In our last public update we said we were closing our long gold and AUD/USD positions and looking to buy dollars again. We have had to wait on the sidelines for the past two weeks, but the dollar index appears to have finally bottomed at the exact 78.6% (square root of 61.8%) retracement of the January to February rally. Since the dollar trade is simply one part of the overall holistic approach we take with the market, in this update we will show why the current backdrop in oil, bonds and euros is similar to that of October 1998 and what to expect going forward.

Readers may recall that on December 13, 2004 we made the case for a rebound in crude oil, and added that traders not comfortable in the futures market should look to get long XLE, the energy iShare. Below is the same chart we showed on 12/13/2004.

Readers may also recall that we showed a relative strength chart of the OIX:SP500 and said it pointed higher. Since then we have experienced a "blowoff" style top in that ratio. In our chart below we show similar blowoffs in the OIX/SP500 ratio and the corresponding tops in the oil index. Note that the average decline in oil stocks after the blowoff top was about 30%. As such we have exited longs and will look to buy again after the coming retracement.

So, while we remain long term bullish on the sector, our call from last December to climb aboard the oil rally (crude and oil stocks) is no more. We now advise taking profits off the table.

When oil stocks run swiftly ahead of financial stocks, any market watcher should take notice. The recent surge in the ratio between oil stocks and financial stocks is the greatest since October 1998 so we feel it warrants a brief discussion of that turbulent time in the markets.

In the chart below we show the oil/financial stock ratio followed by the T-bond and the euro in 1998. Note that in many cases a falling dollar and falling yield environment can be very bullish for financial stocks - like they have been for the past two years. But this is not the case when the falling dollar and low yields work their way into runaway oil prices. As you can see below, the surge in the oil/financial stock ratio occurred amidst a sharp rise in oil prices, bonds and the euro/dollar. But this was quickly unwound.

Recall that the Canadian dollar is tied to oil and commodity prices in general. Here we quote from a Bloomberg story written last week: “Yesterday the Canadian dollar rose 1.4 percent to 82.45 cents; the two-day gain is the biggest since October 1998.” Whenever a reporter draws reference to something "big" that happened in the past but does not tell what immediately follows we look it up. As you can see, in the chart above the EUR/USD crashed between October and December 1998, then continued to decline in 1999.

Admittedly, the financial backdrop in late1998 was completely different than today, but if we ignore the fundamentals and follow the 1998 market action as an example it says that oil and the euro are headed into major tops.

So as crude oil nears our target of $60 - which we called for back in December - we are fascinated by the similarity between now and late 1998. Recall that in numerous updates we have said that at rally to $60 would likely coincide with a major stock and bond market top and rebound in the dollar – or decline in the euro. In the chart below we show the likely price action in these markets over the coming weeks to months.

Our forecast relies on the premise that the entire stock and bond market rally has been a mirage of sorts as a falling dollar simply ‘inflated’ the global markets. But as long as the Fed thinks growth is strong it should keep raising rates this year. This will drain liquidity from the market and the reflation trend should reverse. As such, our view remains unchanged that the ‘reflation trade’ is on its last legs. And if that is the case the main driver of the reflation - the US dollar -is poised to rally.

Therefore, we are still fascinated with the overt bearish talk surrounding the dollar. It seems that currency traders are unabashed in calling for a fourth consecutive year of decline in the dollar. Even award winning economists now chime in about why the dollar must fall. Leave it to an economist to explain the obvious. Recall that in 2001 they still gushed about the dollar.

We distinctly remember the same bearish talk in early 2003 as the stock market was holding above its 61.8% retracement of the 1991 to 2000 rally at 775 in the SP 500. The bears said there was much more downside to come and that an “unprecedented fourth year of decline” was not really that significant considering we were coming off of a bubble.

But the 775 level provided the springboard for a bottom in stocks. Similarly, the dollar index bottomed three previous times around the 80 level over its 30-year history and a break through here would likely spell the end of dollar hegemony. We are certain that is where things are headed but we still think the 80 level can act as a similar springboard for the dollar as the 775 level did for the S&P 500. Also recall just how bearish people were in late 2002 on the stock market. The bears were in control then but paid the price by staying short the market. We feel the same is in store for dollar bears in 2005.

In essence, because monetary policy does work, but with a lag, the “reflation trade” finally picked up some steam in 2003 and carried the stock market through its steep downtrend line, only to prove the bears wrong. The market has been with the bulls ever since.

But monetary policy works the other way as well and a full year of rate hikes has now made it a losing money position from an interest rate perspective to be short the dollar. As such, we have repeatedly warned that once the downward momentum in the dollar is broken, the dollar could stage a large rebound. And when that happens the stock market is likely to retrace a significant portion of its “ill gotten gains.” Therefore, much of our analytical work relies upon intermarket trends to correctly position our portfolio.

Finally, in the chart above we have zoomed in on the dollar’s “three tests” of its lows. If the third test were to mimic what we saw in the SP 500 in March 2003 at 775 we should see one new spike low and a bullish reversal in the dollar to mark the third and final “test.” This appears the most likely outcome so we are sitting on the sidelines, watching and keeping our powder dry before we take another stab at buying like we did in January of this year.

© 2005 Jes Black
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