My Latest Insights On The Dollar

• December 3, 2004
• Mark Boucher

Time to
Watch the Dollar

A virtuous circle is leading
global markets to continued growth that investors need to fully understand. 
China exports tons of goods to the US causing the US current account and trade
deficit to soar.  The US current account deficit is over 5%, usually a tipping
point for currency problems.  However the US current and trade accounts are
largely being funded by China and Japan.  The Chinese have excess savings and in
order to prevent their currency from rising they are purchasing US Treasuries
with some of their trade surplus and excess savings dollars.  Japan sops up the
rest of the US current account and is the largest purchaser of US dollar
securities.  This triangle keeps US interest rates low and the US consumer bent
on consuming cheap Asian imports.  Yet investors need to realize that this
virtuous circle cannot continue indefinitely — and when it eventually unwinds it
has the real possibility of turning into a vicious circle that will wreak havoc
on global markets.   The circle is unsustainable because eventually either the
US current account deficit will soar to such an extreme that it will drain the
US growth rate so much that the US sinks into a recession, or it will hit the
dollar so hard that bond prices will crunch and that will force the US into a
recession, or Asians will create enough inflationary pressures that they will
need to stop buying dollars to fuel the flames.  But once the cycle stops, there
is a real argument that can be made that the artificially stimulated rate of US
consumption demand will not reoccur for some time, and that the overcapacity
created to feed this demand will lead to economic pain in Asia as well.

Japan is particularly in a rut
in this circle.  If it were actually ever to let its currency rise to
market-determined levels, it is likely that the Yen would rise to a level beyond
that which the Japanese economy could handle — and with Japan still on the verge
of deflation and encumbered by an aging population that could be a very painful
adjustment.  So painful that we doubt Japan will avoid currency intervention to
keep the Yen low at some point, and we suspect they will continue to finance the
US current account deficit for the foreseeable future.  Currency intervention
leads to interest rate convergence among global economies — and this continues
to be a potent force for long-term lower interest rates and rotating stimulus. 
As long as Japan continues to hold down its currency, US interest rate pressures
will be heavily muted. 

Investors should note that the
US current account deficit was just over 3.5% of GDP in 1985 (versus 5.7% now)
when it last began to impact the dollar heavily.  It took a drop of 40% in the
trade-weighted dollar between 1985-1988 before the US current account deficit
began to correct.  Today the trade-weighted dollar has depreciated only around
17% since peaking in 2002.  In addition trade imbalances are usually not
corrected in a currency until it starts to become undervalued in PPP terms.  The
US dollar is still OVERVALUED in PPP terms (versus G-6 countries’ producer
prices), although it is now close to fair value.  Thus longer-term investors
need to understand that for the dollar to be the mechanism to correct trade
imbalances, it is likely to have to fall significantly further ultimately.  The
other mechanism that could correct the trade imbalance is if the huge difference
in growth rates between the US and Europe-Japan starts to close, meaning much
stronger growth in Europe and Japan relative to the US.  And in fact as the
dollar weakens, fear of too strong a currency in foreign countries is forcing
more accommodative liquidity conditions abroad — helping to fuel global stock
prices higher.

Some analysts are suggesting
similarities between the current dollar decline and the dollar decline in 1987
that preceded the stock market crash.  It is true that in both 1987 and today
there is an amazing complacency in the US about the slide in the dollar.  And
there are mounting tensions between US and European authorities today as well
regarding the current account deficits and dollar decline.  The key factor in
the 1987 situation that developed was that the US bond market began to be very
negatively impacted by the repeated dollar decline as global investors bailed
out of US bonds in a near panic.  The world is much less inflationary today and
the dollar is still fairly valued.  In addition Asia’s interests lie in
preserving the US bond market.  The backlash phase of the dollar decline is not
yet developing ala 1987 — though it bears close watching.  If bonds start
declining in earnest, 1987 could repeat.

These are some of the pressures
fueling the decline of the US dollar that has been so prevalent in global
markets since global stock markets began their recent rally.  The dollar is at
previous sentiment and momentum extremes as it continues to drop faster than
many global authorities would want. 

The dollar is nearing 80
support, while the Canadian dollar and a host of currencies are also reaching
fairly long-term support levels 5% or so from here.  This comes at a time when
the dollar’s decline has been too swift for the comfort of many global central
bankers.  Greenspan further unwound the market with comments at the G-20 meeting
in November, in which he bashed the US chronic current account deficit and
emphasized that the currency will weaken at these deficit levels.  No G-20
coordination may push the dollar down to new lows.  However the Yen is now in
the 100-105 region where the Japanese have defended with intervention in the
past.  The Japanese economy is not on firm enough footing for Japan to let its
currency explode unabated.  Other Asian currencies have exploded as well.   Some
European officials are also discussing intervention against the dollar’s
collapse.  Most probably, at some point between here and 80 in the dollar,
intervention will begin, and a correction in the dollar’s slide will develop.

Investors also need to start
watching carefully the bond market’s reaction to events in the foreign currency
markets.  There is some evidence that the dollar’s decline is starting to spook
the bond market.  An orderly dollar decline is bullish for the market — and
likely to allow bonds to avoid a resulting decline.  But too swift a decline is
undesirable — and the swiftness of this dollar decline could hit bonds, which
would in turn hit stocks.  More tradeoffs in this story may make market gains
more volatile and less consistent in the period ahead. 

Investors need to watch the
movement of the dollar and currencies and its impact on bonds and stocks
carefully in the period ahead.  Global equities will likely continue to rally
until bond markets riot.  A sustained decline in bonds should be taken as a
warning to run for the exits in equities.   Realize that an unstable foundation
for this rally has been built and that some time in 2005-2006 it could swiftly
fall apart to the detriment of global markets.

Our model portfolio followed in TradingMarkets.com with specific entry/exit/ops
levels from 1999 through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in
2001, 7.58% in 2002, and we stopped specific recommendations up around 5% in May
2003 (strict following of our US only methodologies should have had portfolios
up 17% for the year 2003) — all on worst drawdown of under 7%.   This did not
include our foreign stock recommendations that had spectacular performance in
2003. 

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 155, 192, 148, and 193 with 28 breakouts of 4+ week ranges, no
valid trades and no close calls.  Breadth is expanding again and more close
calls would be a call to add some long exposure.  Position in valid 4+ week
trading range breakouts on stocks meeting our criteria or in close calls that
are in clearly leading industries, in a diversified fashion.  This week, our
bottom RS/EPS New Lows recorded readings of 0, 1, 0, and 1 with no breakdowns of
a 4+ week ranges, no valid trades and no close calls.  We’re seeing a growing
number of valid breakouts, though this is not a gung-ho environment.  Valid
signals are in place in MLI, VIP, KMRT, GBX, and BHP.  The rally is picking up
and so is our allocation, though investors should be aware of possible headwinds
looming as discussed above.

For those not familiar with our long/short strategies, we suggest you review my
book

The Hedge Fund Edge, my course “The
Science of Trading,”

my video seminar, where I discuss many
new techniques, and my latest educational product, the

interactive training module. Basically,
we have rigorous criteria for potential long stocks that we call “up-fuel,” as
well as rigorous criteria for potential short stocks that we call “down-fuel.”
Each day we review the list of new highs on our “Top RS and EPS New High List”
published on TradingMarkets.com for breakouts of four-week or longer flags, or
of valid cup-and-handles of more than four weeks. Buy trades are taken only on
valid breakouts of stocks that also meet our up-fuel criteria. Shorts are
similarly taken only in stocks meeting our down-fuel criteria that have valid
breakdowns of four-plus-week flags or cup and handles on the downside. In the
U.S. market, continue to only buy or short stocks in leading or lagging
industries according to our group and sub-group new high and low lists. We
continue to buy new long signals and sell short new short signals until our
portfolio is 100% long and 100% short (less aggressive investors stop at 50%
long and 50% short). In early March of 2000, we took half-profits on nearly all
positions and lightened up considerably as a sea of change in the
new-economy/old-economy theme appeared to be upon us. We’ve been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally.

A playable rally is upon us.  Enjoy it but realize it is not likely to last as
long as normal.  Remain nimble and enjoy the good times while they last, but
don’t be afraid to take profits quickly.

Mark Boucher