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August 27, 2004

US Dollar Bear Intact
by Adam Hamilton

One of the most fascinating enigmas of the markets this summer has been the erratic behavior of the mighty US dollar. Since this leading fiat paper continues to command world-reserve-currency status, its machinations directly and indirectly affect countless other markets.

Wall Street, which could easily spin a bullish scenario even if a doomsday asteroid was about to smash the world into oblivion, has its bases covered on dollar movements. Whether the dollar goes up or down, the ministers of financial propaganda in New York are convinced it will be bullish for stocks.

They claim that a higher dollar will increase foreign demand for US stocks, boosting stock prices. At the same time they claim that a lower dollar will increase the profits of major US exporters, boosting stock prices. The perpetual all-bullish-all-the-time cacophony from Wall Street leaves me shaking my head in amazement, but the Street always has been little more than a marketing machine designed to help dump stocks on the public regardless of valuation or merit.

The red-hot oil market is also affected by the dollar. The oil-exporting countries are acutely aware of the dollar's value relative to other major currencies like the euro. If the dollar continues its multi-year secular bear market, they are going to do everything in their power to hold back production to keep oil prices high in dollar terms. The lower the dollar goes, the more dollars per barrel they will demand to compensate them for the reduction in dollar purchasing power.

While the relationships between the dollar and stocks and the dollar and oil are often more indirect than direct, the gold market has an indisputable direct relationship with the dollar. Gold is a powerful hard-money currency that competes directly with the dollar, so it tends to move inversely with the dollar at least during this first stage of our current gold bull market.

As a contrarian investor and speculator heavily long gold, gold stocks, and gold-stock options as this summer winds to a close, the near-term fortunes of the dollar are of great interest to me. If the dollar manages to extend its 2004 rally to new heights, everything precious-metals related will almost certainly take a major hit. But if the dollar reverts back into its bear-market mode of recent years, the precious-metals sector ought to fly.

Since the dollar's coming course is probably the single most important key for precious-metals performance in the next few months, this week I wanted to reexamine the dollar's strategic and tactical technicals. These charts offer a great deal of evidence to help us determine whether the dollar bear remains intact or whether we are likely witnessing a secular trend change to a new dollar bull.

Both charts also include the Relative Dollar, or the dollar divided by its own 200-day moving average. This red line grants us an absolute normalized measurement that does not skew over time regarding how the dollar has behaved relative to its key 200dma. In secular bear markets like the dollar's the 200dma forms the most important foundational overhead resistance so the dollar's behavior relative to this line is very revealing.

I know I am not the only one interested in the dollar these days either, as my incoming e-mail traffic in recent weeks has shown increasing nervousness among precious-metals investors and speculators regarding the dollar's apparent strength. Compounding this unease, an increasing number of contrarian analysts are expecting major rallies in the US Dollar Index that they claim could take it to anywhere from 92 to 100 in the months ahead. Naturally this would not be good news at all for precious metals if it really transpires.

The arguments for a renewed dollar rally range from election manipulations by central banks to the unwinding of various global carry trades to relative weakness in other paper currencies. All of the dollar-bullish arguments I have read are interesting, but the markets are ultimately a study in probabilities. While the dollar-rally theories sound plausible, are the odds really in their favor? These strategic and tactical price charts below can help us sort through all the dollar commentary and directly take the pulse of the dollar itself.

This is the big strategic picture. In the financial markets context is absolutely crucial and nothing can quite put current price movements into their proper context like seeing them within the prevailing secular, or long-term, trend. In the dollar's case, this long-term trend is indisputably down. This powerful dollar bear market has been underway since the summer of 2001 and has yet to show any signs of abating.

One of the most important principles for successful investing or long-term trading is the idea that one should position their capital to run with the primary trend. Long-term trends have tremendous inertia and they often run for many years before ending. Unless big fundamental changes are afoot, probabilities almost always favor the speculator willing to bet with the primary trend.

In the dollar's strategic chart above, its long-term trend is clearly bearish. Until the dollar price rallies aggressively enough to convince us otherwise, in this situation we must grant the dollar bear the benefit of the doubt since probabilities continue to favor it. All of today's theses for a major dollar rally just ahead are betting against this primary dollar trend, a low-probability bet. Fighting the primary trend is usually a losing strategy, except at rare secular trend changes.

The reason that a major dollar rally today is so improbable in technical terms, at least if this secular bear has not yet given up its ghost, is due to the dollar's current position within its downtrend channel. This channel is defined by its lower support and upper resistance lines. The primary problem with the dollar rally theses from a technical standpoint is that the dollar is now crowding its upper resistance line. If the dollar breaks out higher from here it will power above multi-year resistance and cast its entire secular bear trend into doubt.

A bet for a major rally today is essentially a bet that the dollar bear may be ending. All bears eventually end of course, so why should we give so much credence and respect to these long-term dollar trendlines right now?

Technically, the strategic downtrend pipe shown above is really quite remarkable in its precision. For several years now the dollar has cleanly bounced between these support and resistance lines. On the low end the dollar has intercepted its major support line multiple times, and on the top end its major resistance has also witnessed multiple intercepts. Other than the massive double top of early 2002, the dollar has not traded significantly out of this trend channel for years.

Since the dollar has not yet been able to break out of this downtrend for its entire bear market to date, odds are speculators around the world are closely monitoring these long-term trends and continue to sell when the dollar is near its upper resistance like today. With so much history and precision inherent in this trend, probabilities favor it continuing until some major fundamental change occurs that signals the dollar bear's end. A technical rally today that moves significantly outside of such a powerful strategic trend is really a low-probability event.

And the longer that a secular trend remains in force, the more it reveals about the power and magnitude of the underlying fundamentals that are ultimately driving it. The dollar's bear market exists because global dollar supply exceeds global dollar demand. Is this fundamental situation changing now or likely to change soon? This fundamental consideration is very important since the implicit assumption necessary to forecast a major dollar rally from here that breaks its bearish downtrend is that the dollar bear market may be ending. Secular trend changes require underlying fundamental changes. Are we seeing a fundamental sea change to dollar bull-market conditions?

On the supply side, the world remains awash in dollars today. Not only does the goofy and irresponsible Fed continue to print new dollars like there is no tomorrow, but central banks and private investors around the world have spent a half century accumulating dollars. The worldwide hoard of dollars in paper and electronic form is absolutely enormous and the Fed adds to this virtually every single day due to its incessant fiat inflation. Dollar supplies are unlikely to shrink, ever, as long as a Keynesian central bank controls it and it is backed by nothing tangible like gold to impose discipline.

A perpetually rising supply remains bearish for prices, so the only hope for the dollar bulls is a vast increase in global dollar demand. On the contrary however, various developments seem to be conspiring to lower dollar demand around the globe.

The US stock markets, which once drove global dollar demand as foreign investors were seduced into chasing abnormally large US stock returns in the late 1990s, are now in their ugly post-bubble bust phase. If history is a valid guide, it will be decades before another bubble in the general stock markets is witnessed. During this bust the US economy is plodding along rather uninspiringly while stock valuations gradually mean revert back down towards historical fair value near 14x earnings.

At the same time alternative global currencies are rising up that will eventually threaten the dollar's hegemony as the world reserve currency. The young euro, for example, has witnessed spectacular progress in the short years since its birth. Already the dollar-laden Asian central banks are reducing their dollar holdings to increase their euro holdings, and some of the OPEC nations are even accepting settlement of oil contracts in euros now. With both central banks and oil exporters growing weary of the ongoing dollar bear, a major source of dollar demand is fizzling.

The growing tide of Washington DC's imperialism is also hurting dollar demand. Just like ordinary people, nations don't appreciate other nations meddling in other nations' business. Whether Washington was right or wrong to invade two sovereign nations and install two puppet governments in recent years, billions of people and scores of nations around the world are furious about the new American imperialism. From the Middle East to China, these people and nations are looking for dollar alternatives since they are so disgusted with Washington. This also reduces dollar demand.

On top of all this the dollar's bear itself breeds a kind of self-fulfilling prophecy. Persistent dollar weakness leads foreign investors to question just why the dollar is weak.  They eventually form an opinion which, correct or incorrect, causes them to reduce their exposure to dollars. Perception can become reality in the markets. This too further reduces dollar demand.

So we have a bearish fundamental situation here where the Fed is increasing dollar supplies at the same time when central banks are diversifying out of dollars which throws more dollars into the global market. And as the US becomes a less attractive place for foreigners to invest in during this supercycle bust, other currencies are rising at the same time while Washington's imperialism retards global dollar demand.

Any way you want to slice it, it does not look like a major fundamental change is afoot that is signaling the end of the dollar's secular bear. On the contrary, the supply and demand fundamentals seem to be greatly buttressing this ongoing bear. Rising supply plus slumping demand equals lower dollar prices, period. In light of these ugly fundamentals, the major breakout above the strategic downtrend that would be necessary for a major dollar rally seems extremely unlikely.

Now if the dollar was near its lower support line today, as it was in early January when I warned gold investors of a major dollar rally approaching, then the case for a new dollar rally would make sense within the context of its secular bear. But with the dollar hugging its upper resistance today the case for a dollar rally is very weak unless the dollar bear is ending, and the supply-and-demand fundamentals just don't seem to be turning around.

There have actually been four major bear-market rallies in this dollar bear to date, as well as four major downlegs which preceded them. All are numbered in the chart above. Downlegs one through four registered respective losses in the US Dollar Index of 13.4%, 9.9%, 9.6%, and 14.3% for an average bear-to-date downleg loss of 11.8%. Bear-market rallies one through four saw respective gains of 4.2%, 4.3%, 7.5%, and 8.2% for an average bear-market-rally gain of 6.1%.

The fourth major downleg and its subsequent oversold bear-market rally are of special interest to us today. Downleg four began in the autumn of 2003 and slid all the way down from the top of the dollar's downtrend channel to the bottom. This 14.3% loss in the US Dollar Index was its biggest single downleg to date. This largest downleg was followed by the largest bear-market rally, early 2004's 8.2% run higher in the US Dollar Index. This move also carried the dollar all the way back through its downtrend pipe, from its lower support to its upper resistance.

And this brings us full circle to today. The major rally in the dollar that some folks fear has probably already happened in early 2004. In addition to the dollar failing to break above its long-term strategic resistance in recent months following the climax of this latest bear rally, the dollar is also slamming into short-term tactical resistance today. Our next graph zooms into the short-term technical scene and highlights the dollar's plight from this tactical perspective.

This chart highlights the relentless final plunge of the fourth major downleg of this secular dollar bear and the subsequent fourth major bear-market rally. These short-term tactical trends move within long-term strategic trends. As you recall from above, all of the action on this entire short-term price chart is contained within the dollar's long-term downtrend. While not as important as strategic trends, tactical trends are still very valuable for speculators to follow.

The biggest bear-market rally in the dollar bear to date launched in early January with a sharp V-bounce that is so typical of major interim bottoms. The dollar surged higher before retreating in February, actually to a slightly lower low which formed a double bottom. After that it was off to the races, with the US Dollar Index powering relentlessly higher into early May. This bear-rally uptrend is crystal clear in this chart as the trendlines above reveal.

After briefly touching 92 in early May though, the dollar witnessed its sharpest single decline since its last downleg. It fell below its 200dma and then knifed through its 50dma and out of its tactical uptrend channel. It had a chance to recover and move back up into its uptrend as it had in February and late March, but it couldn't pull off a hat trick in May. By early June the dollar ground down to a new lower low and its uptrend was decisively broken.

Since those lofty highs of early May failed, the dollar has been in a very clear tactical downtrend which is marked above. Both its tactical support and resistance lines have witnessed multiple intercepts making for a very well-defined trend channel. A central midline is also forming, a halfway point in the trendpipe where the dollar can bounce either way. For several reasons I suspect that this new downtrend is actually the start of the fifth major downleg of this secular dollar bear.

Technically, the dollar has been unable to break decisively above either its strategic resistance shown in the first graph or its tactical resistance in this second graph. And after almost four months and three failed attempts, I think the time of giving this dollar rally the benefit of the doubt is long past. If the dollar was due to rally it should not be having such a tough time breaking out of both short-term and long-term resistance zones.

Second, the dollar has not been able to trade decisively above its key 200-day moving average for any significant amount of time. It has made several attempts to break above this most foundational bear-market resistance line, but so far it has failed. Technically a transition from a bear to a bull absolutely requires the 200dma to be broken and start heading higher, and the dollar hasn't even come close to achieving this.

In fact, the dollar's 200dma continues to slope rather sharply down, and a 200dma usually runs parallel to a market's primary trend. A new dollar rally from these levels would require the dollar to catapult through its heavy 200dma resistance and march higher, and so far this summer we have seen no confirmation whatsoever that there is enough dollar demand out there to ignite such a breakout.

And speaking of demand, even over the short-term the dollar supply seems to be growing much faster than dollar demand. And one does not need to be an economics professor to realize that a growing supply and flat to declining demand inevitably leads to lower prices. The dollar apparently remains in this very ill-fated boat right now.

The bottom line is the secular dollar bear seems quite intact. Despite the growing chorus of bullish commentary, even from within the contrarian community, technicals and fundamentals just don't seem to support the dollar-rally case. The dollar is banging its head bloody against the walls at both its long-term and short-term resistance lines, not to mention its 200dma, and it has just not been able to make headway for the better part of four months now. This is a sign of bearish weakness, not bullish strength.

If the dollar bear continues as expected, it should be a great autumn and winter for precious-metals investors and speculators. A falling dollar will almost certainly lead to higher gold prices which we will continue to leverage through carefully chosen elite unhedged gold and silver stocks and gold-stock options. As always my specific existing and new trading recommendations are available to our subscribers in our acclaimed monthly Zeal Intelligence newsletter.

Until the dollar can manage to break decisively out of its short-term and long-term downtrend channels, there is no reason to expect an abnormal rally that throws this entire secular dollar bear into disarray.

And until a convincing case can be made that dollar demand is growing faster than dollar supply worldwide, there is no reason that we should expect this secular dollar bear to end prematurely.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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