09 September 2008

Dollar Musings and the Potential for a Significant Stock Market Decline

What to make of this US dollar rally?

The fundamentals are decidedly negative, looking at the Trade Balance and Current Account Deficit, despite the case many make that we are 'better off' than Europe.

Our take is that the dollar is much worse off because it has been the world's reserve currency for the past thirty years or so and that is unwinding, in addition to the slumping economy and ballooning deficits. There is really no good fundamental reason anymore for two countries to conduct their trade in a third country's currency, and to maintain a reserve in it for those purposes.

Arguments about this can go on almost endlessly tit-for-tat since there are so many variables and exogenous factors, and too many degrees of freedom to make an objective short term projection with a high level of confidence.

So let's do what we always do when we are in a position of uncertain outcomes, and try to decide what to look for and what data might be important to help us come to a better understanding. For us that includes some charts.

The last sustained rally we had in the dollar ran almost the entire length of 2005, starting on New Year's eve in 2004.

Here is what it looked like.

That was a classic bear market rally. It had duration, and the overbought condition never reached extremes for any extended period of time. It was sustainable.

The funds were leading the buying to the upside, as they always seem to do in the Dollar Index market. We are very aware that this is only a narrow snapshot of their overall positions, and will very likely be more predictive than causal.

Nevertheless, however it works, the funds are the price leaders in this market, and the commercials make the market for them.

If you look at the 2005 dollar rally period on the funds' Commitments of Traders chart below the net long positions are obviously built over time to a top.

In this latest rally the net longs of the funds soared quickly to a near term record. The explanation for this has been the unwinding of trading pairs that favored commodities to the long side and the dollar to the short side. There is also some likely forced liquidation of positions from failing funds.

Here is what the 2008 dollar rally looks like so far on a price chart.

Anything can happen, we will gladly stipulate that. But how does this rally stack up so far in this particular market. Percentages help, so here is a chart of the dollar with some fibonacci retracement levels.

As it stands now this rally is remarkably similar to another short covering rally we had on the same leg down in this obvious bear market. From a probability point of view, admitting than anything is possible, until the dollar can take out the long term neckline and stick a close and hold it over 82 we think this is just another bear market rally. The Trend is the trend until proven otherwise.

We also believe that this dollar rally is at least partially due to a flight to quality in addition to a short squeeze and a likely central bank intervention. Dollars are coming home from emerging markets, and fleeing stocks and riskier investments. This is indicated by the Treasuries rally.

We have to remind you all that significant market declines or "crashes" are notoriously low probability events, and that people who predict crashes typically predict lots of things, most of which are incorrect and quickly forgotten.

We think that there is a heightened chance of a significant stock market decline that will start in the next thirty days. As we have previously said we are watching for a 'failed rally' hall mark in our model, We are almost there.

A likely target for clarification will be around the week of this month's option expiration on 20 September.

Keep an eye on the volatilty index or VIX. We put links to most of these charts on our site every day on the left hand section labeled "chart updates."

This may turn into or be linked with an "October Surprise" or a major bank failure.

Working against this is the desire of the G7's central banks to prevent a global market crash from dampening economic and monetary growth, threatening the world's banking system.

Or it may be something else entirely. But we now have a few more signposts on this difficult trail.