Is There An Across The Board Reversal Around The Corner?

The dollar is doomed as the world’s reserve currency. That is currently the sentiment among investors and speculators especially after yesterday’s fed meeting which included a statement that the Fed would maintain low interest rates and continue with the purchases of mortgage backed securities and US Treasuries. The dollar index has lost 17% in the last year and has broken through multiple support levels in the last several months. One thing that got lost in the Fed’s statement amongst the dollar bearishness is this:

AP: But Bernanke said the Fed is less inclined to do more to lower unemployment because additional stimulus could lead to higher inflation.

“The trade-offs are getting less attractive at this point,” Bernanke said. “It’s not clear that we can get substantial improvements in payrolls without some additional inflation risk.”

I should also mention that QE 2 is still scheduled to end in June.

Despite this, we have seen continued rallying in the equity and commodities markets. The Euro also continues to gain on the dollar. I believe that this is a blowoff rally and we are close to a major reversal in the trends that we have seen over the last 7-8 months. At the very least, if not a major reversal, then a significant correction similar in proportion to the bear market last summer.

The dollar ETF UUP has dropped about 5% in the last week and trading volume for the last 2 days has been 2x above average. After months of selling for the dollar and the idea that what the Fed would say on Wednesday was more or less common knowledge among Wall Street, the dollar’s drop should have already been priced in. In other words, those who are selling the dollar now are late to the party.

The above is an example of capitulation or when the market gives up completely on any hope of a rally. Volume this high after the bears have been in control for months does not make sense unless you count the possibility that the only ones who are buying are lagging the trade.

The dollar has sold off in waves of 10%. At the tallest peak in June 2010, the dollar fell roughly 10% from $88 to $80 in about 2 months. It rallied 4% in the next month. The peak in August was just above $83 and the next low came in November at below $76 – about 9% in just over 2 months. For the next month, it rallied from $76 to $81, a 7% gain. From the beginning of January to today, it has fallen 10%. This time it took a little over 3 months.

Two things can be taken from these statistics. One, based on time zones it is very likely that the dollar will rally 4-8% in the next month or more. Two, the last 10% drop took almost double the amount of time that the last two 10% waves took to play out. That means that momentum in price activity has been declining and a slowdown or reversal could be coming soon. To the contrary, most pundits would have you believe that the dollar is currently in a freefall.

Regarding the pattern on the chart, the dollar generally reverses course via shoulder head shoulder patterns. For what it’s worth, we are set up for a textbook inverse head and shoulders reversal should we hit a bottom in the near future.

Conversely, the euro is setting up for a shoulder head shoulder reversal. This makes sense as the euro makes up 58% of the dollar index’s weighting. I have stated before that the rate hike should have been priced in and so far it has traded as if it has not been though the news was no surprise. That means that the only people who are buying are not the astute “in the know” investors. In addition, an ECB rate hike increases the cost of servicing further EU nation bailouts which makes for a weaker euro in the long run.

These next charts further illustrate the inevitability for a reversal in the equity markets and the dollar index. At the very least, one cannot argue that there will be many scalping opportunities off of major support and resistance levels that we are quickly approaching. I believe that these charts line up far too much for any of this to be a coincidence.

The S&P has major resistance at $1400, that alone is a scalping opportunity but notice the ascending triangle going back to 2009. If you were able to short it at $1200 When QE 1 ended, you could have made a decent profit on the way down last summer. The 2010 lows bounced higher and started a lower ascending triangle pattern that carried the market into the fall after the Jackson Hole speech. The important thing to remember is that the market stalled after QE ended.

Fast forward to today and we are a few months or so away from nearing $1400 assuming the current trend holds. Last week I stated in a video blog that we had built a bullish triangle on the S&P and that we were headed higher. We have since broken through resistance and have resumed the previous trend. I believe that as we close in on $1400, QE 2 will be only just weeks from ending which will make for an obvious sell signal for the market and the resistance at $1400 would then be likely to hold.

The Nasdaq has outperformed the S&P and has already made closing highs above the 2007 high of 2,861. I’ve expressed my concerns in the past that while the money supply has grown, unemployment is double what it was in 2007 and the equity markets should reflect job and income growth over money supply growth. After all, supply and demand must work together for the finished product to come out properly. In any case, continued rallying could be in store for us in the near term as retail volume increases.

Speaking of rallying, silver has thrived since Jackson Hole and even moreso in the last 2 months. I believe that if silver does not correct lower immediately, it will break above $50 and then perhaps experience a blowoff rally as the psychological number will attract plenty of new investors into the market. The blowoff rally could coincide with the topping of the S&P, and the bottoming of the dollar. If this isn’t the case, and silver takes a breather, expect gold to outperform silver in the next couple of months and eventually hit a top somewhere between $1600-$1700 as the S&P tops at the same time at $1400.

Recent surveys have traders at 90% and above bullish sentiment on silver. Volume on SLV has been greater than the SPY in some of the last trading days this week. Earlier I said you don’t want to be selling the dollar right now because the Fed’s announcement was already common knowledge. The same concept applies here. Silver has many reasons to be gaining multiple percentage points at a time, but the fact of the matter is there has been a massive surge in volume and that parabolic moves up are met with parabolic moves down. There are several instances in the last 10 years where silver has doubled in similar periods of time only to lose 50% or more of those gains in half the time it took to make them. For what it’s worth, some silver guru’s such as David Morgan have openly disclosed that they have taken speculative profits off of the table due to the volatility and hyperbolic price movements.

Whether silver goes to $65 or $35 in the near future, I will not be surprised at either outcome, but at some point in the future, it must correct lower and make the pundits bored enough to move into a different asset class. Until then, I will be putting my money to use elsewhere.

Going back to the dollar index once again, you can see how the potential support at $73 should match the upcoming resistance levels in the S&P, gold, silver, and the Euro. Also, remember that support doesn’t need to be exactly at $72, it may turn out be a few points above due to institutions buying in order to get ahead of the trade.

QE 2 should end on schedule and I would advise that those who are long equities or commodities to start using options hedges or taking profits off of the table. I currently have money in cash after taking profits on silver related investments last friday. As far as my strategy for the next 6-8 months, I will likely be looking to purchase UUP calls if the market gives me a clear buy signal. I can’t be certain of the particular strike or month, but I may disclose it when if and when I do enter a position. I may also find other bullish opportunities in the market, but given the signs that the dollar could be due for a lengthy rally, I won’t be buying anything that I don’t believe hasn’t been thoroughly beaten up by the market.

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About Aaron Basile
Market Technician, Equity/Commodity Trader, Austrian Economist, Contrarian Investor

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