Contrarians, unite! While it appears that the forex herd is climbing over everything in its path to go long on the U.S. Dollar in 2015, commercial traders, the “Smart Money” in these parts, have been silently maneuvering in the background for what looks to be a major reversal of the greenback’s good fortunes of late. Yes, every retail forex trader and their extended family members, all looking for a sure thing in forex, may actually be standing upon a precipice of avarice, primed and ready for an avalanche of losses. As if the Swiss Franc Debacle was not enough of a warning, new reports are revealing that another liquidity crunch may be imminent on the near-term horizon.
Was that intro dramatic enough for you? Did I get your attention? Chris Puplava, a registered investment advisor with the PFS Group, certainly got my attention with an interesting set of charts and arguments that support this viewpoint that opposes the one dearly held by most forex experts in the industry. As a matter of fact, the crowd of so-called forex experts has been dwindling over the past few years. Their finest strategies have fallen victim to the deliberate manipulative actions taken by major central bankers. The sad results have been millions in portfolio losses for a select group of hedge fund managers that are struggling to find new employment.
No one likes surprises, especially when sizable chunks of money are at stake. Our financial markets seem to be staging their own form of “Climate Change”. Strange extremes of “weather” keep popping up, slamming down everyone in their wake. Today’s forecasts barely make it to tomorrow. The future appears to be burdened by potential chaotic conditions and uncertainty. Analysts are frantically searching for anything in historical or current data that will provide a safe haven of sorts. Here is one special chart that blows the whistle on the current shorting extravaganza with non-U.S. currencies:
This picture is definitely worth a thousand words! The Dollar Index in the top part of the chart is followed by the retail forex trading crowd in “Red” and the Smart Money crowd in “Blue”. Bloomberg supplied the data, but it is actually a summary of data reported weekly in “Commitment of Traders” reports. This process reviews activities in the Futures market and computes the net number of positions at a given point in time. A positive figure means that participants are going long, whereas a net negative figure denotes a tendency to short the US Dollar.
If you are searching for a definition of “divergence”, then this chart is right up your alley. The scary part of the divergence, depicted in the latter portion of the chart between speculators and commercial traders, is that both values are the most extreme that they have ever been. Also of note is that, when the Dollar Index peaked in the past (the periods highlighted by “Pink” columns), it always depreciated soon thereafter. The “yellow” warning column suggests that the Smart Money might actually be on the mark this time around, trying to recoup record high losses from past mistakes.
What are the fundamental arguments that support this technical conclusion?
There are several logical arguments put forward by Mr. Puplava to support his proposition. Taken as a whole, they do appear convincing, but so do the arguments on the other side of the equation, as well. Markets are uncertain, and no one has a lock on the future, but that, after all, is half the fun of trading – guessing how the future will roll out and, especially, how quickly. The best advice at this point is to be aware of these counter positions, remain defensive, and cautiously wait for the future to reveal its secrets. Here are the points in order:
1) Euro Resilience: The Euro comprises the largest portion of the USD Index, so it is best to start there. Although sentiments for the Dollar are running at very high levels, there have been no less than eight similar occasions since the turn of the century where the Euro was confronted with such gloomy prospects. On each occurrence, the Euro subsequently rallied over the following two months at an average pace of roughly 250 pips. During this short recovery period, there were three times that the Euro declined, but, in all cases except for one, the common currency rebounded over 7% over the subsequent eight months. If history holds, then the index should go down;
2) Reversion to the Mean: One of the most respected terms in trading communities is “Reversion to the mean”. Its principles form the basis for many a winning strategy, but especially so in forex, since neither component of a major paring is likely to fail or default, as a business can with stocks or bonds. This theory suggests that, “prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry. Percent returns and prices are not the only measures seen as mean reverting; interest rates or even the price-earnings ratio of a company can be subject to this phenomenon.” When prices move way beyond historical averages, as in the above chart, the pressure to return to the mean is heightened. The USD Index has also moved well outside expected norms related to the interest rate differential between the Fed and the ECB, another fact that begs reversion;
3) Global Economy: Global GDP growth has been tapering for some time, but the bottom has been in doubt. There are many indicators that suggest that a bottom is forming and that even Europe will see a steady recovery take shape in the coming months. In the past, even a minor hint that the EU was headed for better times sent the market into a euphoric celebration, and the Dollar suffered in each case. Puplava suggests that, “It is always darkest before the dawn and currently we are seeing the biggest global reflationary wave since 2008/2009 as central banks across the globe are slashing interest rates and expanding their balance sheets. Monetary policy acts with a lag and in the months ahead we are likely to see its effects as global growth should pick up with the added tailwinds from falling commodity prices and inflation.” Despite Yellen’s hawkish comments to Congress, the Fed is already showing signs that it must slow down for the rest of the world to catch up. The Dollar will retrench if the Fed balks;
4) Other Technical Issues: As per Mark Twain, the history depicted in the following chart appears to be “rhyming”:
Mr. Puplava’s last convincing chart for the day would have us believe that technical resistance (the sloping Red line) has been reached by the USD Index. It must, therefore, stall and correct for a bit, as it did the last time it broke out of an extended symmetrical triangle pattern. Mysteriously enough, the breakouts, both then and known, rose just over 18% in each case from the mean. Will history repeat itself? It “sounds” the same, but actions speak much louder than sounds. I think Mark Twain would pass on this trade.
Concluding Remarks
There is only one thing certain about divergence – only one side can be right; the other side must be wrong. If the markets believed in Mr. Puplava’s proposition, it would move resolutely in that direction. As he points out, positive sentiment for the greenback from speculators, i.e., retail forex traders, has reached “frothy levels”. A pullback seems imminent, but the market is presently ranging, a sign of uncertainty. The reason for the uncertainty is that we are in uncharted territory. Never have central bankers gone to such extremes on a global basis to accelerate the economic growth engines of their respective nations.
The actions of these bankers have a desperate quality about them, almost like dueling banjos, each waiting for the other to “squeal like a pig.” The logjam brought about by ZIRP (Zero Interest Rate Policies) is growing everyday. One can only imagine the amount of financial dynamite that will be necessary to get market forces to begin flowing naturally once more. Each mini-crisis will beg the question of is there another one out there? We are past the point of claiming that every occurrence is a “fat tail anomaly”, the term used by economists to describe why the Great Recession was such a surprise.
Much of technical analysis is based on a combination of wave theory and statistical probabilities. The easiest way for a forex trader to observe this relationship is to employ Bollinger Bands on his charts. The boundaries represent two standard deviations from the central mean line. If prices occur in a normal distribution, then 95% of them should fall within the boundaries. Technical arguments may look elegant, but erratic activity is more an indication that a normal distribution does not exist. In such a case, the risk of a “fat tail anomaly” is much greater. In other words, shorting the USD is not a lead pipe cinch. Be cautious and defensive. Prepare for a breakout in either direction.
Lastly, Peter Drucker, who has been described as "the founder of modern management", used the term “recurring crisis” to indicate that a systemic problem was more than likely the issue at hand when similar attempts to solve a problem did not work. The more central bankers try to solve the systemic problem of slow growth with tools of the past, the more this problem will continue until the root causes can be dealt with using new approaches. Unfortunately, participants in our global economy rarely operate in a coordinated fashion, as computerized models of specific systems can and do. Greed and politics always get in the way. Modern game theory speaks against that notion, as well. And so, we wait. Stay cautious, and keep your powder dry!
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.