US Dollar Correction: Part I

In quite a few previous articles, I have been writing about the US Dollar strength and how it has affected so many of the global asset classes. Starting today and continuing for several posts, I will be covering the possibility that USD rally has now ended for awhile and how it might benefit some of the asset classes which have been under pressure for so long. Today we start with foreign currencies.

Chart 1, 2, 3 & 4: Foreign currencies have been demolished by the USD! 

European CurrenciesCommodity CurrenciesAsian CurrenciesBRIC Currencies Source: Short Side of Long

When observing Charts 1 through 4, we can clearly see that the US Dollar has just about demolished all major currencies around the world. In the European continent the Swiss Franc has managed to hold its own, while the Euro and Swedish Krona have suffered immensely. As a matter of fact, Swedish Krona is the worst performer out of all the global majors.

In the commodity complex, Norwegian Krone and Canadian Dollars have under-performed the Australian Dollar and especially the New Zealand Dollar. The most likely catalyst has been a sharp correction in energy commodity prices, such as Crude Oil. In the Asian continent the Taiwanese Dollar and to a lesser degree the Korean Won have managed to outperform steep losses seen by the Japanese Yen over the last two years. Also of interest, Singapore Dollar has been under strong selling pressure in recent months.

Finally, we focus on the major Emerging Markets (BRICs), where three out of the four currencies have suffered steep losses. In 2013, Indian Rupee was under pressure, but by early 2014 Russian Ruble made that look like a walk in the park with a huge crash. Brazilian Real has been super weak as of late, playing catch up with its own weakness. The only currency that remains strong in this complex is the Chinese Yuan (Renminbi).

Chart 2: Possibility of a shake out as funds remain heavily long the USD

US Dollar COT Source: Short Side of Long

It seems that the major inflection point on the US Dollar Index occurred during last weeks FOMC meeting. Therefore, foreign currencies will now have a chance to regain at least some of the losses suffered in the last 9 months or so. This is true in particular for currencies where hedge funds and other speculators are holding very large short positions. From a contrarian point of view, a short squeeze could now be playing out and rebounds might be swift and rather powerful, catching many of guard.

FOMC Decision

Chart 1: US Dollar is extremely overbought and sentiment overly bullish

US Dollar vs 200 MA Source: Short Side of Long

Before last nights Federal Market Open Committee decision, I was talking to a friend at an amazing rooftop bar in Singapore, about the potential of future interest rate rises in the United States. We covered a few case scenarios and the one we discussed in-depth was the fact that the US Dollar rallied way too far, way too fast over the last 9 months. Sentiment on the currency was overly bullish, COT positioning skewed towards the net long side and various technical indicators historically overbought (refer to Chart 1).

I explained that, even though I remain long the US Dollar (and short Aussie), a high probability exists where the greenback would correct in coming weeks and months. And since the run up was parabolic, the correction could be just as sharp. The catalyst for the USD pullback would be a FOMC surprise, where the initial rate hike is delayed even further. The thinking process was derived from the fact that the economy has weakened a bit, but more importantly inflation expectations have collapsed (refer to Chart 2).

We should be able to notice that the current readings of the 5 Year Forward Break Even Rate is below level with which the FOMC is confirmable with. As a matter of fact, in the past the Fed has remained dovish (cut rates or started QE) whenever the inflation expectations fell to similar levels or even lower. It seems that Janet Yellen has followed the script quite well, and just about all asset classes rallied on the news. US Dollar was down sharply. The question now is how long will the Fed remain patient for? Some are speculating that we will see no rate hikes in 2015.

Chart 2: Inflation expectations are at levels where Fed remains dovish...

5 Year Forward Inflation Expectation Rate Source: Short Side of Long

Commodity Crash Points To A Bottom

Chart 1: Commodities have crashed back to levels seen in 2001 & 2009

CRB Index Source: Stock Charts

We have been following the strength of the US Dollar for awhile and its impact on various asset classes throughout the second part of 2014 and the first quarter of 2015. A major story that we have touched on, but not discussed in-depth, is the crash in commodity prices over the last 9 months. Those who follow this blog regularly should probably remember from previous posts that many of the individual commodities are down between 50 to 70 percent from their respective 2011 peaks. But what about commodities as a whole? Observing Chart 1, the most popular of commodity indices tends to be the Thomson Reuters CRB Index.

Over the last 35 years, this level has been very significant. Firstly, commodity bull market that peaked in in late 1980 eventually bottomed out around the 200 level in 1986. This level was later re-tested once again in 1992, during another commodity bear market. Secondly, the major double bottom in commodity prices occurred in 1999 and 2001, both of which saw the 200 level violated only briefly (as a bear trap or a false breakdown). Finally, during the GFC liquidation panic, CRB Index found a support at the 200 level once again, from which prices bounced very sharply.

Today, the CRB Index once again finds itself at the all important 200 level. In other words, the commodity prices are still trading at the same level we saw in 1986, 1992, 1999, 2001 and 2009. If we adjust the CRB Index for inflation, prices are now significantly cheaper relative to the 1986 bottom, even though nominally the index is at the same level. Since this area of historical support is extremely important, in my opinion, there is now above average chance that commodities could start forming yet another meaningful bottom. Mind you, this process could take awhile so patience is very important.

Technical indicators in Chart 1 are extremely oversold by any historical comparison, so a mean reversion is definitely in the cards. At the same time, Chart 2 shows that sentiment on the CRB Index is at rock bottom levels, usually witnessed at major bottoms. Commodities aren't even hated anymore... the truth is majority of the media has totally forgotten about this asset class. Contrarians should look at this asset class very closely. My opinion continues to be that the best way to play commodities is through Precious Metals, and especially Silver.

Chart 2: Sentiment is now extremely bearish similar to '01 & '09 bottoms

Commodities Sentiment Source: SentimenTrader (edited by Short Side of Long)

Precious Metals Update

Chart 1: Strength of the USD rally has pretty much surprise everyone

US Dollar COT Source: Short Side of Long

Before I get into the markets, I have apologise for the lack of updates on the blog in 2015. I have been busy living life, traveling around Asia and working on some new projects. Personally, I stay on top of the financial markets as this is my work, but I just do not have extra time to update the blog as often as I did during 2013/14 period. However, I am sure things will settle down eventually and regularity of posts will return.

Today I am focusing on the Precious Metals sector. But before I discuss the price movements and sentiment, I would like to touch upon the US Dollar. As we can clearly see in Chart 1, the greenback has been very hot since June of 2014, moving up in a straight parabolic fashion. I never expected the rally to be this strong and this sharp, and I'm sure 99% of other market participants didn't either.

Chart 2: Gold & Silver are now close to making new bear market lows...

Gold COT Source: Short Side of Long

After all, focusing on the US Dollar strength is important, as it remains one of the key drivers of Precious Metals weakness. Gold's mini-rally that occurred into January of 2015 has all but fizzled out and many are still scratching their heads as to why. Several weeks ago, I mentioned to my readers that both Gold and Silver failed to make a higher high and break through any meaningful resistance levels, while at the same time abundance of net long money joined the party.

This was a red flag and a warning signal, without a doubt. It seems that just about everyone was expecting a new uptrend in PMs with over 150,000 net long Managed Money contracts in Gold and over 40,000 in Silver. As we can see, those types of numbers usually mark a top and not a buying opportunity.

Chart 3: ...while majority of the net longs have not yet been shaken out!

Silver COT Source: Short Side of Long

Now, we are witnessing a potential breakdown in prices towards new 52 week lows and bear market lows, while majority of the hedge funds have still not been shaken out. In my humble opinion, a major bottom in Gold will still occur around $1,000 per ounce, as discussed many times on the blog. More importantly, until we see hedge funds (COT Managed Money) get towards net short positions in both Gold and Silver, we most likely won't be near a meaningful bottom. As of last weeks COT update (refer to Chart 2 & 3), we are still a decent way from such an event.

One final thing I would like to mention is the fact that Gold Miners, which are incredibly oversold already, are now flirting with a possibility of breaking below a critical support level (please refer to Chart 4). The bear market has lasted almost 4 years now, so I am of the opinion that the final wash out below 160 in the HUI Index could be in the cards. This could end up being one of those false breakdowns that creates a huge amount of pessimism, followed by a super sharp and quick reversal.

Disclosure: As mentioned many times on the blog, personally I was very fortunate to move all of my cash holdings into USD around that time, as well as add to my Aussie Dollar shorts later on in August of 2014. Now I am thinking of lightening up on my USD holdings, but have not yet done anything.

Chart 4: Miners are in process of breaking below an important support!

Gold Miners vs 200 MA Source: Short Side of Long

March Economic Update

Dear readers,

This year is flying very fast, isn't it? We are already in March. After a break in January and February, regular newsletter posting is now back for the rest of the year. As per last year, I will update the readers of the blog and newsletter subscribers with an Economic Update earlier in the month, Breadth Update sometime during the middle of the month and finally Sentiment Update near month end. Also, throughout any random month, I will also alert readers to any major portfolio changes that have been executed.

Before I continue with the report, I would also like to let my readers know that I will be spending some time in Hong Kong and Singapore over the coming several weeks / months, starting this month. As per usual, if you would like to meet up for a drink or lunch / dinner, please do not hesitate to contact me. You can always email via tihobrkan[at]gmail[dot]com or contact me via Instagram @tihobrkan.

Now, let us get into the Economic Update for the month of March...

Leading Indicators

Chart 1 & 2: US manufacturing continues to expand at more robust levelDeveloped Markets PMI Emerging Markets PMI

  Source: Short Side of Long

  • Recent Global Markit Manufacturing PMI data for the month of February showed continued global manufacturing expansion. Emerging markets continue to disappoint with expansion below trend, while developed markets and especially US show a more robust level of growth. Current developed economies PMI readings stand as following: US at 55.1, Japan at 51.6, Germany at 51.1 and UK at 54.1; while emerging economies PMI readings stand as following: China at 50.7, India at 51.2, Russia at 49.7 and Brazil at 49.6. Observing all of the charts above, Markit analysts highlight the following summary:

The global manufacturing sector expanded for the twenty-seventh consecutive month in February. The rate of output growth accelerated to a six-month high, as companies scaled up production to meet rising levels of new work and new export orders. The J.P.Morgan Global Manufacturing PMI rose to 52.0 in February, from 51.7 in January.

The US remained a prime driver of the global manufacturing upturn, as the US PMI rose to a four-month high. Growth was seen across much of the European manufacturing sector in February, with the strongest pockets of expansion registered in the UK. Growth was also signalled in Germany. Completing the picture of modest, yet broad-based expansion across the global manufacturing sector were the performances of the Asian nations. Mild growth was signalled in China and Japan.

Chart 3: Chinese economic activity is showing signs of bottoming out

OECD China LEI vs GEm Equities Source: Short Side of Long

  • Recent OECD Leading Indicators for the month of February showed a continued, but modest expansion in all major regions apart from China (click here for the chart). Nevertheless, after many quarters of slowing growth rate, Chinese OECD LEI is showing signs of possibly bottoming out. Investors should note that there is a very high positive correlation between Chinese growth and emerging market equity performance (refer to Chart 3), which are extremely cheap art present. Summarising the overall report, OECD states that:

Composite leading indicators (CLIs) point to tentative signs of a positive change in growth momentum in the euro area, particularly in Germany and Spain. In Italy, the CLI also points to improvements, with this month’s CLI pointing to stable growth momentum compared to weakening momentum last month. The outlook for France is unchanged from last month’s assessment, with stable growth momentum anticipated.

The CLIs indicate stable growth momentum also in the OECD area as whole and in some of the major economies, including the United States, Canada, Japan, China and Brazil. In the United Kingdom, the CLI points to an easing in growth momentum, though from relatively high levels. The CLI for India indicates firming growth while in Russia the CLI continues to point to a loss in growth momentum.

Chart 4: US leading economic indicators are giving us a mixed picture

US Leading Economic Indicators Source: Short Side of Long

  • United States is still by far the largest and most important global economy. That is why following US domestic leading indicators should be very influential in decision making for all global investors. The high positive correlation between S&P 500 equity index, ECRI's Weekly Leading Indicator and the Weekly Jobless Claims data has broken down in recent weeks. The stock market continues to march towards new record highs. At the same time, ECRI's Weekly Leading Index has been falling rather sharply, most likely due to the sell off in the Energy related high yield bonds (credit spreads widening). Finally, weekly jobless claims have stagnated since the summer of 2014.

Consumer Confidence

Chart 5: US public is getting optimistic on the stock market prospects

US Consumer Sentiment Source: Short Side of Long

  • Uni of Michigan US Consumer Sentiment has broken out rather sharply since our last update in December. Current readings are at 95.4, which is an impressive improvement from a year ago when readings stood at 81.6. I have included a rather long term chart, which shows close similarities between 1966-1982 secular bear market and the current environment, from 2000 until present. One should be able to decide for him or herself, what the recent Consumer Sentiment spike might mean in both short to medium term, as well as in the long term. Note: Consumer confidence is one of the best contrary indicators to time long term equity purchases and sales. US Consumer Sentiment has averaged 86.7 over the last six decades, with a record high of 112 in January 2000 (during the tech bubble peak) and record low of 51.7 in May 1980 (during the high interest rate recession squeeze).

Chart 6: Eurozone consumer sentiment is improving as stocks break out

Eurozone Consumer Sentiment Source: Short Side of Long

  • EU Sentiment Indicator has managed to recover as ECB launched its QE program. The chart above shows the current readings at -6.7, which is a modest improvement from a year ago when readings stood at -12.7. ECB's monetary efforts have diverted a more meaningful correction in Europe and now we have the stock market breaking out to new bull market highs. The economic expansion continues... Note: Consumer confidence is one of the best contrary indicators to time long term equity purchases and sales. EU Sentiment Indicator has averaged -12.7 over the last three decades, with a record high of 2.7 in March 2000 (during the tech bubble peak) and record low of -34.2 in March 2009 (during the GFC crash trough).

Chart 7: Japanese stocks lead the way, while consumers don't feel it... 

Japanese Consumer Sentiment Source: Short Side of Long

  • Japanese Household Confidence remains subdued, despite the fact that the stock market is rising almost vertically. Cabinet Office of Japan releases the data one month behind, so focusing on January readings, we saw readings come in at 39.1, which is basically showing no change from a year ago. As stated many times before, investors should be paying attention to the market rather then lagging indicators. While not perfect, we can clearly see in Chart 7 that Nikkei tends to lead consumer confidence. Note: Consumer confidence is one of the best contrary indicators to time long term equity purchases. Japanese Household Confidence has averaged 42.4 over the last three decades, with a record high of 50.8 in December 1988 (during the Japanese bubble peak) and a record low of 27.4 in January 2009 (during the GFC crash trough).

Fund Managers Are Very Bullish

Chart 1: Recent fund manager long exposure has averaged above 80%

NAAIM Exposure Source: Short Side of Long

Contrarian investors should start to pay attention. Over the last several months, NAAIM survey has been showing signs of extremely optimistic investor behaviour and it could be a dangerous signal. Since November of 2014, the average weekly reading for the survey was 83% net long, with the lowest level recorded at 65% (refer to Chart 1). This is a far cry from the levels seen during the recent intermediate bottom in October 2014, as exposure fell to only 10% net long.

Furthermore,  the difference between the net long managers relative to those who are net short, has been skewed more and more towards the bullish side. This is especially true over the last month, where the intensity has averaged 200% - a maximum reading possible - signalling outright greed. This kind of persistent bullishness, usually but not always, results in a sharp and fast shake out. For those who are net long equities as of today, caution is advised!

Chart 2: overall positioning is very skewed towards the bullish side... 

NAAIM Intensity Source: Short Side of Long

Breadth, Volatility & Volume

If we observe the overall broad index performance, US investors have been enjoying a relatively uninterrupted ride higher during the current bull market. But that does not mean that all is well within the equity space. The overall MSCI World Index has been struggling since June of 2014, so let us look at the way breadth, volatility and volume have been behaving. Let me quote some great research from Gavekal Capital, on two different occasions to put my breadth point forward:

For every country in the MSCI World Index, we measure the percent of stocks that are outperforming the index. The results give us some indication of the breadth in the equity markets. Currently there are only three countries where the percent of companies outperforming the MSCI World Index over the last 200 days exceeds 50%--the US, Japan and Hong Kong. An extreme example of underperformance is Austria, where none of its companies are outperforming the MSCI World Index. Most difficult for active managers is the fact that many large markets are experiencing terrible breadth. In France, only 19% of the companies have beaten the MSCI World Index over the last 200 days: in Canada, only 28% have outperformed: in Germany, only 19% have outperformed. of the ways we like to measure what is going on underneath the surface is to take a percentage of stocks that are trading at levels less than 10% off its 200-day high, 10-20% off its 200-day high, 20-30% off its 200-day high and greater than 30% off its 200-day high. By doing this, we get a good idea of what the price dispersion of stocks currently looks like. So while the MSCI World Index is basically at its all-time high, almost half of the 1600+ stocks are down 10% from its 200-day high (i.e. in a correction). Also, almost 1/4 of all stocks are in a bear market and 10% of stocks are down at least 30%.

Chart 1: Equity volatility has been on the rise since the summer of 2014

Volatility Index Source: Short Side of Long

If we observe Chart 1 and Chart 2, we can clearly see that volatility and volume has been on the rise over the last two quarters. In other words, investors have been selling down their positions, but certain large cap stocks continue to rally, pushing the broad indices higher and masking the underlaying weakness.

Volatility, in particular, has put in some kind of an important low in June of 2014. Using a three month moving average, volatility has been rising over the last two quarters, despite the fact that the index continues to rally (refer to Chart 1). Pervious instances during the current bull market have shown that the rise in volatility has correlated very closely to a decline in stock prices, but not this time.

So why has breadth been so weak, and volatility / volume rising since June 2014? There will obviously be many explanations, but I would state that the US Dollar rally has created deflationary pressure on majority of the asset price, with only some managing to buck the trend. If we once again refer to the start of this article, the only equity markets that have benefited are the ones where the USD is either an official currency (US & HK) or where USD strength is welcomed (Japan).

Chart 2: Selling pressure via volume has seen spiked in recent months

S&P 500 Volume Source: Short Side of Long

Swedish Krona Under Pressure

Chart 1: Swedish Krona is the worst performer out of all the majors... 

Currencies Annualised Performance Source: Short Side of Long

Unless you have been living under a rock or in a underground cave, you've surely have noticed how the powerful US Dollar has been rallying against just about every other global currency. Media coverage has been focused towards currencies which have been falling apart, such as the Russian Ruble. Majority of investors, including myself, have been discussing the European Euro, showing how oversold it is.

However, one currency that isn't frequently discussed, and yet has been totally hammered by the US Dollar, is the Swedish Krona. Out of all the majors, Swedish Krona has performed the worst over the last 12 months (refer to Chart 1). The currency has lost about quarter of its value, as the greenback has managed an impressive rally of 12 monthly candles in the row.

Impressive rallies such as these definitely let us know that from the short to medium term perspective, US Dollar trend is now highly recognised and over-owned. Therefore, investors who are thinking of buying the Dollar right here and right now should exercise caution and patience. In my opinion, there is an above average probably that the greenback is due for a major correction or at least a pause in the uptrend.

Chart 2: ...falling for 12 monthly candles in the row against the US Dollar

Swedish Krona Source: Bar Chart

Euro Is Extremely Oversold!

Chart 1: European Euro has become extremely oversold vs the Dollar!

European Euro Performance Source: Short Side of Long

The European Euro originally came afloat against global currencies in the late 1990s, so we do not have a lot of data to go on by. But one thing is for certain, the currency is currently at one of the most oversold levels it has been since 1999.

The quarterly performance (green line) shows a persistent oversold condition at almost 2 standard deviations away from the mean. Furthermore, annualised performance (blue line) shows the second most oversold level, well below 1.5 standard deviations away from the mean.

With these two points in mind, one could argue that the European single currency has only been more oversold in early 2000 and late 2008, both marking major bottoms.

Precious Metals Shake Out

Chart 1: Precious metals are still in well defined pattern of lower highs...

Gold COT Source: Short Side of Long

Precious metals continue to puzzle majority of investors. From the bullish aspect, market participants see great value and extremely depressed prices, so it only makes sense that we see a random "guru" or "finance expert" call a bottom in this sector every second month. Recent price action showed us an oversold condition being reached in December 2014, from which a powerful rebound occurred in January of 2015. Obviously, it was only normal to yet again hear calls that the Precious Metals sector bottom has finally been reached.

But the simple analysis of the price action so far disagrees. Neither Gold or Silver registered a higher high on the weekly chart, which usually in its purest form, signals an uptrend. It is quite clear that both metals still keep printing a pattern of lower highs. Finally, as we should be able to observe in both Chart 1 and Chart 2, hedge funds and other speculators piled into the hype and were holding the largest net long position since late 2012. So, should we be surprised at the way both Gold and Silver have reversed in recent weeks?

In my opinion: No.

The recent purchases at the start of the year, of GLD and GDXJ from my newsletter portfolio, have been closed this week for only a very very minimal gain.

Chart 2: ...while hedge funds & speculators have piled into the long side!

Silver COT Source: Short Side of Long