Market Shaping Up for a Major Top
by Jes Black
March 18/05
In our last public update we said we were closing our long gold and AUD/USD positions and looking to buy dollars again. We have had to wait on the sidelines for the past two weeks, but the dollar index appears to have finally bottomed at the exact 78.6% (square root of 61.8%) retracement of the January to February rally. Since the dollar trade is simply one part of the overall holistic approach we take with the market, in this update we will show why the current backdrop in oil, bonds and euros is similar to that of October 1998 and what to expect going forward.
Readers may recall that on December 13, 2004 we made the case for a rebound
in crude oil, and added that traders not comfortable in the futures market
should look to get long XLE, the energy iShare. Below is the same chart
we showed on 12/13/2004.
Readers may also recall that we showed a relative strength chart of the
OIX:SP500 and said it pointed higher. Since then we have experienced a
"blowoff" style top in that ratio. In our chart below we show similar
blowoffs in the OIX/SP500 ratio and the corresponding tops in the oil
index. Note that the average decline in oil stocks after the blowoff top
was about 30%. As such we have exited longs and will look to buy again
after the coming retracement.
So, while we remain long term bullish on the sector, our call from last
December to climb aboard the oil rally (crude and oil stocks) is no more.
We now advise taking profits off the table.
When oil stocks run swiftly ahead of financial stocks, any market watcher
should take notice. The recent surge in the ratio between oil stocks and
financial stocks is the greatest since October 1998 so we feel it warrants
a brief discussion of that turbulent time in the markets.
In the chart below we show the oil/financial stock ratio followed by
the T-bond and the euro in 1998. Note that in many cases a falling dollar
and falling yield environment can be very bullish for financial stocks
- like they have been for the past two years. But this is not the case
when the falling dollar and low yields work their way into runaway oil
prices. As you can see below, the surge in the oil/financial stock ratio
occured amidst a sharp rise in oil prices, bonds and the euro/dollar.
But this was quickly unwound.
When oil stocks run swiftly ahead of financial stocks, any market watcher
should take notice. The recent surge in the ratio between oil stocks and
financial stocks is the greatest since October 1998 so we feel it warrants
a brief discussion of that turbulent time in the markets.
In the chart below we show the oil/financial stock ratio followed by
the T-bond and the euro in 1998. Note that in many cases a falling dollar
and falling yield environment can be very bullish for financial stocks
- like they have been for the past two years. But this is not the case
when the falling dollar and low yields work their way into runaway oil
prices. As you can see below, the surge in the oil/financial stock ratio
occured amidst a sharp rise in oil prices, bonds and the euro/dollar.
But this was quickly unwound.
Our forecast relies on the premise that the entire stock and bond market
rally has been a mirage of sorts as a falling dollar simply ‘inflated’
the global markets. But as long as the Fed thinks growth is strong it
should keep raising rates this year. This will drain liquidity from the
market and the reflation trend should reverse. As such, our view remains
unchanged that the ‘reflation trade’ is on its last legs. And if that
is the case the main driver of the reflation - the US dollar -is poised
to rally.
Therefore, we are still fascinated with the overt bearish talk surrounding the dollar. It seems that currency traders are unabashed in calling for a fourth consecutive year of decline in the dollar. Even award winning economists now chime in about why the dollar must fall. Leave it to an economist to explain the obvious. Recall that in 2001 they still gushed about the dollar.
We distinctly remember the same bearish talk in early 2003 as the stock market was holding above its 61.8% retracement of the 1991 to 2000 rally at 775 in the SP 500. The bears said there was much more downside to come and that an “unprecedented fourth year of decline” was not really that significant considering we were coming off of a bubble.
But the 775 level provided the springboard for a bottom in stocks. Similarly, the dollar index bottomed three previous times around the 80 level over its 30-year history and a break through here would likely spell the end of dollar hegemony. We are certain that is where things are headed but we still think the 80 level can act as a similar springboard for the dollar as the 775 level did for the S&P 500. Also recall just how bearish people were in late 2002 on the stock market. The bears were in control then but paid the price by staying short the market. We feel the same is in store for dollar bears in 2005.
In essence, b ecause monetary policy does work, but with a lag, the “reflation trade” finally picked up some steam in 2003 and carried the stock market through its steep downtrend line, only to prove the bears wrong. The market has been with the bulls ever since.
But monetary policy works the other way as well and a full year of rate
hikes has now made it a losing money position from an interest rate perspective
to be short the dollar. As such, we have repeatedly warned that once the
downward momentum in the dollar is broken, the dollar could stage a large
rebound. And when that happens the stock market is likely to retrace a
significant portion of its “ill gotten gains.” Therefore, much of our
analytical work relies upon intermarket trends to correctly position our
portfolio.
Finally, i n the chart above we have zoomed in on the dollar’s “three
tests” of its lows. If the third test were to mimic what we saw in the
SP 500 in March 2003 at 775 we should see one new spike low and a bullish
reversal in the dollar to mark the third and final “test.” This appears
the most likely outcome so we are sitting on the sidelines, watching and
keeping our powder dry before we take another stab at buying like we did
in January of this year..
Jes Black
Recent Testimonial for FX Money Trends: “I find FX Money Trends’ work extremely helpful. As a macro hedge fund manager I base my success on ideas generated both internally and through external research services: FX Money Trends and its founder Jes Black constantly provide ideas which are based both on very clever fundamental and technical analysis and research. FX Money Trend’s intellectual independence makes their ideas precious, never obvious nor “late.”
Francesco Clarelli, Italy.
Jes Black, hedge fund manager at Black Flag Capital Partners, specializes in foreign exchange and global macro trends. Prior to organizing the fund he helped MG Financial Group launch Forexnews.com. Afterwards he went on to found FX Money Trends, a research firm catering to professional traders.
Mr. Black holds a degree in economics from the University of Kansas and
an MBA from the ESC in France. His market commentary is often featured
in the Wall Street Journal, Financial Times and Reuters. He has also written
numerous strategy pieces for Futures magazine. To find out more about
the fund’s research letter visit www.fxmoneytrends.com. Qualified
prospective investors can find out more about Black Flag Capital Partners
by e-mailing info@blackflagfund.com
Jes Black
FX Money Trends, LLC
One Henderson Street
Hoboken, NJ 07030
646.229.5401 Tel
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www.fxmoneytrends.com
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