Speculators Bearish as Dollar Tries to Hold Major Support
FS Insider recently spoke with John Derrick, CFA, President of the Derrick Letter, regarding his outlook on the dollar, the US stock market, and more. Derrick believes there is a good case to be made that we are nearing the end of the dollar's decline and that the risks of a near-term correction in the US stock market have increased (see Derrick: Retail Investors Buying As Institutions Trim Back for audio).
Dollar Weakness Set to Reverse
The dollar has traded lower over the course of this year, and it’s now approaching an extreme, Derrick noted.
Right after the election, there was a great deal of enthusiasm for President Trump’s agenda. With the expectation of greater economic growth and fiscal stimulus, the dollar rallied strongly as investors anticipated a shift towards tighter Fed policy in response.
However, for most of 2017, investors have lowered their expectations both on Trump and on the Fed's response, leading the dollar to reverse all of its initial post-Trump gains...and then some.
As of now, we're down nearly two standard deviations from the high and right at a key support zone, Derrick told listeners.
“That dollar trade is likely to reverse,” he said, also pointing to positioning in the futures market, which, as you can see below, shows speculators are no longer excessively long and back to a slight net bearish position.
Near-Term Risk of a Correction in Stocks
It’s been over a year since we’ve had even a 5 percent correction, Derrick noted. This is the longest streak of low volatility since 1996.
Though we’ve had a strong earnings season, the market is basically in the same place it was 2 months ago. We’re starting to see churn, and the market is starting to struggle a little bit.
“My thinking is that the trade—particularly in the same technology names—is getting tired,” Derrick said. “We’re getting to the point where seasonals are working against us now, and equities are expensive.”
Derrick sees the opportunity to rebalance portfolios and take gains from stocks that have done well, such as the FANGs, and possibly reposition into defensive plays, such as healthcare, utilities, telecoms and consumer staples.
“The key message is, it’s not the time to take that incremental risk and grab for something else,” he said. “It’s time to take risk off the table.”
Long-Term Outlook Looks Clear
While Derrick sees a correction of possibly 5 or 10 percent in the near-term, the picture is different further out.
It’s important to keep in mind that leading economic indicators are still growing.
“From an economic perspective, that basically signals the economic all-clear for at least the next 12 months,” Derrick said. “With the Conference Board's LEI making new highs, I think it’s really dangerous to get too bearish and too cautious.”
The global economy is on a good path, Europe continues to show strength, and China has stabilized, he added.
Risks are higher than average over the next 1-3 months, Derrick said, but we'll want to see more deterioration in longer-term indicators before calling for a top in the market.
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