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Everyone Is Probably Wrong About The US Dollar

Submitted by Lance Roberts via STA Wealth Management,

Bob Farrell once penned:

"When all the experts and forecasts agree – something else is going to happen."

This rule fits within Bob Farrell's contrarian nature. This view was also confirmed by Sam Stovall, investment strategist for Standard & Poor's, who said:

"If everybody's optimistic, who is left to buy? If everybody's pessimistic, who's left to sell?"

The point here is that as a contrarian investor, excesses are built by everyone being on the same side of the trade.  Ultimately, when the shift in sentiment occurs, the reversion is exacerbated by the stampede going in the opposite direction

While this analysis is typically reserved for commentary about the stock market, it also applies to any traded commodity or asset where the price is ultimately driven by the supply and demand of buyers and sellers. In this particular case, I am specifically talking about the U.S. Dollar.

Beginning in mid-2014, fears of a "Greek" contagion spread throughout the Eurozone seinding shock waves through the financial system. The fears of instability, a run on banks, and a variety of other concerns sent foreign reserve holdings running into the perceived safety of US Treasury bonds and dollars. This can clearly be seen in the chart below.

The meteoric rise of the dollar has become singularly the biggest story in the global markets. While a strong dollar is good for importers, it is equally bad for exporters. This is particularly the case with US-based multi-national companies to do a bulk of their business overseas. Given that exports make up roughly 40% of corporate profits, it is no surprise that the surge in the dollar has become one of the biggest excuses for earnings weakness as of late.

However, as with bull markets in stocks, when a trend develops the bulk of analysts jump on the proverbial "band wagon" and begin to assume the current trend will last indefinitely. Just as the bull market will end, the rally in the dollar will end also and sooner than most expect.

Economically Speaking

From an economic standpoint, there is a difference between a rise in the dollar and a spike. As shown in the chart below, slow, steady rises in the US dollar have been coincident with economic expansions. This should not be a surprise as a stronger domestic economy attract inflows of foreign capital. However, at the point where the dollar strength sufficiently impacts exports, a recession is eventually triggered. 

The problem currently is that economic growth is not sufficiently strong enough to offset the negative impact to exports of the sharp dollar spike. This suggests, as shown in the chart below of the USD and Exports (inverted scale), that the dollar impact on economic activity could trigger a much more drastic slowing of the economy than currently perceived.

When looking at a historical perspective, sharp declines in exports have been a precursor to the onset of economic recessions in the past. Given the economy is currently growing at roughly 2%, there is little ability to absorb a shock of any magnitude.

Therefore, while the majority of analysts suggests strength in the dollar will continue, a flight out of the US dollar could be easily triggered by a further unfolding of domestic economic instabilities. This is particularly the case should such economic weakness be coupled with a sharp decline in US asset prices.

Technically Speaking

Economic developments tend to be longer-term issues that are only understood in hindsight. This is always the case as we often hear the media mainstream proclaiming "how obvious such and such was" well after the fact.

However, technical analysis can provide more "real time" clues as to the state of the U.S. dollar. The chart below is a monthly chart of the US dollar going back to the 1970's.

The blue area represents 2-standard deviations (95.4% of all possibilities) above and below the 3-year moving average. The purple area represents 3-standard deviations (99.7% of all possibilities) of the same moving average. In other words, historically when the price of anything moves to these levels, above or below, it has typically marked the beginning or end of a particular move.

As you will notice, there have only been four (4) times in history where the US Dollar has traded more than 2-standard deviations above the long-term moving average. In all three previous cases, it marked the end of the bullish move.

Could the current dollar rally last a bit longer? Absolutely. However, it is unlikely to move substantially higher without a correction first.

Prices, like anything, are subject to the laws of gravity. Long-term moving averages are essentially the "gravity" to prices. A moving average can not exist without prices have traded above and below the average over time. The longer the term of the moving average, the greater the gravitational force it applies. In order for prices to move higher, prices must eventually "revert to the mean," or beyond.

From a contrarian standpoint, with everybody on the long side of the trade, it may be time to take the opposing view. There is substantial evidence of economic weakness beginning to take a firmer hold of the global economy and the damage inflicted by recent dollar strength is more pervasive that currently recognized. The problem, as always, is that most won't realize the validity of that statement until long after multiple revisions of historical data finally reveal the truth.

As such, it is likely time to remove long-dollar hedges from portfolios. The good news is that a weaker dollar will play favorably for commodity driven sectors of the market that have been beaten down over the last several months.

But, that's just my "dollar's worth."