My Nine Reasons Why the U.S. Dollar May Have Bottomed

It’s always difficult to pinpoint where we are in terms of a trend, whether it’s in stocks, bonds, or other assets. Long-term trends in the currency markets have ranged from six to ten years, measured by the various bull and bear markets in the dollar since the inception of the free-floating currency market back in 1971.

Here’s the pattern as measured by the U.S. Dollar Index:

•   1971-1978: Seven-year bear market (President Nixon closes the gold window)

•   1978-1985: Six-year bull market (Fed Chairman Volcker squeezes inflation)

•   1985-1992: Seven-year bear market (triggered by the Plaza Accord)

•   1992-2001: Ten-year bull market (tech boom and money flow to U.S. assets)

•   2001-2008: Seven-year bear market (bottom on the credit crunch)

•   2008- ?: Next major bull market?

No one can say when multi-year bull and bear markets end without some perspective. But we can evaluate conditions as they develop that may indicate the potential for a change in the big trend.

I’ve found that the boom/bust cycle of price action, as shown in the chart below, helps put these longer-term moves into some type of perspective.

The dollar, especially from a longer-term perspective, moves in waves — discernable waves based on human emotion and supported to differing degrees by the underlying economic fundamentals at various stages along the way.

It sounds complicated, but it’s not. Here’s an example of the waves or stages of the dollar in a boom/bust price cycle …

Stage 1: The unrecognized trend — This represents the beginning of a new trend that is recognized by only a few of the major players. Yield differentials may have shifted in favor of a currency, but few have noticed.

Because of the self-reinforcing price-led move at the latter stages of the move down (the flipside as described in the “climax stage” below) few want to worry about bad news. At this stage some underlying fundamental shifts can be seen and often lead the price move by several months.

Stage 2: The successful test — This is the pull-back that challenges the initial rally phase that reinforces the primary consensus view, even though the consensus is starting to lose some conviction. The sentiment extreme has peaked and is starting to decline. It represents a significant retrace of the prior wave “unrecognized trend” stage.

Stage 1 & 2 Combined: The beginning of a self-reinforcing process in the other direction — This is the area, initial move off the low then the test of the low, where many in the consensus begin to question the old trend and realize there may be some underlying fundamental rationales why a change in trend has validity. This is the precursor to the most powerful leg up, which is …

Stage 3: The growing conviction, resulting in a widening divergence between reality and expectations — This represents the major leg or wave of the trend. It is where the consensus is fully engaged. They are right about the fundamental rationales, or the related expectations, supporting the trend. Simply put: The currency is moving in-line with the news.

Stage 4: The flaw in perceptions — This is the stage in the cycle when some of the major players begin to realize the currency cannot be supported by the fundamentals much longer. In other words, the move higher has led to an “overshoot” of the currency’s underlying value relative to other major currencies.

It represents a leg down, or a correction of ‘the growing conviction’ stage of the move. It is the precursor to the climax, when the public is fully in the trade and “knows” it will go higher.

Stage 5: The climax — This is the final stage of the move and represents the “overshoot.” It’s where the original rationales no longer make sense to support the move higher in price. Thus, the move becomes price-led as the players fully believe higher prices support their rationales no matter how flawed those rationales may be. This is where the currency moves higher in spite of bad news because players are still adding to their winning bet. This stage can also be called the sentiment extreme stage, or maximum bullish stage, of the move.

After this, a new self-reinforcing process begins in the opposite direction — the trend begins in the opposite direction and the 5 stages start anew.

So Where Are We Now in Terms of
a Major Bear or Bull Market in the Dollar?

I think we are late into Stage 1 and Stage 2 as players are starting to recognize the trend change.

The “climax” stage is far away in this new dollar move; when reached you’ll know it. That’s when everyone in the world will love the dollar every day, all the time. Shoeshine boys will be playing the FX market, going long the dollar and making a killing. That’s when you know it’s time to start looking in the other direction. But that is a long way off!

So, the key question is: Has the U.S. dollar bottomed?

My answer: The dollar has bottomed and has entered a new multi-year bull market.

Since currencies began floating in 1971 (i.e. governments no longer set currency prices) and values were left to the forces of market supply and demand, there have been two multi-year bull markets. And the move from bottom to top has been significant, 110 percent and 55 percent, respectively (highlighted in yellow in the chart below).

#1: 1978-1985 (7-years) Approximate move = 100 percent

#2: 1992-2002 (10-years) Approximate rally = 55 percent

If you can catch a multi-year bull move in the dollar early, there is a ton of money to be made. Of course that requires you have the staying power — or confidence — to stay with the trade.

Now, here are my …

Nine Reasons Why the
U.S. Dollar May Have Bottomed

1. Credit crunch forces change — U.S. savings are going up; debt sentiment has changed.
2. Flight from risk — Euro-zone crisis
3. Growth in U.S. — Not as bad as expected; it’s all relative. Much better in U.S. than Europe, UK, and Japan.
4. Carry trade history — The Fed hiked rates before the Bank of Japan and before European Central Bank (ECB); and the ECB should be cutting rates soon.
5. U.S. assets are very cheap and enticing — A currency plays a major part in that role. Foreign direct investment is improving in the U.S., and some manufacturing is coming back home.
6. Sentiment — Newsletter writers still tell us the dollar is doomed. Usually those who don’t trade the dollar, but like to talk about it, are the most strident at the wrong time.
7. Correlation — Stock market down and dollar up. If stocks break down, as I expect, the dollar will likely rally on that alone.
8. Technical — Upside momentum. Broke its weekly downtrend and has cleared some key resistance on the upside.
9. Euro craters as a currency — Crisis peaks. If the euro experiment comes unglued, traders will rush into the U.S. dollar on their way to buying Treasuries.

This kind of long-term trade setup doesn’t roll around very often. And it is a great risk-reward trade. We’ll know exactly if we are wrong; but the upside potential is huge!

So stay tuned and watch how a new long-term bull market in the U.S. dollar is likely to develop. And if you want to get in on the action, be sure to read my latest report. Just click here.

Jack