Currency Watch

We have been waiting for some time for a period of a week (5 trading days) or longer when our Top RS/EPS New Highs list outpaces our Bottom RS/EPS New Lows list by 40, which would usher in a good environment for adding long exposure more aggressively.  As our chart at the bottom of this column (each week) shows, we got a few days of +40 and then a collapse that failed to produce our desired environment.  Currently Bottom RS/EPS New Lows are actually higher than Top RS/EPS new highs – hardly an ideal environment to aggressively position in on the long side or the short side.  In a true bull market, we will usually get a rather quick transition to consistently +40 readings or higher that allow us to pick and choose among multiple breakouts that are close to meeting our criteria each day for many weeks in a row.   That has not been what has developed since the March lows so far, and our suspicion remains that this is a bear market rally.  Some leaders such as E&P and steels and natural gas and fertilizers have had good runs and catchable rallies, and there may yet be another leg to this bear rally, but it is not something that sizeable allocation can be put to, at least yet.

However a wonderful thing has happened to the stock market over the last many years.  ETF’s of many kinds have been placed that allow investors in stocks to actually access other asset classes at least in a limited fashion.  London has led the US in innovative new ETF’s, but the US market still offers a growing list of alternative asset classes that US exchange investors can now access.   When the market environment is not great, it is good to review what is happening in other asset classes too.   So let’s take a brief look at the currency world that can now be traded on US exchanges via ETF’s.

We talked about the FXS/FXB spread, which essentially buys Swedish Krona and shorts British Pounds for an ETF created SEK/GBP cross.  The cross or spread is still trending higher, and investors can use last week’s lows in the spread as a trailing stop to cut risk to virtually break even now from our original recommendation. 

We’ve also talked about CNY (the ETF that is long the Chinese currency versus the US dollar).  The action in CNY since early April shows why the ETF is a vastly inferior vehicle to NDF’s (non-deliverable forwards) on the forex market.   Shorts in the 1 month NDF are essentially the same transaction as buying long the CNY ETF, yet the NDF’s are flat since late March, while the ETF’s are lower.  For those interested in actual forex market recommendations see our MRG Weekly Institutional Macro Research service (www.midasresoucegroup.com) which has made consistently strong profits in the forex arena for years.   However we continue to suspect that the trend higher in the Chinese currency will be so substantial that even the inferior CNY ETF will be able to benefit and post low double digit type potential annual returns.    In fact the trend toward higher Asian currencies like the Chinese Yuan, the Singapore dollar, and others, remains our favorite long-term macro theme in the currency arena.  Unfortunately the CNY ETF is the only way outside of actual forex trades or CD’s at Everbank (www.everbank.com), to play this theme for those not having full forex accounts at major investment banks or European Private Banks.  But I suspect over time that more ETF’s will allow better access to this theme.

On a trade-weighted basis, the dollar is setting up to test its all-time lows, whereas the dollar index, derived from trade-flows from decades past in its composition, is already at all-time lows.  Some of the prime drivers of currency moves relate to interest rate differentials and expected interest rate differential shifts amongst the various countries in the forex world.  Relative economic performance is also important because it ultimately becomes a prime driver of future interest rate differential shifts.  Longer-term variables such as current account and trade flows,  PPP (purchasing Price parity) valuation, and shifts in a countries terms of trade also bear watching for currency traders. 

The dollar index has been on a long-term downtrend since early 2003, declining from around 120 to around 71 currently – a 40% decline in value, whereas the US trade-weighted dollar, which accounts for who we are trading with each month and how the dollar fares on a basis weighted to our trade flows, is down about 25% since peaking in 2002.  Investors need to realize that on a global purchasing power basis, US investors denominated in dollars have lost somewhere between 25% and 40% of their global purchasing power since the 2002-3 period.  I have and continue to make the argument that the biggest beneficiary of this trend has been the one true store of value currency in the world, gold.  But to many, gold is no longer a true currency, and the EUR has been a prime beneficiary of dollar depreciation. 

The dollar decline against the EUR has accelerated since last summer, with FXE, the Euro ETF, gaining around 18% on the dollar in that short period.  This accelerated decline has largely been attributed to the huge interest rate cuts the US has had to institute in the face of its financial crisis, while Europe has not cut rates at all in the face of massive US rate cuts of 3% in the Fed Funds rate and expectations of another 25 bp’s next week.  In other words, the dollar has fallen sharply as rate differentials between the US and Europe have fallen sharply.  However the dollar has also fallen to a degree of PPP undervaluation that has generally led to a bottom in the history of the currency since 1972 when the US closed the gold window to foreigners and became a total fiat currency.   This means that increasingly, further drops in the dollar versus the Euro will start to weigh on European growth, because Europe is being priced out of international markets by an overpriced currency.   A currency can remain PPP undervalued at historic values for many many months, but moves down below a certain level of undervaluation have been unsustainable in the past. 

What usually happens when one country’s currency reaches historic undervaluation versus another because of relative growth shifts that cause interest rate differentials to become more and more negative is that eventually the strong currency country begins to show a path toward weakening growth too, but with a lag.  Europe normally lags the US growth cycle by 6-18 months.  And the longer the dollar is priced at historic undervaluation levels versus the Euro, the more difficult it becomes for Europe to compete against the US on international markets.  The weak dollar helped keep the US from technically sliding into recession in 2007 because increased trade gains fed 1% GDP growth which largely offset the decline in GDP of a slightly higher amount from the housing drag.  For Europe trade is becoming more difficult because of an overvalued currency.  Thus it is important to watch European growth indications for signs of a slowdown.  Indeed today’s IFO survey showed a sharp decline below expectations, that both confirmed a drop off in industrial orders and other growth leading statistics, and hit the Euro pretty hard.  A further slowdown in European growth might make further dollar declines more difficult and the trend more volatile ahead.

While the US is still expected to cut rates and markets are not yet discounting European rate cuts, a US recession has already been discounted by the forex market and rate cut expectations are starting to ease up in the period ahead.  There may still be a bailout or monetization of sub-prime debts needed to fully end the crisis in the US, but further easing efforts are slowing in the US.  There may come a time when increasingly (as occurred today at least temporarily), forex markets focus more on relative economic strength and on deteriorating strength in Europe versus the US, than they do on interest rate differentials.   A consistent focus on relative economic strength as the US recession bottoms and as the European growth slowdown builds steam, could lead to a bottom in the dollar, at least on a multiple month basis.   We suspect that increasingly the dollar decline trend will become more of a two-way affair as Europe slows.  That could make gains in the Euro trickier and less plentiful than since this summer, and is one reason we haven’t suggested taking the Euro as a trade on recent action for longer-term stock traders.

In contrast to the European economy which is starting to soften, the Australian economy remains very strong.  Yesterday’s Australian CPI report showed strong price pressures in Australia that may force the RBA (the Reserve Bank of Australia is the Australian central bank) to tighten ahead.   This means that rate differentials versus the US are likely to continue widening versus Australia.  Despite substantial gains in the Australian dollar, those gains have still lagged the terms of trade gains to Australia coming from price rises in gold, base metals, and coal.  Money is pouring into the country to exploit the on-going commodity boom.  The Australian dollar may be carving out a cup-and-handle pattern and a breakout over the February highs should setup a move to par or higher, and may give a decent reward/risk trade if it is setup properly.  This then, becomes another forex trade that investors wanting exposure uncorrelated with stocks can watch.

 
Chart 1:  Is FXA (Aussie Dollar) setting up for potential cup&handle breakout run to par?  Courtesy StockCharts.com

Leadership in stocks is now starting to shift and deteriorate as the action in our Top RS/EPS New Highs versus Bottom RS/EPS New Lows chart demonstrates.  You can access the list of Top RS/EPS New Highs daily on www.midasresourcegroup.com).    The larger the plurality of stocks breaking out in a particular group, the more valid, reliable, and profitable breakouts in stocks meeting or close to criteria are likely to be.   Those wanting short hedges could look to Managed Care, publishing, gambling, and Indonesian groups and breakdowns of close calls in Bottom RS/EPS New Lows.

For many weeks our long/short strategy had been nearly 100% on the sidelines and in T-bills.  Last week we finally got two valid trades on the long side in AGU and SID, and this week we got a valid short sale in CKR.  On the long side there were also close calls in RIO and SDA.  We now have to watch carefully to see if the leadership in our Top RS/EPS New Highs can recover and rebuild or if Bottom RS/EPS New Lows will begin to dominate and the market will rollover at the first resistance zone we’ve been talking about for some time.  Next week’s action may be critical in this regard.

For those not familiar with our long/short strategies, we suggest you
review my book “The Hedge Fund Edge,” my course "The Science of Trading," my video seminar, where I discuss many new techniques, and my latest educational product, the interactive training module. Basically, we have rigorous criteria for potential long stocks that we call “upfuel," as well as rigorous criteria for potential short
 stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published
on www.midasresourcegroup.com for breakouts of four-week or longer flags, or of valid cup-and handles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags
 or cup and handles on the downside. In the U.S. market, continue to only buy or short stocks in leading or lagging industries according to our group and sub-group new high and low lists. We continue to buy new long signals and sell short new short signals until our portfolio is
100% long and 100% short (less aggressive investors stop at 50% long
 and 50% short).

The chart below shows that Top RS new highs (available on www.midasresourcegroup.com) stayed 40 over Bottom RS/EPS new lows for under 5 days and have now dropped sharply to beneath them.  This is disappointing action and the differential must grow to new high’s favor quickly for this market rally not to begin to deteriorate.