Why I Think The Dollar Has Bottomed

• March 25, 2005
• Mark Boucher

Tightening
Starting To Bite

For many weeks we have been
warning investors that Fed tightening and inflationary pressures would begin to
negatively impact stocks.  This week the Fed for the first time acknowledged
inflationary pressures and signaled that it may have to tighten more
aggressively.  Global markets finally clued in via a number of significant moves
and actions.

The dollar has likely put in at
least an intermediate-term bottom.  Sentiment reached an extreme that I can not
remember witnessing in the currency markets.  Newsweek and The
Economist both put bearish dollar front page illustrations on the cover. 
Markets focused on the current account deficit, but ignored rising US relative
rates, a much more consistent and reliable indicator of currency trends.  In
addition, investors need to understand that the trade reports do not properly
account for services exported.  If I sell my consulting services abroad, that is
not counted.  In a high-tech, high productivity world, the real trade deficit is
not nearly as bad as government statistics relate.   Many forex traders globally
sold the dollar in anticipation of disaster scenarios in the Middle East that
have turned toward more hopeful democracy movements, albeit with substantial
violent undertones.  Investors also focused on central bank diversification of
reserve announcements, many of which tended to be after the fact.   I suspect
that the long-run implications of the chronic current account deficit will
indeed remain a long-term bearish pressure on the dollar, but that yield
implications will begin to dominate until the Fed tightening begins to soften
economic growth in the US — meaning a substantial intermediate-term bottom in
the dollar (and intermediate term top in gold).

Long-bonds have started to
behave differently as well.  Since the 2002 bottom, whenever stock prices took a
hit, bond rates eased up in response, acting as a safety valve that prevented
further downside in stocks.  No more.  Now, due to heightened inflationary
pressure, bonds are not rallying as stocks fall, and bond rates likely will move
irregularly higher (though not markedly I suspect) until higher rates begin to
show evidence of creating sub-par growth economically.  Cyclical inflation
pressures seem likely to continue pressuring rates higher short and long as long
as economic growth is above potential.  Note however, that strong current
account surplus countries bond markets did not fall nearly as substantially as
US bonds — inflation is not yet a global problem.  Investors should realize that
it is not uncommon for some sort of financial accident to occur along with
evidence of weaker economic growth, before interest rates peak.  We may be in a
period similar to 1994, where the Fed is striving to engineer a soft-landing but
an accident signals that tightening is severe enough (in ’94 it was an accident
in the mortgage market and in Mexico).   Bond market sentiment hovers at nearly
60% bullish and usually falls to under 40% before an intermediate bottom.

Note also that many of the
leaders of the 2002-5 bull cycle are now very weak.  Emerging markets are
melting down.  Resources and gold are taking hits.  Financials in particular are
weak.  We expect financials to continue to underperform until the Fed eases up. 

Even the mighty commodity bull
market and energy leaders are finally taking a hit here.  We suspect oil will
fall to around 50 and commodities will fall to a range trade environment until
rate pressures subside.

 

The markets have broken clearly
through the levels I had indicated for signaling intermediate-term tops as
well.  Expect a correction of 33%-68% of the entire 2002-5 bull market to
develop. 

We continue to suggest a pretty
defensive posture for investors and traders and fairly even short/long mix for
those wanting exposure.  We still favor value/growth and outperformance by
defensive groups like health care (especially managed care and hospitals),
staples like CLX, with underperformance by financials, autos, and brewers. 

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 31, 37, 26, 37, and 14 with 10 breakouts of 4+ week ranges, one
valid trade in CHTT and no close calls.  This week, our bottom RS/EPS New Lows
recorded readings of 30, 26, 23, 27, and 36 with 13 breakdowns of a 4+ week
ranges, no valid trades and no close calls.  Valid signals remain in place in
LCAV and CHTT on the long side and JBLU on the short-side (exit BHP and lower
stops to lock in profit on JBLU).    Notice that the balance of top rs new highs
versus bottom rs new lows has shifted toward new lows this week. 

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 big part of keeping risk down and profiting consistently in the markets is
knowing when not to risk capital much.  Only investing substantially when the
odds are substantially in your favor is critical.  There are some relative value
themes that aggressive traders could exploit here, but most investors should be
mostly out of the market and awaiting better odds opportunities here.

Mark Boucher