The US Dollar Bear
Adam Hamilton April 11, 2003 3144 Words
Since the mighty US dollar is the de facto global reserve currency, its trading behavior is exceedingly important for investors and speculators around the world to monitor.
In many ways the US dollar has become the central linchpin of the entire global economy, including both financial markets and international trade, so it is difficult if not impossible to overstate the importance of the dollar to the world financial system today.
While investors and speculators basing out of other countries are ever cognizant of the fluctuating tides of fortune driving the dollarís value as a currency, we Americans all too often take the dollar for granted and totally ignore its trading behavior. Most Americans, having spent their whole lives in a dollar world, donít even consider the potential impacts of dollar trading on the US markets and economy.
Yet, the dollarís performance in the international currency markets has absolutely enormous implications for American and foreign investors and speculators alike. The dollarís behavior has dramatic effects on the equity markets, bond markets, interest rates, commodities, and international trade in the United States.
The more that I ponder the dollar, the more that I realize how deeply it affects so many other critically important markets in the States and abroad. Every dollar-denominated financial market or asset on Earth today is both connected with and vulnerable to the fate of the US dollar in the international currency markets. As such, all investors and speculators need to stay abreast of dominant dollar trading trends.
While the US dollar spent all of the late 1990s, the bubble years in US equities, in a magnificent bull market, today the dollar languishes in a powerful primary bear market. As investors in US equities have been learning the hard way in the past few years, investment strategies that work smashingly well in a major bull market are suicidal in a bear market.
Why can I make the assertion that the US dollar is now in a primary bear market? Easy, the dollarís recent technical behavior fits the classical definition of a bear market perfectly! If it walks like a bear, growls like a bear, and mauls like a bear, then itís probably aÖ
A bear market is simply a persistent downtrend lasting longer than one year marked by a long series of lower interim highs and lower interim lows. Some folks also like to go a little farther, claiming that a 20%+ total loss over the same greater-than-one-year timeframe is also necessary for induction into the pantheon of formal bear markets.
While this 20% number seems a bit arbitrary in my opinion, there is no doubt that the one-year-or-more time component is crucial. Any financial-market trend lasting less than a year is probably merely an emotionally-driven speculatorsí game. Until a dominant trend can flex its muscles unopposed for a year or more, it is dangerous to consider it something more than temporary. As an example, the powerful countertrend bear-market rallies in the NASDAQ typically flare up intensely for only 6-8 weeks or so, while the primary downtrend has run for 37 months straight!
The single most popular way to measure the dollarís value in the world today is without a doubt the famous US Dollar Index. The US Dollar Index is a futures contract that trades on the New York Board of Trade. Futures and futures-options speculators around the globe relentlessly trade these US Dollar Index contracts to actively speculate on the US dollar.
The US Dollar Index is valuable not only because it is popular, but because it compares the US dollar to a basket of global currencies rather than just one. Today the index consists of a trade-weighted geometric average of six currencies. Currently the European euro dominates the index with 58% of the weight, the Japanese yen comes in second at 14%, the British pound 12%, and the Canadian dollar at 9%. The remainder is divided between the Swedish krona and the legendary Swiss franc.
These weightings change periodically, just as the components of major stock indices change over time, but the US Dollar Index remains a fantastic way to monitor the US dollarís performance as a whole in the global markets. I suspect that the Chinese yuan will eventually be included, especially if the massive emerging economic power of China is combined with the worldís first major gold-backed currency in decades. A golden yuan could rapidly dominate Pacific and Asian trade and would have to be included in the US Dollar Index.
With the US Dollar Index being volunteered as our chosen measuring rod, the new primary bear market in the US dollar is quite apparent. All the graphs below show the US Dollar Index, and for the remainder of this essay I am going to use the terms ďdollarĒ and ďUS Dollar IndexĒ interchangeably.
Our first graph this week not only highlights the dollarís bear, but shows a provocative comparison with the flagship US S&P 500 equity index. The behavior of the dollar in global currency markets intimately affects the performance of the S&P 500, one of many reasons why American investors and speculators need to pay very close attention to the dollar!
A dollar primary bear market? Charts donít lie! The dollar topped in early July 2001 around a dollar-index level of 121 before it began plummeting sharply. The dollar soon regained its composure and started marching higher again after 9/11, ultimately climbing to 120 by January 2002, a slightly lower high. These two highs together formed a massive technical double top, which is shaded in blue on the graph above.
Fast-forward to March 2003, mere days before Washingtonís annexation of Iraq was scheduled to commence. The dollar closed below 98, a level not witnessed in over three years. The dollar has carved an unmistakable downtrend for 21 months now since its top, well over the classic greater-than-one-year bear-market-induction criterion.
Since currencies, especially globally important ones, tend to move at the blinding speed of cold molasses, the dollarís steep downtrend since its secondary top is particularly ominous. This blisteringly fast fall in the dollar is readily apparent above. Provocatively, the recent war rally in the dollar on the US invasion of Iraq only managed to carry it back up to its top resistance line of this sharp downtrend channel, and no farther. Since the dollarís rally failed at this major technical level, odds are the dollarís war rally is already over.
From its ultimate top to its latest pre-war interim low, the dollar has already fallen over 19% on a closing basis. I realize this isnít quite the magical 20% number some technicians like to see in order to declare a primary bear market, but it is close enough for me. If you are keeping score at home, we need to see a US Dollar Index close under 96.7 to officially hit the 20% hurdle. If the steep downtrend above holds, this pivotal psychological event wonít tarry too far into the future.
A 19% dollar decline over 21 months? Itís hard to deny that this is definitely primary bear-market material!
In addition to the dollarís unambiguous bear-market downtrend, the dollarís high correlation with the US equity markets is very interesting. In the graph above, especially during the last few major S&P 500 bear rallies and subsequent downlegs, the dollar tended to move in lockstep with the equity markets. Major dollar interim tops occurred near the major interim bear-rally tops in equities, and major dollar interim lows closely coincided with major interim V-bounce lows in stocks.
Intuitively this high correlation makes sense. When foreign investors seek to deploy their surplus capital in the States as an investment, the primary destination of this capital is the US stock and bond markets. When stocks are going up and everyone is happy, demand for dollars increases as foreign investors sell their local currencies to buy dollars to use to buy US stocks. Increased dollar demand drives up the international price of the US dollar.
Naturally this relationship holds in bear-market environments too. As foreign investors already invested in the US equity markets watch the US stock indices plunge, they rapidly grow nervous. Not only do they face the equity loss that we Americans face, but foreign investors have to add a currency translation loss on top of that too! So, as the stock markets fall foreign investors want out so they sell their US stocks for dollars and then sell these dollars to buy back into their own local currencies. Increased dollar supply drives down the international price of the US dollar.
So ultimately the endless psychological ebb and flow in short-term equity trading helps drive global demand for US dollars. While I suspect that the stock-index behavior dominates this relationship, the dollar adds feedback into the loop too. A perfect example of this phenomenon is unfolding right now.
If you examine the lower-right corner of this chart, you will note a sharp slide in the dollar since the latest interim equity-market top in late November. Between the November equity top and the March 21st war-rally interim top, the S&P 500 lost 4.6%, the modest total pain that American investors have felt in this major S&P 500 downleg so far.
The US dollar also fell 4.5% between these same interim tops. While American investors are down 4.6%, foreign investors are down 9%+ when their currency losses are added to their US equity losses! A 9% loss in foreign-currency terms in the S&P 500 from interim top to interim top over only 15 weeks or so is pretty hefty. Foreign investors fully understand this and some will no doubt decide that enough is enough and sell their US stocks, putting farther downside pressure on the US equity indices.
While subtle, it is also provocative to note how the dollar led the final V-bounce stage of the last two major S&P 500 downlegs in the chart. Like our current S&P 500 downleg today, the dollar began to fall sharply while the downslope of the early equity downlegs still remained moderate. The dollar seemed to lead the waterfall plunges leading to the characteristic equity V-bounces, as if foreign sales of US equities reinforced a downward spiral in stocks leading to ever more foreign and US selling.
The same thing is happening today, which is another reason why I still think another brutal S&P 500 waterfall decline is rapidly approaching. While the downslope of US equities has been moderate thus far in this early downleg, the US dollar has already fallen sharply which may once again prove to be a harbinger of much more general selling approaching in the near future. As the war rally euphoria continues to fade, the probabilities for a rapid decline in both the dollar and US equities continue to increase daily.
The foreign capital that the American markets so desperately need to attract is not foolish and does not like being squeezed by both falling US stocks and a falling dollar. These rapidly compounding losses are almost certainly going to lead to increased selling of US stocks and dollars by foreign investors seeking to flee the ongoing US financial carnage.
With US stock markets so heavily dependent on foreign capital flows, American investors and speculators need to carefully watch dollar trading and monitor the unfolding primary dollar bear!
In addition to intimately affecting capital flows into the major US equity indices, the international dollar price is also very important to the US bond markets. Our next graph shows the US Dollar Index graphed with real interest rates, highlighting the powerful correlation between the dollar and returns in the bond world.
This comparison between interest rates after inflation and the dollar price is quite provocative as well! The strong correlation zones between real interest rates and the dollar are shaded in blue above. When real rates were healthy in 2000 before the foolish Greenspan Gambit attempted to bail-out stock speculators and reignite the doomed NASDAQ bubble, the dollar was in a strong primary bull market.
As the Fed began to viciously slash the rates of return that both American and foreign investors could earn in short-term Treasuries, the US dollar topped as supply and demand matched reasonably well. For over a year there was a time of indecision as investors were on the edge of their seats waiting to see if the Fed would really drive real rates negative to their lowest levels since 1980. Sadly following right in Japanís footsteps, the US Fed pulled the trigger and carried out its mortal threat to short-term bond investors.
As soon as real rates of return after inflation began to plunge due to active Fed manipulation of short-term interest rates, the US dollar decline accelerated dramatically. Now any foreign (or American) investor will actually lose 2% of their purchasing power each year by merely holding 1-year US Treasury Bills, a sorry state of affairs. Naturally the global demand for the dollar is dropping as foreign investors flee from this predatory inflationary stealth tax on savers.
Just as the declining equity markets are accelerating the dollarís slide, so are declining real returns in the US bond markets. Foreign investors are less willing to hold US bonds and finance the incredible debt binge in the States if they are going to lose real purchasing power because of inflation. As some of them start to sell and repatriate their capital back into their local currencies, the dollar decline will accelerate leading to even larger losses for the remaining foreign holders of US bonds. As they start to sell in ever greater numbers, the implications for todayís red-hot bond market are profound.
Watching the dollarís trading and dominant trend is very important for American bond investors and speculators because any widespread foreign selling will crush the prices of bonds and lead to rising longer-term interest rates, which could spawn a vicious cycle leading to a catastrophic bond bloodbath.
As these comparisons between the dollar and both stocks and bonds illustrate, a falling dollar is bad news for all US intangible financial assets. The falling dollar leads to greater total losses for foreign investors which causes them to sell, driving down the dollar farther. This in turn magnifies the total losses for the remaining foreign investors in US financial markets and begets even more selling. Welcome to the dollar bear market!
While a falling dollar hurts intangible paper assets, hard assets like gold soar in primary dollar bear markets. As our final graph illustrates, each major downleg in the US dollar helped accelerate a major upleg in gold. While most US investors have suffered tremendously in the past few years, gold investors are blessed to be growing rich riding the new bull market in the Ancient Metal of Kings.
While the dollar is bumping its upper resistance line after its fleeting war-euphoria rally, gold is trading right in its secondary support zone. For over a year now gold has tended to charge higher after spending some time near this support, a very bullish omen for gold investors in the months to come. While US stocks and bonds will suffer with the dollar bear, gold will be the primary beneficiary of dollar weakness and its bull market will continue to dazzle.
So far in goldís bull market to date the best way for investors to play it has been in quality unhedged gold stocks. Gold stocks have shown spectacular leverage to gold on the order of 5-to-1 since the US dollar topping process began. This means that, in general, for every 10% gain in the price of gold, unhedged gold stocks have managed 50% gains over time. I fully expect this awesome strategic leverage to gold to persist as the dollar bear continues helping to catapult gold prices higher.
If you are interested in knowing into which elite unhedged gold stocks my partners and I just recently redeployed our own capital for the next dollar downleg/gold upleg, please consider subscribing to our acclaimed Zeal Intelligence newsletter for full details. It is still a great time to buy these gold stocks before the war rally euphoria fades and the primary opposing trends of the dollar and gold reassert themselves with a vengeance.
Interestingly, major dollar bull and bear markets in history tend to run for 5-7 years or so. The last major US Dollar Index low occurred in mid-1995 in the low 80s. It ran for six years until mid-2001. Our current primary dollar bear today is also likely to follow this historical currency rhythm, running for 5-7 years after it started in mid-2001. This gives us a conservative dollar-bear-market ending timeframe around 2007 or so, quite a ways into the future from here!
As a mere mortal who cannot see the future I certainly have no idea if todayís dollar bear will really last this long or how low it will go, but I strongly suspect that this dollar bear has quite a ways to run yet. If it behaves like past dollar bears, it will probably plunge about 40% in total to a US Dollar Index level around 72-73 before it fully runs its course.
The overall implications of a primary dollar bear for the US financial markets are staggering. Without an enormous influx of foreign capital into the US each year, Americans will actually have to start saving for themselves rather than paying foreigners to do it for them. Total demand for both US stocks and bonds will decline, extending the Great Bear market in stocks and spawning another bear market sooner or later in bonds.
In such a surreal and dangerous environment, there are not many safe destinations for capital left. Folks buying the major US equity indices today when the S&P 500 is still trading above 22x earnings and only yielding 1.85% after a major bubble burst are falling prey to madness and will ultimately pay a heavy price for their lack of discretion.
At the same time placing long-term core capital into the bond markets with interest rates at anomalous and unsustainable 45-year lows is foolish as well. I recently saw a news item detailing a survey where 70% of American bond investors had no idea that rising interest rates could cause them catastrophic losses of principal as their bond portfolio is gutted. Unreal!
When a primary dollar bear is combined with a brutal equity Great Bear and a coming bond bear once interest rates inevitably respond to the Fedís massive monetary inflation, for my money the best place to park long-term capital today is in physical gold and quality unhedged gold stocks.
Since all financial markets are cyclical, the time to sell gold and buy undervalued stocks and bonds once again will come someday, but for now the dollar bear is the dominant force exerting immense selling pressure on US financial assets. Only gold will continue to shine in such a difficult environment!
Adam Hamilton, CPA April 11, 2003 Subscribe at www.zealllc.com/subscribe.htm