Saturday, September 10, 2011

Dollar Holler

"I am sitting inside the truck, watching a screen. The truck reels the tool back up out of the hole, slowly - more slowly than if you were reeling it in by hand - and foot by foot, the tool passes through all that dark mystery of time, emitting signals and picking up signals. I watch the tool's response to the formations it passes through on my screen, little green blips of radioactivity, and like an EKG, each blip indicates something...

I love to log wells. I've logged a thousand, and I still find myself holding my breath when the tool first starts up out of the hole, when the electronic green lights begin to flicker and race. 

No one has ever before seen what I am seeing." Rick Bass - Oil Notes
Part of the analytical overlay from my previous profession as a geologist is in taking certain data series - stripping away the noise - and extrapolating where things may be and the quality of the information at hand. As a geologist, you are often modeling data from a source that you can not witness in-situ or interact with for more than a few moments. It takes experience, intuition and the ability to render a field that is not readily apparent. 
"Curiously, however, in geology, when I pour a cup of coffee and sit down and begin to map, I'm not hiding behind anything; there's no pretense, no deceit, just an inquisitive hunger and innocence where I am neither superior nor inferior to the reader, but am the reader. There's truly an amount of trust. The earth lies there, still and obeys certain rules. I have faith that I am not going to let myself believe something that is not true. It is perhaps the purest thing I've ever done. Perhaps that is why geologist become so fervent about a particular prospect. Not holy men, but sill there is that aspect to it - as in athletics, and religions." - Rick Bass
I often find that market research today confuses the reader by overindulging the analyst's enthusiasm and concerns towards the subject at hand. When it comes to macro issues, where causation is often a fools game with regards to the daily and weekly market movements, there is an almost unlimited resource of information to pull from in justifying ones expectations. It is the main reason why I find charts so efficient in translating information without the excess baggage often woven into research reports. I find that as long as you have a fundamental understanding of the backdrop (which you get from charts) - focusing your attention on a few pivotal components will yield greater clarity than the nuance that works off of the system itself. Today's almost maniacal obsession with daily and even hourly CDS spreads in Europe comes to mind. 

We are really just observing the ebbs and flows of energy transmission and momentum in a dynamic system - whether we would call it an open or closed system is open to debate. As traders, do we really need a 2000 word white paper to describe something akin to how a wave translates across a body of water? Certainly you could describe that process in great academic detail if you were arbitraging an esoteric relationship, but for most market participants, a more simple explanation will suffice and likely free you from becoming steeped in confusion and unable to capitalize on developments in the markets in realtime. There is a fine line between perceiving an investor or trader as ignorant - versus someone who has simply discounted information from the big picture.

With that said (and certainly hypocritically over-indulged on my end), for those who have been following my notes since the Spring, a great deal of my forecast accuracy and trading acumen have revolved around the notion that the U.S dollar was bottoming and likely to embark upon a significant advance. Having confidence in where I believed the dollar would trade gave me a certain assurance towards shorting silver in the Spring and positioning myself towards an equity market that was going to go through a transitional phase. This in-turn influenced how I approached the markets this summer.
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"For all the dollar bears that are waiting on pins and needles for the bottom to fall out or for America to enter into a hyper-inflationary tailspin, just turn their attention to the historic chart of the American currency, post the Nixon Shock in 71'.  
Where's the doom and gloom? 

I see a rather normalized trending currency, reflecting moderate fiat debasement, within a technical framework remarkably similar to late 1980 early 1981. 

And low and behold, silver has very much been acting within the technical part as it did in 1980. 

...This is why I have entered a position that is long the U.S dollar and short silver. It's not a daytrade, it's a thesis position (I can just feel traders cringe)."

This thesis was based on structural formations in the dollar and the CRB and developments across the Atlantic on the opposite side of the currency pair.
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"Appraising the commodity sector (a component of the everything goes up market), we can see that we have pulled up to both the 61.8% fib retracement level from the 2008 top and what could end up being the right shoulder of a very broad H&S pattern. Considering the commodity trade has been partially a trade against the U.S dollar, and the dollar is about as washed out as it could possibly become from both a technical and sentiment perspective (yes, and even the great currency trader - Matt Drudge, believes the greenback is headed significantly lower) - there remains to be seen what will propel the sector higher at this inflection point." Taking Shelter - 4/28/11


So what comes next?

From my perspective, no one should discount how influential and significant a stronger U.S currency is to the financial markets - both here and abroad. Judging by the long-term technical picture, you would have to go back to 1995 and then to 1980 to see a similar set-up. For obvious economic reasons I would argue from a comparative viewpoint that the early 1980's would be a more appropriate precedent of perspective than 1995. Of course these extrapolations are based on the thesis that the U.S currency - as well as the euro - is at a major inflection point

During these contentious times, the financial media will always be louder with their concerns and anxieties, rather than the silver lining imbedded in a development such as this. U.S corporations will certainly have a headwind with their international footprint (some would argue a good thing for domestic investment) and certainly a stronger dollar will make U.S exports more expensive for foreign consumers. Considering that the U.S export story has been one of the only bright spots in an otherwise downtrodden economy - it will be highlighted and pinata-ed by the pundits in the financial media for some time. We are also likely to continue going through a transition where traders do not accept that the stock market can go up at the same time the dollar index appreciates. For many traders today they simply have never witnessed that dynamic for more than a few days to weeks. The dollar goes lower - the stock market goes higher. Eventually the market will transition to a positive correlation with the dollar - the question is just when

This is why to a certain degree I have had more confidence in my expectations for the commodity sector and certain currencies, because I could see those inflection points in the charts. Broadly speaking - the equity markets are currently in no-man's land. I have my suspicions, but the degree of confidence is not the same as in the commodity and currency markets. 

Irrespective of these concerns, I believe that the trade off will eventually far outweigh the perceived negatives - considering: 
  • It will come at the expense of high commodity prices - which have been pick-pocketing the U.S consumer and domestic business activity during a very difficult economy.
  • It will significantly boost the attractiveness of U.S investments. At a time when analysts and market pundits are wondering where the capital inflows will come from next (especially considering the baby boomer demographic), inflows from foreign investors benefiting from a strengthening currency exchange will be a much welcomed tailwind.
  • A stronger currency makes it easier for a nation to borrow and finance its debt. Although that issue has yet to become a real concern, even with the downgrade - in the light of the shenanigans in Congress, we could use all the help we could get. 
  • The trade deficit will improve (as it did last week). Considering the majority (>50%) of the deficit is comprised of petroleum imports - cheaper energy will benefit the government as well as the consumer.
In summary - the net effect of a strengthening U.S dollar will eventually have real benefits towards the U.S financial markets and our economy. And while it looks pretty darn bleak out there in light of the developments in Europe - the backdrop is always darkest before the dawn.