Is it Still Contrarian When You Expect A Reversal?

This month I took a break from the normal routine to scout out investment opportunities on the ground in Mexico, literally. Luckily, while there I was able to track my long US dollar investments and even add to it after the new record trade deficit.

I don’t mind being a contrarian if my gut tells me to do it. In fact, it was a pretty straightforward trade to buy the dollar these past few weeks. Some of you may recall that we called for a THE FINAL low in USD to occur by the New Year. Today I will share with you our research and charts from November and December that led us to buy the dollar. Hopefully it will give you an insight into our methodology, which rolls into one the use of fundamental, technical, sentiment and Elliott Wave analysis.

The Dollar and Election Cycles

In September 2004 we published a study on the dollar and election years to rebuke those Wall Street analysts that were again rehashing the same tired reports about how the dollar would do this, or do that based on who was elected. We proved beyond a reasonable doubt that this was intellectually bankrupt and not worth reading. Instead, our research showed that seven of the past eight elections had coincided with a major dollar reversal within three months of the election. You can read this at www.fxmoneytrends.com. Therefore, in our mind there was a high probability of another major reversal considering that the dollar index was nearing key support at 80 after an intense three year long bear market.

Staying up into the night after Election Day it was interesting to see that once the race was decided, only then did the dollar begin to decline. This was completely at odds with the Wall Street houses that called for a mild boost to the greenback if George Bush was reelected.

Meanwhile, we knew that the odds heavily favored a major dollar reversal but our only concern was to know just how plausible it was for the dollar to have peaked when George Bush was elected in 2000 and bottom upon his reelection. That seemed almost to strange to be true.

Reagan is Like Bush, Except the Exact Opposite

Luckily, we noticed a precedent with Ronald Reagan. So to compare the Reagan experience with President Bush we regressed EUR/USD back to Reagan’s first four years and placed an inverted scale of EUR/USD for the first four years of President Bush. What we saw was a fascinating relationship between the two.

Getting Weird Looks From Gold Bugs

My presentation at the November 8 Traders Expo in Las Vegas focused on telling traders to begin buying the dollar and to not be long gold after the New Year. Initially this was met with a great deal of skepticism as nearly every trader we met was long EUR/UDD or long gold. The idea that the dollar could stage a significant rebound by the New Year, just as the inverse had been true after President Reagan’s reelection, seemed entirely implausible. Nevertheless, we showed traders what we believed to will be the most profitable trade of 2005 – Long USD.

In the chart above is what we showed traders would likely be the dollar’s bottoming process. Below is an update of the original chart showing the first four years of Reagan and Bush. We find it fascinating that the dollar is starting to rally, just as our comparison indicated it would.

Using Sentiment to Forecast Trend Reversals

The reason we felt so strongly back in November that this similarity between Reagan and Bush would hold up has to do with our analysis of sentiment data. On December 22, 2004 we were published in Futures magazine online calling for a major dollar rally based almost entirely on our understanding of how sentiment bottoms before prices do. http://www.futuresmag.com/marketwatch/archive/122204.html

We based this forecast on our research showing that sentiment usually peaks or bottoms well before the actual price top or low, giving way to a bearish or bullish divergence similar to momentum measures of the market. This is the same approach we use to look at stocks, bonds and commodities and why we called for a major top in gold at the November 8, Traders Expo in Las Vegas as well. http://www.fxmoneytrends.com/dx9.htm

Below is a chart of the dollar index and trader sentiment that we showed in Futures magazine online. It is important to see two things in relation to this chart. First, each new dollar low for the past two years has not seen a similar decline in sentiment. Instead, traders have become less bearish as the dollar declined. Second, sentiment spiked higher in late December despite no obvious reversal in the dollar. We immediately recognized this as the usual reversal of emotions before a market turn. Traders begin to sense the end of a trend and without warning sentiment measures begin to diverge against price before the market inevitably follows. The media and inexperienced traders are always the last to know.

Using Elliott Wave to Know Where You Are

Our final technical application is to use Elliott Wave analysis to try and gauge just where we are in the overall scheme of things. I do not profess to be an expert, but sometimes it is quite easy to label a chart if you have reassurance from other technical and fundamental measures.

Below is the same chart we showed in the December 22, 2004 article in Futures magazine online. Notice that we used both USD/CAD and USD/CHF to show slightly different looks at the same picture. Our forecast was for USD/CAD to pull back in an “ABC” formation in “wave 2” down before starting “wave 3” up. Our forecast for USD/CHF was slightly different in that we saw a typical “wave 4” consolidating triangle pattern that called for a final thrust to new lows in “wave 5” before staging a dramatic reversal.

The following week saw these markets perform just as expected, allowing us to buy dollars near their lows without any reservations. At this point we alerted subscribers to begin buying the dollar. Below is the a chart of USD/CHF from December 29, 2004 showing that the market had bottomed.

Not only did USD/CHF thrust lower in “wave 5” but USD/CAD made a deep “ABC” retracement in “wave 2” back to 1.1950, which provided an excellent opportunity to add to our longs. That this low occurred in the aftermath of a new record trade deficit did not dissuade us from our bullish stance. In fact we welcomed the continued bearishness.

Fundamentals Work If You Know How to Read Them

Having worked as a currency strategist on Wall Street for four years prior to launching my own research service, I am not overly prone to technical analysis to the determent of fundamentals. But I also know that the public is always wrong at the major inflection points. That said, here are the arguments we gave in our weekly research notes in regards to the fundamental underpinnings of a major dollar rally for 2005:

December 3, 2004: “With the Fed’s upcoming rate hike taking the Funds rate to 2.25%, deposit rates will be higher in the US than in the Eurozone. The US dollar will then pay more than the euro, franc, and yen, meaning that the carry trade appeal is quickly eroding. In addition, the RBA and BOC have both implied they will hold off on raising rates.”

“The implication therefore, is that the dollar’s steep decline against the majors is coming to an end, and possibly it will now begin to decline against the Asian currencies thereby bringing down the trade weighted dollar index.”

December 19, 2004: “President Bush’s comment that the US will do what it can to maintain confidence in the US dollar was also quite surprising and a signal to the markets to quit selling the dollar.”

December 27, 2004: “As we see it the dollar must rally soon to avoid a crisis of confidence. This predicament would send interest rates soaring in typical third world fashion. Recall that President Bush’s plea to the markets that his second term would instill more confidence in the dollar stands in stark contrast to the unpersuasive references to a ‘strong dollar,’ just months ago.”

January 2, 2004: “Recall that two weeks ago we published a study showing that the fifth week after a major low in sentiment the dollar rallied. With sentiment remaining near 30% after a one-day spike from 20% two weeks ago we are as convinced as ever that the low we have anticipated for months now has been reached.”

January 16, 2005: “Our seemingly contrarian forecasts have focused on the persistent two-year intermarket relationship whereby a rise in yields and the dollar sees a decline in stocks and bonds. Recall that one month ago we pointed out that President Bush practically pleaded with the markets in a well-scripted speech to not shun the dollar. The message was clear as day to those that wanted to listen.”

“Not only does the dollar now pay more than the second and third biggest economies of Europe and Japan but the Fed has now signaled that rate hikes might not be so gradual anymore. If you aren’t buying the dollar yet, you should.”

“Meanwhile, most foreign exchange analysts have concluded that the three-year downtrend in the dollar will continue in 2005. Of course, these analysts do not trade the markets, which is why they can confidently extrapolate the past into the future as if it were a straight line.”

© 2005 Jes Black
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