Loading...
Symbols:
Authors:

On the Dollar and Commodities: Currencies Move Because We Let Them

by: Chris Ciovacco August 18, 2008 | about stocks: DIA / EEM / GLD / IYJ / OIL / QQQQ / SLV / SPY / UDN / UUP    

Chris Ciovacco

About this author:
Become a Contributor Submit an Article
  • Font Size:
  • Print

Mohamed El-Erian is the former highly successful manager of the Harvard endowment and current head of PIMCO. In an August 15, 2008 Bloomberg interview, he makes some comments which may help us to begin to understand the recent surge in the dollar in the face of less-than-ideal U.S. economic conditions.

Currencies move not because they ought to but because they are allowed to. Previously rigid currencies are going to become more flexible because it is in their own interest.

While respecting there are numerous factors influencing the currency markets not covered here, my interpretation of his comments:

  • The dollar is moving in part because some countries and central banks around the globe want to see it move for specific reasons.
  • Once the move was set in motion, currency traders and money managers saw it and responded to it, which gave the move more momentum. Short covering played a role as well.
  • The dollar’s recent surge was influenced more by orchestrated actions than a change in long-term dollar fundamentals.

We would be remiss if we did not mention the obvious importance in the currency markets of slowing of growth in Europe and the possible impact on interest rate differentials between the dollar and euro.

What Happened In The Last Month?

Commodities have rapidly reversed course and the dollar has made a countertrend move the likes of have not been seen for almost 40 years. Regardless of where markets head from here, the magnitude of the moves have pushed principal protection to the forefront. The charts below show both the dollar and commodities from March 2007 to the present. Note in the dollar chart, the 200-day moving average [MA], shown in red, and the 325-day MA (in green) have not been even seriously tested in the last 18 months until now.

click to enlarge images

U.S. Dollar & Commodities

The chart below shows it may be a mistake to assume the move in the dollar will not last very long. Like all the charts we present, the purpose is not to predict or forecast, but to understand possible realistic scenarios which could play out.

Dollar

Secular and Cyclical Trends

The long-term story for a weak dollar remains intact. The long-term story for strength in commodities remains intact. These stories (or fundamentals) apply to a period that could last almost twenty years and are referred to as secular stories or trends. Based on history, it is important to understand that counter-trends or cyclical retracements of secular trends can be of significant magnitude and duration. More importantly, they can destroy principal even when you have correctly identified the long-term fundamentals. The chart below of gold prices from 1973 through 1981 illustrates the point. Even if you have the story right, are you willing and emotionally able to suffer a 48% loss in a core position?


200 Day MA

The chart of the NASDAQ (below) illustrates our task, which is to balance the desire to stay with a secular trend with the need to protect against large and hard to recover from losses.

Cutting Losses

What Could Be the Motivation to Want a Stronger Dollar?

While complex financial markets never have singular and simple cause and effect relationships, we can identify a few of the major contributors to the significant shifts which have occurred in the last month. When examining the related movements between the dollar and commodities, the classic chicken and egg question always comes into play. Of the many possible reasons to set an orchestrated dollar move in motion are:

  • A weak dollar has contributed to global inflation which cannot easily be addressed by central banks raising interest rates in the face of slowing economies and a credit crisis.
  • European exports have been seriously negatively impacted by the weak dollar/strong euro.
  • Additional evidence of European economic weakness has surfaced in recent weeks.
  • The same issues, exports and economic weakness, also apply to the emerging market economies.

Oil
200 Day MA

The major drawback for the U.S. is the weak dollar has helped fuel a significant increase in exports. The surge in exports has propped up America’s GDP in recent quarters. From the Saturday, August 16, 2008 edition of The Wall Street Journal:

A stronger dollar, if sustained over a longer term, could put the U.S. economy on shakier ground by raising the cost of exports. Without the improving U.S. trade position, the U.S. economy would have contracted in the second quarter. Exports grew at a robust 9% annual rate during the quarter, helped along by the cumulative effects of the dollar's weakening in recent years.

When Fundamentals and Technicals Fail to Align

My read-between-the-lines of the current economic environment includes:

  • The Fed’s attempt to prop up the economy by lowering interest rates has not and is not working, which is no secret to anyone.
  • The availability of credit is contracting which is exactly what the Fed was trying to avoid by lowering rates.
  • Stock markets around the globe are not anticipating a significant recovery anytime soon.
  • Banks still have serious problems with continued deterioration of their balance sheets caused primarily by falling home prices, which have no rationale hope for finding a permanent bottom anytime soon.
  • The recent slide in commodity prices underscores the contraction of credit, housing outlook, and anticipated future economic weakness. This is not good for stocks.
  • At least for the time being, financial markets are placing economic weakness and the possibility of deflation ahead of any concerns about possible future inflation.
  • All asset prices, including commodities, are on the ropes.
  • Based on the evidence we have today, a rapid reversal in the U.S. stock market is possible between current levels and 1,365 on the S&P 500 (now at 1,298).
  • A possible, but much less probable, outcome is for stocks to respond positively, in a rapid upside move, to falling commodity prices and break through 1,365. The basis for this scenario is that capital is flowing out of commodities and could rush into stocks if managers feel they are being left behind. The move could take the form of an upside "blow off" where the panic buying is quickly replaced with panic selling.

The concepts above appear to be supported by recent disconnects between some fundamental and technical elements in both commodities and stock markets.

200 Day MA
Reaction Two
Reaction Two

Stocks Remain in Downtrend

The S&P 500 Index remains 17.63% below its 2007 high. As the blue lines in the chart below illustrate, despite a month of gains, the primary trend in stocks is still firmly down. A downtrend means if you are betting or hoping that stocks have bottomed, you are swimming upstream with the odds stacked against you. Those odds may change, but as of now there is no credible evidence to support a bullish bet yet on stocks.

Stock Still Down

At Some Point Nothing Else Matters Except Protecting Principal

When asked their secrets of success, money managers who consistently have been top performers almost without exception state the importance of "cutting losses and letting winners run." Similarly, when the best professional managers are asked to name common mistakes made by individual investors, they typically put the failure to cut losses at the top of the list. The cruel reality of the markets is when you lose 30% you need to make more than 30% to get back to break even. As the chart below shows, if you lose 30%, you need to make 43% to get back to break even. The two boxed rows show the danger of “staying the course” while bear markets destroy your hard earned principal. If you "rode out" the 2000-2002 bear market in the S&P 500 Index, your losses from peak to trough would have been roughly 45%. To get back to break even, you would have needed to earn an 82% return from the bottom which was made in October of 2002. When losses begin to pile up, at some point you have to put both the fundamentals and charts on the back burner and focus on preserving principal in order to have the opportunity to fight another day.

200 Day MA

The previous statements and charts are not meant to be forecasts, but simply an assessment of current risk/reward profiles and probabilities as we see them. If the odds shift to more favorable or alternate outcomes, we are keeping an open mind and will gladly adjust our thinking as new evidence unfolds.

Related Articles

This article has 7 comments:

  •  
    Aug 18 07:35 AM
    Great charts! And excellent comments based upon facts. Once could ARGUE one way or another. But a picture is worth a thousand words. And often, the right charts tell the significant story better than a thousand reporters spouting words. Thank you!
    Reply
  •  
    Aug 18 09:00 AM
    User244491---WHAT IS YOUR PROBLEM? The man presented imfo in a clear precise and imformative way. I enjoy reading his articles on this site. You must be a competitor writer or totally against an oppisite view of your own opinions, or just do not care to be educated. Keep up the good work Chris, I for one appreciate it!
    Reply
  •  
    Aug 18 01:09 PM
    Excellent work. I appreciate your use of numerous Stockcharts to assit in making your points. In this article I especially enjoyed the final data on the importance of cutting losses. Cutting losses short is a practice I have utilized for years, even though it flies in the face of all the buy-and-hold, invest for the long run, Warren Buffett fundamental types. Technical analysis protected my clients money by exiting US stocks in October of 2000 and staying out until March of 2003. Our US stock allocations were sold again this past January.

    I am curious about your use of a 325-Day moving average. It is not a fibonacci number and I have never seen it used before by Murphy or any of the other technicians. Does it have any significant characteristics that caused you to choose it?

    Thank you for sharing your thoughtful insights.
    Reply
  •  
    Aug 18 04:01 PM
    Very worthwhile, intelligent read. Thanks for the contribution. Much food for thought here presented in a logical and unbiased fashion. Please keep posting!
    Reply
  •  
    Aug 18 05:50 PM
    Good article, Chris! I have been making the case for some time on my own blog that the "buy and hold" strategy of sitting tight through deep dips in stocks is likely to create steep losses that will take many years to dig out of. Your last chart makes that point very powerfully!
    Reply
  •  
    Aug 18 05:54 PM
    One more thought. In a day when there are stock index ETFs that short the market, why would ANYONE just sit and wait through an economic downturn! We can be either long or short the market at all times, benefiting from both bull and bear markets! Learn to read the charts!
    Reply
  •  
    Aug 20 01:20 AM
    Why would one hold investments that are down? When one feels the underlying fundamentals for the investment remain in force. I've seen other charts of stocks that had steep declines and then became enormous winners. What are the fundamentals? These can be misunderstood until they're finally understood--such as the case for peak oil.
    Reply
More Comments on UUP ยป
More by Chris Ciovacco
Investment Resources
Money Managment
Research
Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Dollar/Currencies
Commodities
Bonds
Earnings