A few weeks ago, in the TWR report “Avoid the Rocks” I made the point that the best investment processes focus on both the underlying fundamentals of a given market as well as its quantitative aspects, like price action. This is true because price action on its own is meaningless.
As an investor, you can only make smart decisions if you understand the fundamental context in which price action occurs.
If it was unclear at the time how my sailing analogy could make you a better investor, then the recent developments in the US Dollar shines a bright spotlight on why understanding the context of price movement is critical to standing apart from the crowd and positioning yourself to earn above average returns.
Should you be LONG, SHORT or NEUTRAL King Dollar right now?
In order to answer that question you need to know how the USD has performed over various time periods. The USD is up 17% over the last year, 8% over the last 6 months and has gained 4.5% so far this year.
On the flip side, the USD is flat since late January, has declined 3% over the last month and lost 2% last week alone. Does that help clarify how you should trade the USD?
Is this most recent decline an opportunity to get LONG a market in a bull run, or a change of trend that will lead to a further decline?
The thing is, charts won't be of much help. I’m not saying that charts can’t be helpful but there is one major problem with charts, and that is that human beings are the ones evaluating them. You are predisposed to find patterns in everything you evaluate.
The problem with this predisposition when it comes to the markets and specifically, charts of daily price actions, is that there is abundantly more randomness in markets than patterns. There is much more noise than signal but your brain wants to make sense of every bar or group of bars on a chart.
Given the facts that price performance alone doesn’t tell you much and that we can mislead ourselves seeing chart patterns where only noise exists, means that it is critical to understand the fundamental context in which an instrument trades. This means that we need to understand both the underlying economics of an instrument and the monetary policy of the region where an instrument trades.
The fundamental case for a USD bull market is what I’ve been calling the US divergence trade, which has two legs, the fact that the Fed is moving towards the normalization of monetary policy here at home while everyone else in the world is actively engaged in easing policies of various types.
If you understand that this US divergence trade is the catalyst that is driving the USD then you understand both the massive gain in the USD over the last year as well as the more recent decline. One leg of the US divergence trade has been hobbled by the Eurozone’s strong economic data in Q1 combined with the recent rise in oil prices which have lessened investors fears over deflationary forces abroad. The other leg of the US divergence trade, the normalization of US policy, has been called into question because of the weak US economic data so far this year.
So, the question of whether to be LONG, SHORT or NEUTRAL the USD, comes down to one FUNDAMENTAL question: Will US economic growth accelerate higher in Q2 and beyond?
The core tenet of my process is that the only thing that matters in financial markets are the economic conditions and how central bankers respond. If you believe the weakness in Q1 is just the beginning of a deterioration in US growth, then the Fed won’t raise rates this year and the USD will continue to decline over the balance of the year.
However, if you believe that the Q1 weakness is transitory and that the annual pattern of weak Q1 data giving way to stronger growth the rest of the year will play itself out once again, then the rate hike is on and the USD will continue to run.
My belief is the latter, which is why I continue to have a LONG bias on the USD despite the recent weakness. That said, the April jobs report will be a key factor in determining whether I’m right or not.
This week’s jobs report will not only set the tone for data that will come out over the next few weeks but will also provide a strong floor under the USD if the report is strong. Now a word about positioning.
Behavioral psychology plays a significant role in my investment process. One of the ways I get a read on the investor sentiment of a particular instrument is through the positioning of professional and retail investors in the futures markets.
There are no shortage of articles discussing just how crowded the LONG USD trade is right now. The trade is historically crowded for both smart and dumb money. This type of positioning obviously makes me very cautious because when the crowd runs for the door you can get your face ripped off.
However, as long as the fundamentals stay at your back, there is no reason for the crowd to leave. One interesting development in recent weeks is in the positioning of retail investors or the “dumb” money. Dumb money has been sitting at all-time highs in LONG positions for the better part of 6 months, no surprise there. But the dumb money positioning in USD SHORTs has moved from historic lows to an all-time high in less than a month.
This new positioning took out the previous all-time high in number of SHORT contracts made back in August 2011. Within a week of this previous all-time high, the USD bottomed and proceeded to rally 10% over the next 6 weeks.
History would say fade the dumb money.
This week marks the beginning of a new month, which means it begins the monthly cycle of economic data. We will get further clarity on the trajectory of US growth and more importantly, clarity on the timing of policy normalization. This clarity will not only help us trade the USD effectively but a number of other markets as well.
All markets can be understood with History 101, Math 101 and Psychology 101. Evaluating only one or two of these aspects of a particular market only gives you a partial picture. You must have all three as part of your investment process if you want to achieve above average returns, while taking minimal risk.