The Relative Dollar and Gold

By: Adam Hamilton | Fri, Jan 9, 2004
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The relentlessly plunging US dollar is the primary topic of some of the most widely played financial-news stories these days. This once mighty American currency is rapidly falling from international grace, and even conventional media outlets are focusing more and more on the enormous implications of the down-spiraling dollar.

It's not only the financial markets that are nervously pondering this troubling development, I suspect that all of the major governments on Earth are burning the midnight oil trying to decide how to address this issue. The farther the dollar falls, the more difficult it is for other countries' exporting industries to sell their products into the largest consumer market in the world, the United States.

European officials seem to be pretty calm about the dollar rout so far, but European exporters are growing increasingly vocal as the young euro soars to all-time-record highs. Europe is a major exporter to the US and for the last four months or so the plunging dollar has ratcheted up the pressure on European exporters. Every fresh new dollar low relative to the euro makes European goods more expensive for Americans.

In the past couple weeks I have seen more and more European financial analysts suggest that the probability of public official European intervention in the currency markets approaches very high levels if the euro continues rocketing up to US$1.35, only about 6% higher than today's stellar levels. Aggressive European foreign-exchange manipulation would certainly be a big shock to the currency markets, as it is pretty rare.

The frightened Japanese, on the other hand, can't seem to last one single trading day without actively attempting to manipulate the foreign-exchange markets. As the euro has continued to slam into new highs, massive yen sales and dollar purchases by the Bank of Japan have so far held the dollar above Y106 or so. Last year the Japanese government spent a record Y20t (trillion!) trying to retard the yen's export-crushing rise relative to the US dollar!

Japanese exporters are growing increasingly nervous now as this Y106 level is challenged. The Japan Business Federation, Japan's largest business lobby, is loudly asserting that the Y105 line is absolutely vital to Japanese corporations and must be held at all costs. So, the relatively continuous unannounced Bank of Japan manipulation in the currency markets is almost certain to continue and indeed accelerate.

With the dollar's plunge now headline financial and even general news across the globe, one of the most popular bets around these days is to short the US dollar. As contrarians, however, this rising crescendo of dollar-short noise and coverage ought to trigger loud warning klaxons in our skulls.

Markets are not linear, they do not move in a straight line forever. They perpetually rise and fall with the ebbing and flowing tides of circumstance and herd psychology. As soon as one trade becomes too popular and lopsided, when either greed or fear waxes too extreme, a mean reversion back in the opposite direction is inevitable. These timeless market truths apply not only to stock markets, but to currency markets as well.

While there is no doubt that the US dollar is in a long-term bear market for all kinds of structural and fiat-currency-fragility reasons, short-term countertrend rallies do indeed happen from time to time. Just as there were mighty bear-market rallies in the US stock markets after the tech bubble burst, most quite sharp and extraordinary, similar bear-market rallies have happened and will continue to happen in the US dollar.

As the US dollar appears to be so short-term oversold today, this sharp countertrend bear-market rally in the American currency could launch at any time. Global public sentiment against the dollar is unbelievably negative at the moment as the widespread media coverage attests, and the financial markets abhor extreme situations where everyone piles on one side of a trade. The contrarian play these days, the bet that very few are willing to make, is that a dollar bear-market rally is approaching.

The implications of such a short-term dollar mean reversion are very obvious for currency traders. Dollar shorts can cover and realize their profits and they can go long the dollar or short other competing currencies that are near long-time or record highs, like the euro. The professional forex folks are well aware of this and I suspect that a short-covering frenzy will be the initial buying spark that ignites the coming countertrend dollar bear-market rally.

There is an entirely separate class of "currency" traders as well though, and many of these may not recognize the considerable dangers that a dollar bear rally poses to their short-term positions. Through six millennia of human history the ultimate currency has been gold, a rare and precious metal of indisputable intrinsic value in all times and all places. Just as the euro and dollar have an inverse relationship, so do the dollar and gold.

As the dollar's exchange value falls, it takes more dollars to buy gold so the dollar gold price rises. Conversely, when the dollar's exchange value rises, due to a bear-market rally or any reason, it takes fewer dollars to buy gold so the dollar gold price falls. A short-term countertrend dollar rally portends a short-term bearish omen for the price of gold denominated in US dollars!

This strategic inverse relationship between gold and the US dollar is quite obvious on a longer-term chart. Our first graph this week shows the most popular measure of the US dollar, the US Dollar Index, with the gold price in US dollars superimposed on top. The key long-term 200-day moving averages of the dollar and gold are also rendered below, as they offer many insights into the timing of an oversold dollar bear-market rally.

There is no better mathematical way to quantify long-term strategic trends in progress than through 200-day moving averages, and the black and white 200dmas above beautifully illustrate the strategic antipathy between the US dollar and gold. In general, if the dollar is up gold is down and vice versa, and the near mirror-image cross of their respective 200dmas really drives home this core point.

Please note that this dollar/gold relationship is strategic, but not necessarily tactical. If you look at long periods of time, dollar weakness will almost always translate into gold strength and vice versa. But the shorter the time frame that you consider, the less this relationship will necessarily be true.

For example, if both the dollar and gold are down on one particular trading day, it is no big deal. Markets do all kinds of anomalous things over the short-term while they tend to behave quite rationally over the long-term. I bring this up because fretting and woe is a gold-forum staple these days whenever the dollar is down and gold does not soar. I also tend to receive more concerned e-mails from my consulting clients on curious trading days when the dollar and gold move in the same direction.

Single-day moves, merely considered in isolation, are all but totally meaningless though. Now if the dollar fell for six months and gold fell for six months right along with it, that would be a different story entirely and cause for much concern. But over an ultra-short-term span of time these strategic relationships don't always hold. While what gold and the dollar will do in the next 60 seconds is essentially random and not tradable, what gold and the dollar will do in the next 60 months is anything but random and eminently tradable!

One of the core axioms of all speculation is that the shorter the period of time that one considers, the less rational that the markets should be expected to be. So ultra-short-term dollar/gold decouplings are actually fairly common and absolutely nothing to worry about. Personally, I wouldn't even start pondering a dollar/gold decoupling until it lasted at least a month!

When considered over years, however, as in the chart above, the dollar/gold inverse relationship is as rock-solid as anything in the markets can be. After all, gold and the dollar are competing global currencies just like the dollar and euro, so it makes great sense that weakness in one will translate into strength in the other. Even more revealing is carefully studying both the dollar and gold relative to their key long-term 200dmas.

While the primary secular dollar trend is down while gold's is up, the role of the respective 200dmas in each case is incredibly consistent. Over the long-term, regardless of bull or bear-market conditions, any given market periodically retreats to its 200dma on short-term countertrend moves. Thus, if you know that a certain long-term trend is in place, and you witness a countertrend move back to its 200dma, then you can once again bet with the long-term primary trend with high confidence.

Starting with gold, since it is easiest to think in bull-market terms, there have been several times in the past few years where gold has touched its white 200dma line above. Not surprisingly, all of these gold 200dma encounters proved to be absolutely outstanding buying opportunities, for both gunslinging speculators and long-term investors alike. If you see gold approach its 200dma while the long-term fundamentals supporting its Great Bull remain steadfastly entrenched, then you can buy gold and gold stocks with reckless abandon.

The dollar bear, on the other hand, exhibits the same behavior even though it is inverted. The closer that the dollar retreats to its overhead 200dma during its countertrend rallies, the higher the probability that a fantastic moment to add new dollar short positions has arrived.  While there has only been one major 200dma kiss in this dollar bear so far, early September 2003, it proved to be a phenomenal time to short the dollar and ride this recent brutal dollar downleg that is utterly dominating financial news today.

So, in bull or bear alike, if you witness a price retreat away from its primary trend in a countertrend rally or correction and once again approach its 200dma, then you should not hesitate to bet with the primary trend once again, as long as you believe that the fundamentals supporting this primary trend remain firmly in place.

While 200dma convergences are excellent opportunities to deploy capital with the primary trend, the obvious and important corollary is that 200dma divergences are excellent opportunities to bet against the primary trend.

In both the dollar and gold lines shown above, each time that either currency pulled too far away from its 200dma, a short-term countertrend move back towards its 200dma was inevitable. To put it bluntly, your probability of short-term speculation success is very low if you go long gold when it is way above its 200dma or if you throw short the dollar when it is way below its 200dma!

These 200dma divergences are the very moments when popular market sentiment waxes too extreme in one direction, virtually assuring that a short-term mean reversion is inevitable. And if the financial media constantly trumpets only one side of a trade and extrapolates a current short-term trend into eternity, like today's plunging dollar, it is a telltale warning sign for contrarians that we should really tread cautiously and prepare for a mean reversion back to the 200dma.

While this 200dma convergence/divergence thesis is very easy to understand, it is difficult to quantify precisely. For example, if you just look at the chart above, how do you know when either the dollar or gold are farthest from or closest to their respective 200dmas in percentage terms? How do you compare a 200dma convergence or divergence today with one that happened three years ago, at very different price levels?

We had to address these very visual-skew and time-comparability problems last year while analyzing market volatility via the flagship VIX implied-volatility index. The concept of the Relative VIX was born, dividing the VIX by its 200dma to make it perfectly comparable in magnitude over time. I have since applied this Relativity construct to the HUI gold-stock index and silver as well, with promising results.

By creating a Relative Dollar and Relative Gold, merely dividing the daily gold price and dollar price by their respective 200dmas, we can greatly increase our insight into the critical interrelationship between these two competing currencies. The graph below, introducing both the Relative Dollar and Relative Gold, suggests key levels at which short-term 200dma divergences grow so great that speculators should start expecting a short-term countertrend mean reversion back to the 200dmas.

Since Relativity is calculated by dividing a price by its 200dma, it is most useful to think of these resulting numbers in percentage terms. A Relative Gold reading of 1.15, for instance, indicates that the gold price is 15% above its 200dma at any given moment in time. A Relative Dollar level of 0.90, likewise, tells us that the dollar is trading at 90% of its own 200dma. A 1.00 Relativity reading, of course, indicates that either price is trading right at its respective 200dma.

The true nature of the inverse strategic relationship between the dollar and gold is even more apparent in relative terms. In the past couple years especially the negative correlation between these two competing currencies has been really strong and rock solid. As the vertical yellow lines above indicate, interim dollar lows in Relativity terms tended to coincide rather well with interim gold highs.

Today the Relative Dollar is approaching 0.90, an incredibly strong support line as the chart above reveals. This level where the current US Dollar Index price trades at 90% of its key 200dma has been challenged three times in the dollar bear market to date, but this support has not yet fallen. Back in mid-2002 the Relative Dollar briefly hit 0.905, and in mid-2003 a Relative Dollar depth of 0.903 was plumbed, but so far this heavy 0.90 line has not been pierced.

Today the Relative Dollar has closed as low as 0.908, right above the major short-term countertrend reversal level that has been so consistent in its bear thus far. While anything can always happen in the markets, speculation is primarily an exercise in probabilities, an odds game. If the Relative Dollar 0.90ish levels held in earlier dollar downlegs, shouldn't speculators at least give this support the benefit of the doubt today?

I would not want to be short the US dollar over the near-term right now, even being well aware of all of its terrible fiat failings and long-term structural problems, since it is currently trading near technical levels that have heralded a bear-market rally in recent years. In Relative Dollar terms, the high-probability bet now is to go long the dollar on this 200dma divergence. Once its oversold bear-market rally ends and the dollar converges with its 200dma, then it will be another great opportunity to short, as it was in September 2003.

The ominous implications of this potentially imminent dollar countertrend rally are great indeed for short-term gold speculators. If you look at each Relative Dollar interim low above, and follow the straight yellow lines up, you will note that Relative Gold interim highs tended to happen near Relative Dollar interim lows. Indeed today we have a high Relative Gold reading of 1.153, the second highest interim extreme achieved in gold's bull market to date.

But in the past couple years, right after these interim Relative Dollar lows and Relative Gold highs were reached, in the months following the gold price made a sharp pullback. Gold entered countertrend corrections, bleeding off overbought short-term speculative excesses by heading back down to converge with its own 200dma. If you bought short-term speculative positions in gold near any of these Relative Dollar lows and Relative Gold highs, you would have lost money over the short-term.

Now today gold speculators face these same short-term bearish omens once again. Gold has soared in recent months while the dollar has plummeted. Gold is approaching high levels relative to its 200dma while the US dollar is approaching low levels relative to its own 200dma. In recent years these very Relative Dollar interim low levels have heralded the negative short-term-sentiment extreme that sparked a strong countertrend bear-market rally in the dollar.

But when the dollar rallied off its interim lows to converge with its 200dma, gold was naturally hit hard and mean-reverted back down towards its own key 200dma. As the chart above reveals, both gold and the dollar are stretched almost as far away from their respective 200dmas as they have been in their entire major long-term trends to date, and a temporary mean reversion and short-term countertrend move is inevitable sooner or later for both of these elite currencies.

For my fellow gold and gold-stock speculators, I would be really cautious here and not add new positions. You also probably ought to ratchet up the trailing stop losses on your existing positions. The next great buying opportunity to ride another glorious gold upleg will probably not occur until gold converges with its 200dma, until Relative Gold once again approaches 1.00 parity. If the past is any indication, this countertrend move could take a few months to fully play out.

We are aggressively gearing up and preparing for the next major gold upleg at Zeal. In the January issue of our acclaimed Zeal Intelligence newsletter just published for our subscribers, there are a couple points of interest for gold and gold-stock speculators.

First, we started officially tracking the Relative Gold series shown in the graph above in our Zeal Contrarian Speculation Matrix. Based on this chart, I am interested in an initial general long-to-short range of less than 1.020 to greater than 1.110 or so. In other words I would be enthusiastically buying gold stocks when gold is within 2% of its 200dma but I will be short-term cautious as I am today whenever gold trades more than 11% above its 200dma. We may as well seek to launch high-probability trades only, as there is no reward or glory for becoming martyrs in the financial markets!

Second, the January ZI details fundamental analysis of a half-dozen of the most promising elite blue-chip gold and silver stocks. We ran a technical screen of every gold and silver stock of the elite HUI and XAU indices in the December issue, and then analyzed the six most promising technical winners in fundamental terms in this month's January issue of ZI. I am really thankful and thrilled that this new issue has already become one of our most popular issues of ZI to date.

If you are interested in gold-stock speculation, please honor us with your subscription today! We are working hard preparing for the next major gold upleg, both in identifying the legendary buying opportunity when it arrives and in picking the right horses to run the next race up. What an exciting time to be a gold-stock speculator!

For now though, the oversold dollar levels and overbought gold levels in Relativity terms are troubling. The US Dollar Index really looks like a major countertrend rally is imminent and due. And if a bear-market rally in the dollar launches, for any reason, odds are that gold is going to get hit over the short-term. Get ready!

The contrarian bet today is not to run with the popular short-term media prognostications of dollar doom, but to anticipate a near-term countertrend 200dma convergence for the mighty US dollar.


 

Adam Hamilton

Author: Adam Hamilton

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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