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February 09, 2007

Head of the Trend: Cognitive Dissonance and the Rise of Peso
by Jes Black

The ECB met this week, confirming the expectations of the majority of economists predicting that the bankers will leave rates unchanged at 3.5%. In the coming months, however, ECB has signalled tightening and rates are expected to head to 4.0%.

According to the conventional wisdom of 2006, this will push the euro higher, possibly as high as 1.45 against the dollar, as forecasted by a number of leading foreign exchange banks in January 2007.

Humans are prone to believing Myths without questioning the underlying reality of the situation at hand. As you well know, we take commonly held Myths (ranging from the 9/11 story to the Fed, to the War on Terror and conspiracy theories) to task.

For example, before the War in Iraq began the public was divided over whether we would go to war and whether there were WMDs to be used against us. We flatly called this propaganda and cited the former head weapons inspector as stating they had all been destroyed. This was a simple case of fact being trumped by the shapers of that Myth.

In many of the same ways, the currency market is nothing more than the proverbial "marble game" whereby the winning central banks return to the losers their medium of exchange so that we may all play again. The end result is persistent inflation by all sides that keep currencies relatively range bound over long periods of time.

This is one reason we continue to take the opposing view, saying last May that the euro would likely rally to 1.35 and then fail to go any higher.

At the height of "Peak Oil" we said crude oil had reached our cited target of $80 and would now head lower to around $60 before going higher again. While others continue to follow what we can call "Price Theory Myths" (PTM) we continue to get the major market calls correct for our clients.

PTM, is really a function of what is called "cognitive dissonance" - a psychological term to define the condition that results whenever an individual attempts to hold two incompatible, if not contradictory, thoughts at the same time even in the face of mounting evidence to the contrary.

In the markets this manifests itself when an analyst or trader identifies with a commonly held Myth which will explain the current action in the market. If the trader or analyst holds onto this Myth in the face of price action that refutes it, it is cognitive dissonance. But more often than not, the same PTM is then used to explain the counter move in the markets. For example, "Stocks are higher because of falling oil prices." And, "Stocks are lower because falling oil prices are pressuring profits."

We embrace the fallibility of the human mind, and its strong inclination to allow facts to be overridden by attitudes, emotions, belief systems and the resulting herd behavior.

Conforming to our mind-set to avoid conflict, it is interesting to note highly educated people (think economists, traders, etc) will seek out information that is consonant rather than dissonant with their own views, so as to avoid cognitive dissonance.

We point this out because being on the frontline to challenge commonly held Myths is not an enviable position. Our motivation is profit. Understanding when the groupthink is wrong is what affords the best trading potential on a regular basis.

This is why well educated people do not even question that Central Banks are owned by private banks who "loan" money to our nations at interest. The larger the deficit is, the more control private institutions gain over the public. We do not question this because we prefer cognitive consistency as the mechanism to protect our own self-image. People of all nations say, "I am good, so my nation is good. Ergo, that which my nation does in my name is also good." To question it creates cognitive dissonance.

Currency Focus: Our currency fund posted another good year, amid general underperformance from well know currency managers. Perhaps our best advantage is the long term approach we take, and our view that currencies are an "asset class" unto themselves subject to overt manipulation.

We look for "undervalued," and "fundamentally bullish" currencies. We evaluate them by baskets, thus eliminating the "dollar bias" inherent by looking only at those rates. We add to the mix Purchasing Power Parity measures, then sentiment and finally look for technical measures to give us a good indication of what will happen next.

If all things point to a good "macro" trade, then we execute, caring little for overall entry level, as we are looking for 500 or more pips in general. In doing so we have only had a handful of great months which account for the bulk of our gains.

While non-volatile, this strategy has meant we beat (after fees) the combined performance of the 2005 decline in the euro and the 2006 rally.

This is why perhaps in no other market do the skills of the manager matter so much. In general, successful currency managers average about 10% a year in up and down markets, after their fees. Yet the combined performance of major currency managers has been near zero over this two year period, which we relate to PTM as explained earlier.

One market we continue to like is the Mexican peso. When we moved to Mexico in 2005 PTM was prevalent in the population’s general disdain for their own currency. However, we now notice how shop owners try to return change to us in dollars instead of pesos now. "No thank you," we say.

Meanwhile, the market has yet to recognize that the general population is gaining a sense of awareness that their currency may not be in as bad of shape as the US dollar.

Recall that for the last three months we continue to show charts of the Mexican peso and its likely rally.

If you do not believe us that the Mexican peso "could" rally by 30% over the coming years, then ask yourself, "What if the US dollar falls further and the US pushes for a Continental Union similar to the European Union." That would mean that the currencies of Mexico, US and Canada converge into a currency unit similar to the euro.

Also known as the "North American Security and Prosperity Partnership," it is currently being debated by economists and politicians. We first heard of this at the December FXCM expo where your editor was invited to speak alongside Jim Rodgers on various topics related to foreign exchange.

A man from the audience asked me if I had heard of the "Amero" or the "North American Currency Unit." I said I had not, and he cited a recent CNBC interview where he discusses the plans.

Our point is that information is power. If in the event that the dollar collapse occurs (a low probablitiy event in our eyes), then the Amero becomes a priority for every American. The US could easily convince Mexico to adopt a new currency since most do not like theirs anyway. That leaves only the Canucks as a holdout, who could be bribed with the prospect of cheaper alcohol. Thus the Amero would be born and provoke a rapid rise in the Mexican peso as this under-loved currency would be included the new currency basket.

Further in-depth analysis and more specific trading recommendations are available through our daily Morning Market Updates and FxSignalZone reports.

Jes Black
fx Money Trends

Jes Black, hedge fund manager at Black Flag Capital Partners, specializes in foreign exchange and global macro trends. Prior to organizing the fund he helped MG Financial Group launch Forexnews.com. In the summer of 2004 Mr. Black formed FX Money Trends, a research firm catering to professional traders.

Mr. Black holds a degree in economics from the University of Kansas and an MBA from the ESC in France. His market commentary is often featured in the Wall Street Journal, Financial Times and Reuters. He has also written numerous strategy pieces for Futures magazine. To find out more about the funds research letter visit www.fxmoneytrends.com/products.html. Qualified prospective investors can find out more about Black Flag Capital Partners by e-mailing info@blackflagfund.com

Under no circumstances does the information contained in this site represent a recommendation to buy, sell or hold any security.

Copyright © 2004-2007 Jes Black

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