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This Time Is Different (In Reverse)
In past articles to explain the price action, I have defined the "this time is different" scenario. For example, at market tops we typically see negative divergences between prices and momentum oscillators that measure price. These negative divergences are indicative of slowing upside momentum and a point where traders are likely to look for the market to rollover. If prices continue to move higher despite the presence of these negative divergences, often times we find investors saying "this time is different" as prices accelerate much higher. Of course, I think the acceleration in prices is due to short covering as traders who where expecting the market to rollover are now forced to cover their positions.
The "this time is different" scenario can also work in the other direction too. At market bottoms, we often see positive divergences between price and momentum oscillators that measure the price action. As downward momentum slows (i.e., presence of positive divergences), traders will position themselves for the market to reverse and move higher.
What happens if the market doesn't reverse? What happens if the market trades below those positive divergence bars? Just like we see an acceleration of higher prices to the upside, we can also see an acceleration of prices to the downside as traders unwind losing positions.
Why is this relevant? It appears that the Dollar Index, which is our key asset class that is driving all other assets, has closed below the low of a positive divergence bar, and this is a negative for the Dollar. See figure 1 a weekly chart of the Dollar Index (symbol: $DXY). Positive divergence bars are labeled with the pink markers inside the gray ovals on the price chart. The low of the most recent negative divergence bar is 78.23, and today's close is 78.08.
Figure 1. Dollar Index/ weekly
So let's ask a very simple question: what happens to prices when there is a close below the low of a positive divergence bar? To understand the dynamics at work here, we will construct a simple strategy:
1) sell short the Dollar Index on a weekly close below a positive divergence bar
2) buy to cover on a close above the 40 week moving average
3) buy to cover on a weekly close above the high of the positive divergence bar
4) slippage and commissions were not considered in the analysis.
Remember, this is the reverse of the "this time is different" scenario.
Since 1973, such a strategy had yielded 50 points in the US Dollar Index; buy and hold would have netted minus 18 points. There were 25 trades and 68% of these were winners. The average time in all trades was 14 weeks with winning trades lasting 18 weeks. Figure 2 is the equity curve from this strategy. Maximum equity curve draw down is about 25%, and the RINA Index, which measures trade efficiency (i.e., points gained v. time in market v. draw down), is a very high 248.
Figure 2. Equity Curve
To get an idea how significant the down draft may be in store for the Dollar Index let's look at the maximum favorable excursion (MFE) from this strategy. MFE measures in percentage terms how far a trade can go in your favor before it is closed out for a loss or a win. For example, look at the MFE graph from this strategy in the Dollar Index. Remember we are shorting the Dollar Index here. See figure 3. The green caret within the blue box represents one trade. This trade ran up about 4% (x-axis) and was closed out for a 1% gain (y-axis). We know this trade was a winner because it is a green caret.
Figure 3. MFE Graph
Out of the 25 trades from this strategy, 6 (or 25%) ran up greater than 9%; this is to the right of the blue line. 60% (15/25) of the trades ran up over 5%; this is to the right of the red line. So there is a 60% chance of getting a 5% move lower in the Dollar Index.
How does this set up - a close below the low of a positive divergence bar - compare with the strategy discussed in the article "The Dollar Index: Key To Market Dynamics"? In that strategy, a short position was taken on a weekly close below 3 pivot low points, and this strategy gave a signal 4 weeks ago.
Comparison probably isn't the right word here. Rather, the current strategy is probably best viewed as a continuation of the prior strategy. Both strategies have the potential to see the Dollar Index really unravel; this we know. In both cases, 25% of the trades had large MFE's; in both cases, over 60% of the trades had MFE's greater than 5%.
But here is the kicker: the current strategy sees those gains occurring over an 18 week time frame. Whereas the prior strategy, sees those gains occurring over a 65 week period. In other words, when there is a close below the low of a positive divergence bar in the Dollar Index, losses can accelerate. This leads to more efficient gains (i.e., if you are betting against the Dollar Index) as you make more money with less market exposure. As expected, the RINA Index, which is a measure of trade efficiency, is 30% higher with this strategy than with the original strategy.
So the current set up is like the "this time is different" set up but in reverse.
So let's briefly stop and summarize. The Dollar Index has closed below the low of a positive divergence bar, and I am expecting prices to accelerate lower over the next 4 months. A weekly close above the pivot low point at 79.46 would be a reason to re-evaluate this position.
To be complete in our analysis, the maximum adverse excursion (MAE) graph is shown in figure 4. If a trade lost (or had a draw down of) more than 2.5%, it had a high likelihood of being a losing trade. These are the trades to the right of the red line.
Figure 4. MAE Graph
So if the Dollar is going down, then everything else must be going up. At least, that is how it is working these days. Dollar down, equities get a lift; stocks rally on good news and bad as it doesn't matter. The Dollar is down! A down Dollar is good for commodities too; oil was up 4 days in a row. Even good old Treasury yields have benefited. Forget about equities, the 10 year Treasury yield was up 3.41% today. Yeah, it is sad, but it is what it is!
As far as equities are concerned, well I am starting to sound like a broken record: the market is overbought, oversubscribed (i.e., too many bulls) and has limited upside potential. "Where do we go from here?" is a refrain I often ask myself, and I am starting to think about what happens when investors rush for the exits. From a reward to risk perspective, this isn't my "cup of tea". The market remains range bound albeit we are at the upper limit of that range.
If the Dollar Index continues its downward spiral, then I would expect commodities, gold, and long term Treasury yields to out pace equities. As I have shown in the past, when the trends in these assets are strong, equities face a stiff headwind.
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At some point we are going to have to draw a line and demand our gov defend the dollar. What is occurring now is state sanctioned stealing! They are destroying the prudent savers and devastating those on fixed incomes in order to reflate their rich friends. This must stop!
What do you get if you cross a rabbit with "Pinocchio" ????
-A side shot of Erin Burnett when she's interviewing someone. This girl is all nose, no breast and her sense of humor is like a kick in the balls.
Her favorite "jocke" is about "the Hains bottom..." and about "pup.." these can only mean one thing: She is begging for anal sex!!!
Really going all out to make the case for a dollar collapse.
I'll take the opposite side of this as I have so many times.
Rally!
Trading is observation, thinking just gets in the way.
We're in a deflationary grip as shown by asset classes moving in lockstep.
This is going to continue for quite awhile until our 'collective' balance sheet is restored.
The Street is praying for differentiation, e.g., rising dollar and equities.
Usually the comment 'its different this time' is true only based on the length of the horizon you are examining.
One educational guess, both US and China would like to have roughly three year's time to solve problems, such as deflation force in US and 2.2 trillion USD reserve in China.
Just a guess, therefore, by then the USD should be all right.
I don't think this is a valid thesis. The bottom line would require the equity markets to continue to move up for 4 more months--we all know that the March lows in equities was a moonshot for the dollar. The flight to quality globally to the USD will not change overnight if we get a serious decline. It takes time to break down these patterns.
So to take your assumptions with more than a grain of salt, I would have to drop the correlation between equity markets and a falling dollar. It's too soon to be different in reverse. 1)The weakening Chinese economy will not behoove them to sell Treasuries, i.e. weaken the dollar due to their own lack of organic growth. 2) We are on the brink of a major decline in equity cycles and I have cautiously traded this rally with the ultimate understanding that bear market rallies are violent and cruel, and 3) the dollar will remain a safe haven for at least another year due to global calamity, black swan, resumption of the bear market that globally depends on the US consumer--it is not in the cards in terms of market psychology as far as I can delineate for a decline of the dollar of a serious magnitude for at least a year or two. To be clear--I am in the deflation camp for 1-2 years then moving on to hyperinflation after that. Anyone betting against the buck at this point in time might want to check their thoughts as to how far the violent retracement since the March low that has occurred in equities. Everyone that has been shorting the market since then has been crushed. Shorting the buck at this point could be just as painful.
Howard,
I fundamentally agree. I think that the end of OMO and Liquidity Swap withdrawal could be a catalyst. Not sure when, but fairly soon. Maybe the next 2 to 8 weeks.
On deflation, I think that this can last longer than anyone imagines. Maybe 4 to 5 years.
Honestly, I don't think that we'll know the catalyst until we wake up one morning with the market limit down. Until then, it is my strategy to sell the blips and cover on the dips.
Agreed.
Every punter trashing the USD, was in on it, heard sirens coming, bugged out. Ready for opposite side of trade (USD/EUR, long treasuries, short stocks) to year's end. Entry imminent.
Fed can't keep pumping equities & trashing dollar -> brings back the bond vigilantes -> Bond dump -> high yields -> more mortgage defaults.
Ignore distractions: mortgage debt still front & center for Fed -> *must* rescue yields.
OMO the soft option (locally) but leads to Bond dump. Fed will push China to brink of tolerance then terminate -> equity crash, deflation fear, flight to safety -> nice stick save for yields. Clever. I would do the same.
Next point. Euro banks low on USDs -> needed for balancing books before year's end -> big currency swap in the pipes, I smell US$400B. Repeat of 1 year ago to the letter. Bullish USD.
- Mediocritas
i have to 'agree' 95% with the 'posting' here, word for word parsing, even. i add, that in my opinion, with some basis i might explain, in a moment, the USA dollar 'will indeed remain a safe haven "for at least another year"
due to the reasons given in talking point #3 but more, the dollar will hold value due to 'supply and demand'
World Business, Trade and Transportation, the USA dollar; Business/Trade/market-wise will continue 'in demand' and 'short supply' (from China for instance who WILL NOT sell/dump). - that, in effect, there IS NO EXIT strategy possible from the USA dollar,
1) if World Trade is to resume the contracts for both material shipped and the shipping costs will be dollar denominated, and of course 'hedged' for the duration of the trade - say a few months per trade, where the deal is done, the dollar is out of the picture of course,
so USA dollar as a substitute for Gold shipments back and forth need be stable 'as a placemarker' of valuation, for just those few months
2) the total volume available of dollar denominated instruments that could be 'held' for those two month duration trades, say, in it various forms of 'promise to pay in dollars' has to be considerably higher than the $40 trillion CDS's already used daily to facilitate industry and trade short-term transactions -
especially NOW that massive amounts of additional perfectly legal representations to pay in dollars have come into existence - 'all promises to pay' that can be used to facilitate/tender 'valuation of the moment'
we cannot have the equivalent of post war Germany from May 1945 to mid-1948 'trading cartons of American PX cigarettes' to facilitiate World Business, a fungible and credible financial instrument must be in place massively and Internationally acceptible
3) the other possible currency choices, for World Trade, if aggregated in a basket might equal, say, just a bit more in total than the US dollar, but would be Balkan mix needing itself to be backed by yet another agency, perhaps the Bank for International Settlements,
prepared to underwrite, as third party, the 'value' of that basket aggregate, in the amount of at least the entire duration of that 'two months' promise to pay -
that could amount to therefore to about 17% of the entire notational amount of 1 years World Trade,
there is ONLY one 'institution' capable of THAT kind of third party underwriting = USA
Now i think that the ONE thing that precipated the March 8th 2009 rally, was the USA (Private Bank) Federal Reserve statement essentially saying 'the USA Fed will back any and ALL USA dollar denominated (and anchored in some real way to the USA banking system, in a third party manner obviously) representation of USA dollar 'promise to pay' instruments =>
=> this ONE statement quietly established, pro-temp the USA dollar as the World Currency, that is the RESULT of quiet agreement at G8, and then re-announced to the World via the Federal Reserve upon getting agreement within that organization,
announced just less than a Calendar week before 8th March 2009 -
DO NOT bet 'against the dollar' - the more debt the better, the more 'promises to pay' to circulate/lubricate, 'de-risk' permit a 'credible currency of transaction' for World Trade
continued, on same
4) any devaluation of the dollar 'against' other Trade Partner Countries, IN PARTICULAR will be 'resisted strongly' by those countries whose Trade Goods become 'relatively' MORE EXPENSIVE
In the USA 'market' (still the near-largest 'end-consumer-market') for instance, German Car imports, or Japanese car imports, would become MORE EXPENSIVE if the dollar was 'allowed to drop' -
the Chinese with their $2.2 trillion US dollars, have smarter Bankers than ours i think, and see WE HAVE THEM HOSTAGE, 'no exit' 'for at least a year' - so expect major currency market 'intervention' on behalf of the dollar, holding up the value of the Trade Dollar
Support the Dollar,thats what National Entities will do, to insure a place to 'dump' products, THIS IS THE STUFF of WARS old school style, Clausewitz 1832 (English Translation 1873) was talking 'rational waging of war' (which caught Hitlers attention - a rational old fashioned war for gain, and 'living space' for the breeding population)
for a more concrete exemplication here - <http://www.moneyandmarkets.com/intervention-threatens-the-loonie-2-35157...
interesting point, i'd read, from a seasoned currency trader - FOREX not random, its not even technical analysis,
it is KNOWING the INTENTIONS of the associated Central Banks -
and THEY BROADCAST THAT, you just join in and HELP those banks by going in the same direction....
the trader said, its really the most profitable trading vehicle (FOREX) he could find...sure, regular income! indeed the only vehicle that the small time 'trader' has half a chance 'winning'
The author points to a scenario in which the equity run up will continue. Why are you sure "the brink of a major decline" is now and not a bit later?
So this is the scenario that should have those of us (mostly) in cash concerned. If my dollars are devalued, it doesn't matter that we are experiencing deflation, I still loose.
And the technicals may be compelling too. However, in this case, I am taking the side of the fundies.
I think that a good argument could be made that the two fundamental causes of the current dollar downdraft are the OMO and the Central Bank Liquidity Swap reduction.
Remember, at the peak, the Fed had extended almost 600 Billion in swaps to about every major central bank out there - but as of last month there was only about 100 Billion outstanding. http://www.zerohedge.com/article/are-feds-radpily-disappearaning-cb-liquidity-swaps-crushing-dollar
So, in a nutshell, Bernanke has been slowly withdrawing dollars from foreign central banks - forcing the other central banks to sell dollars and buy back their own currency. Selling dollars forces up commodities (since all commodities are traded in dollars). And the Open Market Operations monetizing debt has the same effect (long debt = short dollars).
So the effect of these two activities at the same time has been very bearish for the dollar and bullish for commodities and stocks.
The question is, where are we now with respect to Liquidity Swap levels and OMO.
I know that OMO is due to wrap up soon...
investors? WTF dude, investors have been out for the better part of 09, this is a jukebox market. Get your wii and play.
I know. Someone hit SHUFFLE on the market machine. The randomness is getting boring.
bonds will not like this ..
long parsnips
". . . I am expecting prices to accelerate lower over the next 4 months. A weekly close above the pivot low point at 79.46 would be a reason to re-evaluate this position."
I anticipate that you will be presented with the opportunity to re-evaluate that position before the end of November.