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December 10, 2004

The Relative Dollar and Gold 3
by Adam Hamilton

The global currency markets boiled this week with all the fury of a raging storm-driven sea, leading to some of the biggest daily swings in months.

On Wednesday alone, the galloping euro fell 0.7%, the perpetually manipulated yen bled 1.1%, the much-maligned US Dollar Index surged 0.8% higher, and the ultimate currency gold plunged 3.3%. It was definitely one of the most interesting currency days in recent memory, since the currency markets typically meander slow enough to make a glacier look swift.

While unique and unprecedented factors were probably responsible for the gold slide in particular, which I discussed in a Zeal Speculator Update published Wednesday evening, all the exciting action this week got me thinking about probabilities again. Probabilities are truly the bread and butter of speculating.

We live in a world where nothing is certain and anything can happen. Physicists, especially the quantum variety, express this mathematically by saying there is nothing with a probability of 1, certain to happen, or 0, impossible to happen. While a particular probability may be very large or fleetingly small, it can never hit certainty or impossibility.

In life we tend to ignore this universal truth although we all intuitively understand it. Next time you hop in your car to head to work or get groceries, there is a tiny chance you are going to burn to death imprisoned in the twisted-metal wreckage of your ride courtesy of a blistering gasoline-fed inferno. Yet, since the risk of dying in an automobile accident is so very small relative to the number of car trips made a day, we all consider this risk acceptable and are willing to bear it.

And if probabilities with no certainty permeate our regular lives, then the financial markets are possibly the purest study in probabilities imaginable. Every single decision to buy or sell in the global markets, whether consciously or not, is not made without the buyer or seller first gaming the probabilities. A market participant must weigh risks and potential rewards, and somehow handicap when the odds are in his favor and when they are not.

Investors and speculators get themselves into the most trouble when they become so enamored with a particular trade that they momentarily forget that nothing has a probability of 1. Contrarians express this in terms of bullish or bearish sentiment, when the majority of traders crowd onto one side of a trade. These very moments when folks feel like a trade is a sure thing are among the most dangerous in the markets. Nothing is certain and the risk of losses, even total losses, always exists.

When a given trade is hot and everyone is talking about it, our natural tendency is to mentally extrapolate it out into infinity. We fall into the deadly trap of linear thinking, assuming the future will conform to only the most recent past. This behavior becomes most pronounced during popular manias, such as the NASDAQ madness of early 2000. While common in the markets since greed and fear blind so many, similar assumptions seem absurd in normal life.

For example, if you saw a child blowing up a balloon that was getting larger and larger, what would you assume? Obviously, the more stretched the balloon grows, the more air it contains, the higher the probability it will suddenly burst. Yet, using typically flawed market logic, the average trader sees a linear trend, like a balloon being inflated, and assumes it will run out into infinity. The trader wrongly assumes that the bigger the balloon grows, the lower the probability it will suddenly burst!

The longer the market has moved in one direction, the more traders think betting with it is a sure thing. It is like betting the larger a balloon swells the larger it is likely to get. Instead, in reality, the longer a particular trend has been in force the higher the probability grows that it will reverse. Nothing moves in the same direction forever and periodic reversals are evident at every scale, from intraday to decades, even in strong primary trends.

At an intermediate time-scale, considering several months, the currency markets seem to be stretched like our proverbial balloon. Dollar shorts are multiplying like rabbits as pretty much everyone expects the dollar to continue lower in the weeks ahead. Before Wednesday's startling events, gold sentiment was waxing pretty bullish as well, although the gold stocks have been stubbornly reluctant to follow.

Thus, I would like to discuss the current dollar and gold scene in terms of probabilities this week. Not you nor I nor anyone knows the future in advance, but we mere mortals can certainly analyze probabilities and attempt to trade only when our odds of winning seem the highest.

In speculating, probabilities are best defined by using a time scale at least an order of magnitude greater than the period of time over which you are interested in trading. In this case, we are interested in the probable behavior of gold and the dollar over the next several months so we should consider a time scale of 10x that, at least 30 months. By considering the perpetual ebbing and flowing of the markets on a 10x greater time scale than the one over which we seek to trade, we can gain a better understanding of when our odds for success are particularly high.

Our first chart compares the US Dollar Index and gold over the past three years or so, relative to each other and to their own respective 200-day moving averages. The negative correlation between these two competing currencies is an astounding -0.95, among the highest I have seen in the markets over several years. This inverse relationship is to be expected though, especially in Stage One of a secular gold bull.

Besides the striking symmetry between the dollar and its arch-nemesis gold, the distinctive X in this chart presents an ideal study in probabilities. By considering the behavior of the dollar and gold over several years, we can gain an excellent idea of when probabilities swing wildly in our favor for being long or short one or the other for the next few months. Since we can't see the future, the best we can hope for is to trade only when the odds seem to be massively in our favor.

The probability analysis begins with identifying the primary trends. While both the dollar and gold oscillate all over the place from week to week, over the last several years the dollar's secular trend has been bearish while gold's secular trend has been bullish. The dollar's top resistance line is drawn above in red while gold's lower support line is rendered in blue.

Now realize these linear technical lines are virtually never mathematically precise. Technicians today generally draw in support and resistance lines framing prices by hand just as they did a century ago. Drawing straight lines is certainly easier with a computer, but technical lines are just as subjective as ever. If you had drawn the lines above instead of me, you may have chosen a different slope for the red dollar resistance and blue gold support lines.

Thankfully though, there are also technical lines that are absolute, without the slightest sliver of subjectivity. Both of the 200-day moving averages rendered above, for example, are precisely defined mathematically. If you, I, and 100 other people compute gold's 200dma, we are all going to get the same number and the same chart line. Since the simple 200dma is absolutely defined and utterly unambiguous, it is a great base from which to launch into probability analysis.

In multi-year charts with trending markets, 200dmas tend to run parallel with the primary trend. This is obvious above with both the dollar and gold. The dollar's absolute 200dma roughly follows its subjective resistance line, and gold's 200dma runs impressively parallel with its subjective support line for years. Thus the mathematically precise 200dmas unmask primary trends and can be used as a reference point from which to judge the soundness of hand-drawn technical lines.

Because of their very mathematical nature, 200dmas lag behind trending markets. A 200dma is computed by adding up today's close with the previous 199 closes and dividing by 200, so it is past-biased and generally lags prices by many months. Thus a secular bear market like the dollar tends to sell off and continue lower after it nears its 200dma, while a secular bull market like gold tends to rally higher after it approaches its 200dma.

The ongoing interaction between a trending market and its 200dma is quite telling, regardless of if the trend is bullish or bearish. Prices tend to diverge away from and then revert back to their own 200dmas over time. If you look at enough charts and consider enough historical markets, it gradually becomes evident that this perpetual flow and ebb away from and back to 200dmas is universal. Indeed it pretty much has to be this way due to the very mathematical nature of the 200dma!

The distance between a price and its 200dma allows us to define probabilities. In both the dollar and gold above, when they are close to their respective 200dmas they are likely to pull away and when they are far from their 200dmas they are likely to revert back. Gaming the 200dmas creates an analytical framework from which we can define high-probability-for-success opportunities for a particular trade.

If you want to short the dollar, the best time is when it is near its black 200dma line shown above. Bear to date the closer the dollar was to its 200dma, even over it briefly, the higher the probability its next major move would be a bearish downleg. Conversely if you want to be long the dollar, your best bet is to wait until it is far below its 200dma, like today. The most powerful bear-market rallies bear to date always erupted when the 200dma divergence of the dollar was greatest. As long as the secular dollar bear remains in force, these odds should remain similar.

If you want to go long gold, you have the best chance of winning if you do it when it is near its white 200dma line rendered above. All of the biggest uplegs in our gold bull to date launched when the metal was meandering near its 200dma. Conversely the best time to short gold is when it ventures far above its 200dma, like today. Just like the dollar, as long as this secular gold bull persists the odds for multi-month speculations are likely to remain similar.

Since any trending price tends to run away from and revert back to its 200dma periodically, the distance between a price and its 200dma is a good proxy for probabilities of reversal. Even with long-term trends short-term reversals are likely when a price either nears its 200dma or runs too far away from it. This idea is very simple, yet it proves quite effective in practice.

The primary problem with using it for active speculation lies with the problems in visually estimating a particular 200dma divergence. As a chart scale grows larger it skews percentage changes. In the chart above a $25 gain in gold from $250 looks the same as a $25 gain in gold from $450, yet in percentage terms the former is almost twice as large as the latter. All visual estimates are subjective anyway, lacking precision.

In order to precisely measure 200dma divergences, I developed the tool of technical Relativity. It takes a price and divides it by its 200dma. The result is a number that expresses where a price is relative to its 200dma as a ratio. When a price is 25% above its 200dma, it has a relative reading of 1.25. When it is 10% under, it has a relative reading of 0.90. This ratio approach ensures that percentage changes over time are considered in constant terms and eliminates all visual skew and subjectivity.

Our final chart graphs these relative dollar and relative gold indicators. Imagine if the conventional X chart above was somehow flattened like opening a scissors all the way up. Both the dollar's and gold's respective 200dmas are flattened on the x-axis along the 1.00 line below while the price data is also flattened onto a horizontal constant-percentage scale as a ratio. This tool allows us to define the probabilities that can guide our tactical dollar and gold trades looking out a few months.

When the dollar and gold prices are flattened along a horizontal 200dma proxy and their prices are expressed as ratios to their respective 200dmas, we can finally clearly understand intermediate-term trading probabilities. Both the rDollar and rGold form well-defined ranges which have held solid for years now in their secular trending markets. These ranges of interest are defined above by the red and blue transparent zones collaring both series.

In the dollar's case, it has tended to oscillate between 0.92 and 1.00 relative in its secular bear to date. When it falls down under 0.92, like it did last Friday for the first time since January 2004, a major bear-market rally grows highly probable. In fact, almost a year ago I used this very analysis to warn our subscribers of a highly-probable imminent major dollar bear-market rally and major gold correction. Probabilities are simply not in favor of being short the dollar when it is already stretched far below its key 200dma resistance like today.

Gold, on the other hand, has tended to meander between 0.99 and 1.14 relative in its secular bull to date. When it gets high above its 200dma, like last Friday's 1.121 reading 12.1% above, the probability increases that a major correction is looming. Periodic corrections are absolutely necessary in bull markets to bleed off speculative excesses and keep the bull healthy. Like a balloon being blown up, the higher gold stretches above its 200dma the higher the probability for a major correction grows.

Thus, just as during the times my first two rDollar and rGold essays were published, early January 2004 and late April 2004, today the probabilities are swinging in favor of a major intermediate trend change, temporary multi-month reversals, in both the dollar and gold. The farther the dollar and gold stretch away from their respective 200dmas, the greater the odds grow that the next several months will hold a major dollar bear-market rally and a major gold correction.

As a hardcore gold investor and speculator myself I fully realize this analysis is not what folks want to hear, but nevertheless I must share it. Periodic multi-month reversals within secular trends like the dollar's and gold's are quite common and very healthy. Without the reversals general sentiment would wax too extreme which would threaten to prematurely end the dollar bear and gold bull. So far at least, 200dma divergences have been one of the best ways to identify these reversals early.

The relativity-based interpretation of the wild currency action of the past week or so is that these extreme 200dma divergences today are just not sustainable. Rather than worrying about the inevitable flowing and ebbing of the markets away from and back to their 200dmas, we can harness this behavior to help us multiply the capital in our portfolios.

For example, if you are a dollar speculator, don't short the dollar today while everyone else is and it is already so far under its 200dma. Odds are you are going to get slaughtered in a bear-market rally so it doesn't even make sense to accept this enormous risk. Instead throw long or get out.

For gold investors and speculators, the best time to go long gold and deploy capital is not when gold is stretched far above its 200dma like today, but when it retreats back down to kiss it. We had such a glorious opportunity last spring and we will almost certainly have many more in the future. Today's big 200dma divergence demands neutrality at least, although aggressive speculators can short it.

Going long gold when it is low relative to its 200dma is a high-probability-for-success trade, not to mention the ideal time to buy long-term investments when they are low. But going long gold when it is high relative to its 200dma like today is a low-probability-for-success trade, a gamble. Heeding the relativity signals thus far has led to excellent realized profits in each upleg in this gold bull to date, not to mention helping speculators profit on the short side during the periodic corrections.

Now we began with probability theory and should end with it. Anything can happen in the markets at any time. While the odds are small, the dollar could still plummet, even from here, on some catastrophic news. And at some point gold is going to leap out of its Stage One currency bull into a Stage Two investment bull, radically changing its slope in the process. Relativity works best in trending markets and works worst when secular trends change, either reversing outright or merely accelerating in the same direction.

Relativity too is ultimately a linear assumption, along similar lines to those I warned about above where traders think the current short-term trend can be extrapolated into infinity. Interestingly though, the longer the period of time the less risky linear assumptions get. A several-year secular trend is much more likely to persist for several more years in the future than a several-day trend is for several more days.

The greater the length of market time considered, the less that random noise affects prices and the more meaningful their trends. Once a trend runs for years, it is highly unlikely to cease until the underlying fundamentals driving it also fully run their courses.

If you are interested in seeing how we apply this relative currency analysis in terms of real-world speculation, please subscribe to our acclaimed Zeal Intelligence monthly newsletter today! The current issue discusses actual trading strategy based on relative analysis and we will certainly point out in the future when the odds once again swing wildly back in our favor for deploying new gold and gold-stock speculations.

We are already hard at work analyzing stocks for potential recommendation in the next major gold upleg. In addition our subscribers gain Web access to relative dollar, relative gold, and relative euro charts updated weekly so you can easily monitor these important developments.

Like a balloon stretching, the farther away a price pulls from its 200dma the higher the probability grows that it will temporarily reverse to revert back to its 200dma. While not exceedingly extreme yet, both the dollar and gold are getting relatively far from their respective 200dmas so we must be very vigilant for the increasingly probable reversals.

A major dollar bear-market rally and major gold correction lasting for a few months are nothing to worry about for those prepared for the risk, but for those who aren't their capital can evaporate rapidly. Please be careful here!

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

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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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