plateau periods where they regroup for a year or more before their primary trend resumes.
A recent example of a secular price trend running opposite to its primary trend for over a year before its primary trend resumed occurred in crude oil. Oil prices bottomed in late 1998 and then ran relentlessly higher into late 2000. Then oil slumped throughout 2001 in a countertrend cyclical bear that caused many to question the secular oil bull's very existence. But once early 2002 rolled around oil started marching up again and has done so on balance ever since.
In oil, as in all secular-trending markets, a temporary countertrend reversal and trend change will never last unless the underlying fundamentals support it. Traders who sold oil near the end of its 2001 countertrend move in the midst of its secular bull at $20 a barrel missed the ensuing massively profitable run from $20 to $75+. So a trend change considered alone, a purely technical development that can be driven by short-term sentiment, is never adequate reason to declare a secular trend over.
Nevertheless, the dollar's trend change in early 2005 from a steep secular downtrend to a low consolidation with rising support is quite interesting. Now that we understand the strategic big picture in which the dollar's action of the past couple years occurred, we can zoom in to it alone and analyze it within the context of its ongoing secular bear. This next chart encompasses the light-blue shaded area in the lower-right corner of the chart above.

The dollar's steep secular downtrend culminated in late 2004 with a blistering plunge that led to the fifth major interim low of the entire dollar bear up to that point. This slide was so sharp and extreme that sentiment looked really unbalanced to the fear side and it was getting obvious a couple weeks before the lows that a major bear rally was due.
Just as periodic corrections are common and necessary within secular bulls, so are periodic bear-market rallies within secular bears. In both cases sentiment gets too unbalanced after a price moves in one direction for too long so a temporary countertrend reversal is needed to rebalance sentiment. In secular bears fear becomes too extreme at major interim lows so sharp rallies periodically erupt to moderate fear and build up some greed before the next major downleg can commence.
The interesting thing about bear-market rallies is they tend to be the sharpest and fastest rallies a market ever sees. Since these rallies occur off of deep oversold lows on a big sentiment imbalance of far too much fear, they can rocket higher at an amazing pace. As of mid-2002 in the NASDAQ, for example, 14 of its 15 biggest daily percentage rallies between 1990 and 2002 happened after its March 2000 bubble top. Bear-market rallies are supposed to be fast and convincing, just like what we saw in the dollar in early 2005.
And a couple interesting things happened when the dollar started rallying in its fifth major bear-market rally of its bear. First, while the dollar's absolute gains in this rally were larger by far than its previous major bear rallies, this fifth rally took an inordinately long time to reach maturity in late 2005. Although major bear rallies 3 and 4 marked on the first chart averaged progress of 0.14% and 0.13% per day respectively, due to its long duration bear rally 5 was much less impressive. It only averaged progress of 0.07% per trading day.
So even though this fifth major bear rally had the biggest absolute gains of the dollar's bear, this rally took so long that its progress per day averaged about half of the dollar's previous two major bear rallies. This could be interpreted a couple ways. The dollar bulls would probably say that the slower rally was more in line with a new bull than a sharp bear rally. They have a point as its signature is not quite right for a typical bear rally.
But the bears can counter and assert the dollar's extended rally was a technical fluke. After all, the dollar initially peaked right at the middle of 2005 before starting to decline sharply. The secondary mini-rally from mid-Q3 2005 to mid-Q4 2005 that extended the duration of the entire fifth bear-market rally should probably not be included in the initial bear-rally's measurement. Considering the fifth major bear rally from December 2004 to July 2005, in its initial sharp phase only, the dollar soared 12.2% in 128 trading days. Thus it averaged 0.10% per day, much closer to bear-rally territory.
And indeed the dollar's incredible surge in Q2 2005 shown above was practically vertical, a telltale sign of a bear rally that is not usually witnessed early on in a major bull. Early on in bulls the greedy sentiment necessary to drive vertical moves just doesn't exist yet as most traders remain bearish. And it is interesting where this entire bear rally eventually topped. In Q4 2005 the dollar failed right at its previous major interim high. This failure to make a decisive new interim high above the previous interim high deep within the bowels of the bear really calls into doubt the technical validity of the new-dollar-bull thesis.
Not long after in Q2 of this year the dollar fell sharply again, a bear-market-style plunge after the greedy sentiment that drove the initial bear rally in early 2005 finally faded. Today the dollar is once again scraping support and remains lower than it was a couple years ago. Will this new support line hold?  If it doesn't, if the dollar falls below it, technically-oriented traders will probably dump the dollar aggressively and its next major bear-market downleg will probably ensue.
Over the last couple quarters the dollar has inched closer and closer to breaking below its latest support line, which is relentlessly rising. Today it is just above 85 and rising at a slope of about 1 dollar index point per quarter. So in the coming quarters if the dollar doesn't rally from here it is going to break this key technical line by default. Provocatively the dollar's 200dma is already pointing sharply down once again which is the best price clue of where a primary trend is headed.
But it is ultimately fundamentals that drive great secular trends, not technicals. On the US dollar's fundamental front there is really only one major positive but a broad array of major negatives. I believe the fundamental negatives far outweigh the positives suggesting that dollar supply will exceed dollar demand in the coming years forcing its secular bear to resume. A dollar oversupply relative to demand ensures falling prices.
The one big dollar-positive development is the rising US interest rates. The higher rates go, the more attractive dollar-denominated debt investments like US Treasuries become to investors around the world. But since debt-laden Americans and Wall Street fear high interest rates so much, the Fed can't keep raising them indefinitely without triggering a massive economic slowdown eventually. So higher rates are a self-limiting positive factor.
And even if the Fed could continue ratcheting short rates much higher, I doubt the relative merit of higher-paying dollar debt would outweigh the considerable negatives facing the dollar. First, and most importantly, is the Fed's relentless debasement of our currency. Each year it grows the total dollars in circulation globally by 7% to 8%+ without fail. For every new paper dollar conjured into existence, dollar supplies grow relative to demand and lead to lower prices. The Fed's red-hot printing presses alone are enough for the dollar bear to continue.
Exacerbating matters is the fact that while dollar supplies are relentlessly rising thanks to the Fed's unacceptable money-supply profligacy, demand is falling for a variety of reasons. Higher supplies and lower demand inevitably lead to falling prices on balance. Really the US dollar doesn't stand a chance of escaping its bear in this environment.
The biggest source of dollar demand which could raise its price is the foreign investors. But there are multiple problems on this front. Foreign investors, from individuals to central banks, are already up to their ears in dollar exposure. Rather than increasing their dollar investments, they are shedding them. Other currencies such as the euro and gold are gaining ground as foreign investors reduce their tremendously over-weighted dollar positions.
And these foreigners have plenty of great reasons to reduce their dollar exposure besides portfolio diversification. Foreign buyers of dollars are financing the great American consumption binge. This was fine when they couldn't find uses for their capital at home, but with the rapid industrialization of Asia why would they choose to finance giant houses in suburbia for Americans when they could instead invest in their own countries' growth?  Increasingly they are doing just this, choosing to invest at home rather than buying US bonds.
Another problem reducing dollar demand is Washington's increasingly aggressive imperialism. No one likes a busybody neighbor messing around in other people's business, and the more countries and people Washington irritates with its foreign adventures the fewer investors are going to want to buy dollars.
Incredibly Washington is even biting the hand that feeds, that keeps our economy afloat, by drawing hard ideological lines. "If you are not for us, you are against us!"  Such rhetoric is not the way to convince global investors to continue buying dollars. Increasingly not only are foreign investors getting irritated with Washington's empire-building behavior, but they are worried their US assets will be frozen and they will take a 100% loss if Washington decides they are "not for us". And even if they don't fear the rising expropriations in the US, they know that their US investments finance the imperialism they so hate. So why buy dollars?
Regardless of your opinion on Washington's policies of late, you have to admit that its chosen course is not winning the hearts and minds of major foreign investors around the world who can bid the dollar higher. There are already many reasons why global dollar demand is waning including portfolio diversification and competing investments at home, so adding political reasons to reduce dollar exposure will only deepen and prolong this bear.
Interestingly it is commodities that are the biggest beneficiaries of secular dollar weakness. The lower the dollar goes in world markets, the more the dollar-price of individual commodities rises. This leads to much higher dollar profits for commodities producers.  As such, if you want to avoid suffering in the dollar bear, the best places to park capital to preserve your purchasing power and even earn awesome real gains is in commodities and the elite commodities producers.
Due to the sharp commodities weakness of late we are taking advantage of this temporary countertrend move to add a bunch of positions in elite commodities stocks with vast potential. Our existing and newly-added trades are outlined as always in our acclaimed monthly Zeal Intelligence newsletter. And if market conditions continue to cooperate, we expect to add more great trades soon. Please subscribe today so you don't miss these dazzling opportunities!
The bottom line is even though the US dollar has traded sideways on balance for the past couple years, odds are its secular bear remains very much alive and well. Relentlessly growing dollar supplies thanks to the Fed's printing presses coupled with a variety of major reasons why international investment demand for the dollar is waning point to continuing dollar weakness in the coming years.
Although we Americans have few refuges from an ongoing dollar bear since our world is so dollar-dominated, commodities tend to thrive in such environments. The devaluing dollar raises the local price of commodities leading to higher profits for producers. These profits tend to rise far faster than the dollar declines leading to great outperformance in the commodities sectors.
Adam Hamilton, CPA

October 27, 2006

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