Review and Dollar Update: Countertrend Conundrum, or Destined Demise?

A brief recap for the new readers.  Our key thesis is that we're in secular bear market in stocks and a secular bull in commodities, and that those markets are behaving exactly in line with the movements of the US dollar.  All of our Technical articles are based on this premise, and we use a variety of in-house models to determine what is likely to occur next in this process, that are based on a combination of economic theories, fundamental analysis, historical precedents and cyclical behaviors.  Of course, we use short term technical indicators to determine if we're on the right track in the short and intermediate term.  The long term is generally a known, the short term is a gamble, and the intermediate term gives us the main trend that we work with to ensure that our model is behaving.  In essence, the model (or actually models) are projections of what could happen, the intermediate term indicators tell us if the model is working or something else needs to be taken into account, and the short term technical analysis points to what is likely to occur in the intermediate term (short term trends may evolve into intermediate and long term trends....).  We encourage you to read the Education section for more details on the models and our methodology.


Central to navigating the waters is the action of the US dollar.  Thus, the dollar is the primary focus of most of our analysis as the leading indicator of what will occur in other asset markets.  Most all assets are moving inversely to the dollar's actions, as measured on the US dollar index (and our own internal variant, charted several times below).  In the big picture, we believe the US dollar, and perhaps all fiat currencies, are in major trouble during the course of this secular bear market.  This is primarily because the entire global monetary system is based on a promise to promise to pay with promises.  It is, in essence, based on nothing but goodwill, which is likely to be in increasingly short supply moving forward.  At the same time, the consumption engine of the world--the US consumer--is tapped out creating major recessions in many parts of the world and likely depressions in the US, and most likely Europe.  We stand on the edge of a major shift in global sentiment with the possibility of a rising Asia and sinking West.  This is history in the making, and we're going to show you something you should watch carefully.

Market fundamentals are poor, but we have rising markets as the US dollar falls.  At some point, this trend will have to stop, but until then, a falling dollar generally means rising asset prices, and increasing global monetary inflation is sure to buoy prices across the board over time.

The global risk level is high right now, and likely to get higher as the US dollar falls.

Big Picture - USDX
Let's see where we are.  First, we'll slice and dice the history of the USDX.  The black, dotted line is the one we're concerned with and is our own "smoothed" version of the USDX from inception to present.  It closely tracks the "Major Currencies" and "G-10" data.

Next, note the red downward, linear trendline (derived mathematically, not drawn by hand).  That's the linear trendline of the USDX since 1971, which is the best graphical description of the dollar losing purchasing power (you will note that most all fiat currencies follow this general trend to one degree or another).

Note that there is a cyclical behavior to the dollar (as with most things)...

 

You can see the substantial, almost parabolic rise of the "credit crisis" of 2008/2009 show up on the chart.  Note that credit crisis afforded the dollar the opportunity to "touch" the trendline, and then fall back below it.  Also note how long the dollar tends to stay below the linear trendline--in each case, the dollar was below trend for approximately 10 years, from 1972 - 1982, 1987 - 1997, and most recently, late 2003 - present.  Conversely, the dollar stays above the linear trendline for 5-6 years.  Assuming we stay on trend, the dollar should rise above trendline in late 2013 or early 2014.  That begs the question, when should we look for a bottom in the dollar in a typical period such as this?

Note the dotted green line that is a 6th degree polynomial trend for the USDX.  Note that although it is trending down, it has a cyclical nature to it where it rises above the trendline and then falls below it.  This polynomial trendline should tell us when the dollar will bottom and begin to turn up--if this secular bear is like the others.

Note that in the above chart, we extrapolated the linear trendline and created a horizontal trendline that is tangent to the lowest point of the polynomial trendline back in 1974 (the lower red trendline).  This, what we call the "Must Hold" trendline, is the furthest point of deviation on the polynomial trendline from the linear trendline.  Note that it nicely marks the lowest points in the dollar trend through the past 38+ years of the floating currency paradigm.  Any break below this trendline has been very, very temporary in the past (note that this is a daily chart).

Here's a closer look at this trendline on the USDX and some key cyclical points to keep an eye on.

 

In the chart above, we have some projections for a "healthy" secular bear period.  If the dollar is to continue in its long term, cyclical trend, it should rise back above the long term linear trendline (top red line) in late 2013 (where the USDX value will be approximately 82), or perhaps as late as early to mid 2014 (the cycle period is stretching over time).  It should bottom in early to mid 2012 at around 68 on the USDX.  That implies that we should see a gradual slide from 76 to 68 between October 2009 and May 2012, or 10.5% over 31 months.  Note that the current rate of decline is much, much faster than this, which is a warning in and of itself.  To correct this pattern and "stay on track" for a "typical" secular bear, we should expect another rally or two in the dollar over the next 3 years that are sharp and dramatic.  Otherwise, the risk of a dollar crash becomes substantial.

Why is this information important?  Because we simply always need to evaluate whether we're in a "typical" secular bear or if this is something different.  Fundamentally, most countries around the world are inflating their currencies away, and this has historically ALWAYS led to hyperinflation and currency destruction.  But the magnitude of the dollar bear market that we've seen so far is not out of alignment for a "typical" secular bear market, though we may be getting close to that danger zone.  As long as we remain within the trend projections above, we're in a "normal" down cycle for the dollar.  If we break those trends, notably we break the lower "must hold" trendline, then dollar holders likely have a very, very serious situation on their hands.

To reemphasize the accuracy, note how the dollar bottomed at the "must hold" trendline in early 2008.  This led to a vicious "credit crisis" rally, in which the dollar hit the 38-year, long term trendline and fell again.  These trendlines certainly seem to have a substantial track record and should be respected.  Conversely, if we break down below the typical behavior, that should be regarded as a MAJOR red flag.  Thirty-eight year old trends that suddenly end probably end badly....

So this leads us to the short and intermediate term trends that should tell us where we're going.

Intermediate and Short Term Dollar
What we typically call "long term" in our technical analysis, at least relative to the 38-year old trends we just reviewed, could better be called "intermediate term" in this case.

Here is an 18 month view of the USDX weekly chart, just prior to the credit crisis and just after.   Note that on a weekly chart, we are approaching oversold(but not there yet).  The last time that the dollar was oversold on the weekly chart, it bottomed for a few months and then rallied strongly (back to the 38-year trendline).  Note that the rate of decline on the RSI has increased since the second top in March (which, by no coincidence, was the beginning of the stock market rally).  The 200 week and 50 week moving averages are on a path to have a negative crossover, also known as a death cross, at the 82 level.  We are oversold on other, faster oscillators.  It is possible for the dollar to move down lower over the next few months, but we are probably due for a rally of significant size at that point (see our October 8 update).  If we do not see a significant rally, remember that things crash when they're oversold, not overbought...

Even shorter term, things are looking bearish--or is it a bear trap?

On this daily chart, the slow stochastic is clearly oversold, though the RSI shows more possible downside.  We have a descending wedge, which while a generally poorly performing pattern, may indicate a rally is coming.

A closer view shows the behavior around 78, where there was a 1.1% decline below the 78.33 level where the dollar recovered for a few weeks (aka, a false breakdown).  We need a daily close below 75 to ensure that this does not happen again.  As of this writing, the dollar appears to be having a minor recovery from its lows and the chance of a return back above 76 is a possibility.  We can see that 75 marks the point where a false breakdown (1.1% from the 75.83 level) may cause a rally, and the point where the descending wedge would break to the downside.  75 is the key daily level to watch.

Note that most all other assets, notably gold, are overbought and have been for some time.  It is risky to enter new positions there, though over time gold is probably our favor asset (for the next few years, anyway).

Summary

We stand at an important crossroads here.  72 on the USDX is certainly in the cards as a result of the double top formation.  Some downside targets put a low for the double top of the dollar at the 67 level.  If we look at our present situation with a wider lens, we can see that the 67 level would be a strong indication that the dollar is in very serious long term trouble (68 by .  Our rate of decline in the USDX is also very troubling.

A close below 75 on the daily chart, or as we stated last week, a close below 75.50 on the weekly chart indicates a rapid acceleration toward 72, with a possible pitstop at 74 (especially if we decline here without a minor rally).  The ceiling on the minor rally should not exceed the 50 day moving average, which is 77.45 at this time.  A major rally, again which we would expect to see beginning at the 72 level, would not exceed the 38-year trendline.