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August 12, 2005

US Dollar Bear 3
by Adam Hamilton

The mighty US dollar has been having an awesome 2005 thus far. Since it bottomed just above 80 in the waning days of 2004, the world's flagship currency has rallied 12.2% as of early July. In the glacial world of currency trading, this is one big move!

Some of this magnificent rally can certainly be attributed to recent news regarding major competing currencies. Back in late May the euro was thrown into stunned turmoil when the French and Dutch overwhelmingly voted against accepting the European Union Constitution. Currency traders reacted strongly and immediately dumped the euro and bought the dollar, accelerating its maturing rally.

And just a few weeks ago China announced that it was severing its longstanding dollar peg controlling the yuan's exchange rate. As the markets struggled to digest the full implications of this long-awaited pivotal event the dollar rallied nicely over the subsequent few days. It has been quite the summer for big currency news worldwide.

Naturally the strong dollar dominating the first half of 2005 has led to very bullish dollar sentiment. Rising prices inevitably lead to widespread bullishness and ubiquitous predictions for more of the same. We are certainly seeing this phenomenon today whenever the dollar is discussed. Financial television is now overflowing with commentators extrapolating the dollar's recent uptrend out into the indefinite future.

While the dollar's recent performance has definitely been outstanding, it does trigger warning klaxons blaring in my contrarian brain. The core tenet of contrarian thought is simple. When the majority of market players cluster on the same side of any trade, such as being long and bullish on the dollar, that is just when the markets tend to suddenly reverse and trap the conventional thinkers with their own hubris.

As a lifelong student of the markets I have found that the best defense against getting caught up in short-term sentiment extremes like the mainstreamers is to always keep the long-term perspective in mind. Current trends like the dollar's six-month rally that seem so powerful and ironclad to us today might not be all that impressive when considered within the context of multi-year secular trends.

And indeed this is the case with the US dollar. Since carving a massive double top just over 120 in July 2001 and January 2002, the venerable US Dollar Index has been trending relentlessly lower for over four years now. Bear to date the dollar is down a sobering 33% as of its late December lows! This is devastating news for dollar holders like you and I, as we have lost one-third of our international purchasing power since only four summers ago.

Powerful long-term trends are considered secular once they exceed three years, so the dollar's bear market is now well into the annals of seculardom. The primary attribute of secular trends is that they are always driven by fundamentals, there is some massive underlying supply/demand imbalance that must be restored. And secular trends, once they are under way, never end before prices move far enough to restore fundamental balance.

Since there are no controls whatsoever on the Fed's printing presses and Washington's voracious appetite to spend money that it doesn't have, the supply of dollars is destined to grow until it is eventually inflated into oblivion. But against this ever-growing supply backdrop, demand is waning around the world. Foreign institutions and investors are growing tired of seeing their dollar holdings lose value year after year so they are diversifying out of dollars. With a growing supply and withering demand, dollar prices must fall to reestablish equilibrium again.

These bearish fundamentals that are driving the secular dollar bear are so evident in long-term dollar technicals. It is true that the dollar was up 12% in the first half of 2005, an outstanding performance. But at that very same July dollar top the currency was still down 25% since the summer of 2001. Your perceptions of the dollar's fortunes of late are totally dependent on whether you take the short view or the long view.

While speculators can take the tactical short view and ride short-term trends up and down, investors need to take the strategic long view if they want to survive. The dollar bear is very much alive and well today despite the bullish 2005 action. In order to technically analyze both perspectives to better comprehend the dollar's prospects going forward, we updated the charts from last November's "US Dollar Bear Notoriety".

The dollar's 2005 rally, which looks so darned big when considered in isolation, looks a lot less impressive when considered within its proper strategic bear-market context. Between a third (at the December bottom) and a quarter (at the July top) of the dollar's international purchasing power has already been eroded by this ravenous bear. While the 2005 rally is unique in many ways, it hasn't even started to undo this bear's damage.

Like any secular market, the dollar's bear market has occurred via a series of ebbings and flowings largely contained within the long-term downtrend channel rendered above. The ebbings are the bear-market downlegs that drag the dollar down to fresh new bear-to-date lows before temporarily reversing to bleed off excessively bearish sentiment. From these lows periodic reversals spawn, bear-market rallies, and take the dollar back up to new lower interim highs.

Bear to date we have witnessed five of these complete downleg-to-bear-rally cycles so far since the dollar's double top four years ago. All five are numbered above in gray, along with the number of trading days that each complete cycle took. Before our current cycle the average duration of the first four cycles was 144 trading days. This latest one, weighing in at 287 days, took twice as long. This longer duration helps explain why dollar sentiment is so bullish today and so many folks believe that the dollar bear is over.

Regardless of this latest longer cycle though, the technicals above, even including the 2005 rally, are incontestably bearish. Each of the five downleg-rally cycles above carried the US Dollar Index to fresh new bear-to-date lows. These lows are noted above by the blue numbers. The fifth major interim dollar low near 80 in late December was well lower than the fourth low near 85 in early 2004. A series of consecutive lower major interim lows over a secular timeframe is the very signature of a healthy bear market.

The second half of these major cycles is the bear-market rallies that bleed away the excessively negative sentiment at the interim bottoms. In all five major bear rallies above, including our current one, the US Dollar Index reached a lower high. At the moment our current bear rally appears to be reversing well short of exceeding the dollar's May 2004 interim high a hair over 92. A series of consecutive lower major interim highs over a secular timeframe is also telltale bearish action.

So technically from a strategic perspective, so far the 2005 dollar rally has given us no evidence that the dollar bear is ending. Yes it rallied materially above its 200-day moving average for the first time bear to date, yes it broke above its major resistance line, but as of now it is still carving lower lows and lower highs. I will discuss the 200dma and resistance breakouts after the second chart a bit later below.

While this 2005 dollar rally hasn't been large enough to end the textbook bear pattern of lower lows and lower highs, it has still been unique in many ways. Not only was cycle five twice as long as the average of the previous four cycles, the bear-market rally this time around was the largest by far in this bear market to date. These differences are interesting and certainly ought to be studied and discussed.

In the downleg phases of the downleg-rally cycles, the first four major dollar downlegs averaged 11.8% losses over 96 trading days each. The fifth major downleg in the second half of 2004 had a 12.4% loss, right in line with the average. Interestingly last year's 12.4% downleg was also the median, with two downlegs running larger and two others running smaller. But at 159 days long, this latest downleg was the longest by far in this bear.

In the bear-rally phases of these cycles, the first four major bear rallies averaged 6.1% gains over only 48 trading days each. Major bear rally five of this year just blew these averages right out of the water. This latest dollar bear rally ran up 12.2%, doubling the average. And at 128 days in duration it nearly tripled the average duration of previous major bear rallies. The 2005 dollar rally is totally unique in terms of its magnitude and duration.

I find this uniqueness very interesting on multiple fronts. The fact that this latest dollar rally was way bigger and longer than what we have come to expect in this bear market goes a long way towards explaining why dollar sentiment is so bullish today. The longer and higher prices climb, the more investors become convinced that a major new trend is underway that is likely to continue higher indefinitely. This is just human nature.

And since this total bear cycle five has taken twice as long as the average of the first four, the memories of the dollar relentlessly sliding lower a year ago have largely faded. The tyranny of the short-term is difficult to escape. Unless one is a student of the markets always studying history to keep the short-term in proper context, the short-term can quickly expand to fill one's whole mind and crowd out the priceless strategic perspective.

Since the 2005 rally was so outsized compared to precedent, there must be some reason to drive this magnitude of move. And if these probable reasons can be isolated, are these factors still likely to keep motivating speculators to buy dollars and drive this rally still higher in the months ahead? Or are these reasons already obsolete and weighing on the dollar's progress?

In order to delve into these crucial questions, a short-term tactical chart is in order. The small blue-shaded area in the lower-right corner of the first chart above is expanded for better resolution in this next chart below. It grants us an excellent tactical perspective into when the dollar broke out so we can figure out why. If the factors that drove this breakout cannot spawn sustainable buying demand, then the dollar will continue rolling over.

Now remember that secular bear markets naturally ebb and flow, steep downlegs cascade lower but then bear-market rallies erupt from the depths of despair to bleed off excessively pessimistic sentiment. Over time these cycles carve a series of lower lows and lower highs, which is exactly what we see on this dollar chart. The best way to understand the 2005 rally in context is to start at the beginning of this chart.

Back in early 2004 the dollar was oversold. It had just plunged 14.3% in its biggest downleg of this entire bear market and general sentiment was unbelievably negative. It was also extended far below its 200-day moving average and even below its long-term support line. As I wrote at the time, "The US Dollar Index really looks like a major countertrend rally is imminent and due." The resulting bear rally in early 2004 proved to be the largest of this bear until this year's 2005 specimen.

By May 2004 the dollar was back above its 200dma again and kissing its upper resistance. A secular trend's 200dma is so critically important because it not only parallels the trend but it tends to be where the periodic countertrend reversals, or bear-market rallies in a bear's case, advance to. With the 200dma convergence in the bag, the obvious bet to make at the time was that the next major dollar downleg was approaching. And indeed it was.

Sliding slowly at first last summer, the dollar plunged dramatically in October and November. By the time December rolled around the dollar was obviously oversold again, sentiment was rotten, and the fifth major bear-market rally was due. And it erupted right on schedule and started climbing higher. Between January and early May the dollar bear rally was proceeding on schedule. It remained within its secular downtrend and under its 200dma.

As you can see above, in April the dollar started challenging its secular resistance line. It couldn't break decisively above until May, but it was certainly trying to. Now it is important to realize that prices moving outside secular trendpipes generally don't threaten the secular trend. A trend is not an absolute, but more like a high-probability zone. Odds are a price will be within trend most of the time, but occasionally big news can drive a price outside of these long-term trends for a season.

On the left side of this chart note that the dollar had broken below support, the bottom of its trendpipe, in early 2004 but it eventually meandered back up into its trend. In any given secular trend prices tend to be within it, but from time to time they move lower or higher than expected. This is no big deal and par for the course in long-term trend analysis.

By the first half of May the dollar had climbed far enough above this downtrend to pierce its key 200dma. This had happened before as recently as last August, as this chart reveals. It alone was not an anomaly and didn't look the least bit concerning. As the dollar stabilized around 86 in mid-May, I suspected probabilities were once again favoring a new downleg. At that point the dollar was up 7.1% over 95 trading days, not too far out of line with the previous four bear-rally averages of 6.1% and 48 days.

But by mid-May, when the dollar probably should have been topping, disturbing reports were emerging from Europe. Eurocrats desperately wanted the important countries of France and the Netherlands to ratify the EU Constitution. Despite dire predictions by dramatic politicians of all kinds of calamities if the voters didn't play along, polls showed that the French and Dutch were not yet ready to surrender their national sovereignty to Brussels.

The euro slid on the growing European uncertainty, pushing the dollar above 87. When the votes were tallied in late May both electorates voted against the EU Constitution and the euro plunged. This drove the dollar even higher, to 89 by early June. The ironic thing about this, as I wrote at the time, was that nothing had changed. Prior to the vote France and the Netherlandswere not under the EU Constitution just as they were not after the vote. The status quo was unaltered, no fundamental change had happened, so emotional trading dominated.

With the dollar at 89, the momentum currency traders grew ever more interested and started to buy the dollar as well. They managed to push it above 90 by early July, but soon selling outweighed the buying. Technicians increasingly pointed out the major resistance zone between 89 and 90 that is shaded blue above. The dollar failed to break above this several times in a row last summer and looked to be failing again. Technically savvy traders heeded this warning in recent weeks and sold.

So from 80 to 86, January to mid-May, this latest dollar bear rally was proceeding just as expected. But from mid-May to early July, not much time in the grand scheme of things, the turmoil in the euro hit it hard enough to reignite the dollar rally blasting it up to 89 or so. By that time dollar momentum was enticing in other players to drive it up to its latest interim high above 90.

If the euro's precipitous fall on the election uncertainty was the catalyst for the second stage of the dollar's 2005 bear rally, then is this cause likely to continue motivating traders to buy aggressively? I doubt it. Nothing changed in Europe and the euro is already recovering from that rout. Not surprisingly considering the notoriously short-term memories of currency speculators, they seem to be already forgetting the whole exciting episode.

And since the latest interim dollar highs of June and July, the mighty currency has stalled in the very major resistance zone that has been worrying the hardcore technicians. The last couple months of dollar action is looking very toppy and it continues to fall on balance. And if most of the rally from 86 to 90 was indeed driven by fleeting euro weakness, then odds are this extratrend anomaly will be quickly erased as the dollar returns to its secular downtrend.

And unlike the euro votes which did nothing, late July's announcement by China that it was severing the dollar peg for the yuan has huge and very real implications for the dollar. Revaluing the yuan higher is the same thing as devaluing the dollar lower, reducing its international purchasing power. As China's vote of no confidence in the dollar spawns worldwide selling, it will probably accelerate the next major dollar downleg considerably.

I discussed the probable impact of this yuan revaluation across major markets in the current August issue of our Zeal Intelligence newsletter. All investors really need to understand just how earth-shaking China's decision will ultimately prove to be. It's not only the currencies that are affected, but stocks, bonds, and even American real estate could be severely adversely impacted if the yuan continues meandering higher ahead. The dollar bear is just the beginning.

Since this dollar bear is alive and well, one of the greatest beneficiaries is likely to be gold. Indeed gold has been getting stronger lately as the dollar continues to swoon. We have been extensively deploying our own capital in elite gold and silver stocks so far in 2005 and preparing for this coming dollar downleg/gold upleg. It is not too late to buy now, but it may be soon. Our August newsletter outlines all of our current buy-recommended gold and silver stocks for our subscribers. Please join us today!

The bottom line is the dollar remains in a secular bear market. Not even the 2005 rally, as impressive as it was, could break this long-term cycle of lower lows and lower highs. While this rally was the largest and longest to date, a good 40% of it was driven by political turmoil in Europe that had no fundamental impact on currencies. As the euro recovers, the dollar's bear is reasserting itself.

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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