-- Posted Sunday, 8 October 2006 | Digg This Article
A major portion of this analysis has been extracted from the Oct 03, 2006 Market Update that was sent out to our subscribers.
Only in quiet waters things mirror themselves undistorted. Only in a quiet mind is adequate perception of the world.
Hans Margolius
This was a simple exercise but one that took quite a bit of time and effort to accomplish. We adjusted the price of the Dow from Oct 1999 on a quarterly basis to reflect dollar strength or weakness. In other words the Dow was re priced on the basis of where the dollar was trading in each one of those quarterly periods. As the saying goes “a picture is worth a thousand words” and so that’s exactly where we are going to start begin this analysis.
As the Dollar index is currently trading around the 85 mark we are going to use this figure to base all our calculations on. We have also plotted a chart of the Dollar on a quarterly basis starting from Oct 1999. Each point on the Dow and Dollar charts represents the highest reading for that quarter.
If one looks closely at both the charts there is a one huge pattern that emerges; the Dollar and the Dow tend to trend in the same direction and usually the Dollar leads. There are several other factors that come rushing out also. First of all is that the Jan 2000 high was not the real high. The Dow went on to put in 3 higher highs before it started to correct (we expand on this soon). The current high of 11865 plus is not really a new 52 week high; in fact we have traded way past this mark in each of the last 3 quarters. In Jan 06 the high was 12081, in the 2nd quarter beginning on April 06 the high was 12318 and in the next quarter (July 06) the high was 12010. Hence in each of these 3 last periods the Dow traded much higher then this so called new 52 week and all time illusory new high. This year’s actual 52 week high occurred in the 2nd quarter.
All this can be explained with 4 words “Currency Strength or Weakness”. For example when the Dow put it’s so called high back in Jan 00 the dollar index was trading at 105. Since we are using 85 as the starting point for all our calculations; the dollar in Jan 2000 was trading almost 20% higher then it was trading today. Hence the true value of the Dow in Jan 2000 priced in 2006 dollars is 14100. This same calculation was performed on each piece of quarterly data.
We are not going to go into details of the currency workings (this is something that is reserved for our subscribers). However those who are able to fathom the inner workings of the currency markets have a huge trading advantage over those who do not (the majority falls under the latter category). Note that in reality the True high did not occur in Jan 2000; the Dow actually went on to put on several new highs one in April 2000 (14167), another in July 2000 (14524) and the all time high actually occurred 15 months later in April of 2001. In April 2001 the Dow traded at 14660 when priced in today’s dollars. You ask how is this possible well that’s where currencies come into play.
Take a look at the second graph of the US dollar. In Jan 2000 the index was at 105 and while the market started to correct the dollar continued to rally. So the dollar was actually appreciating at a faster rate then the market was declining. The two graphs clearly illustrate this relationship. Hence in April 01 the dollar was trading in the 120 ranges or roughly 15% higher then it was trading in Jan 2000 (105).
Other important observations
One can see that in reality most bears were right when they were screaming out in the past that the Dow was just mounting what appeared to be a bear rally. However being right does not mean that one can always make money. One has to be right and also rightly positioned to make money. The bulls were and are still actually wrong but for the time being they are the ones making the money. When it comes to the market only one select group of individuals wins all the time. These individuals are neither bears nor bulls; they are simply wise traders who understand that sometimes one has to be bullish, sometimes one has to be bearish and sometimes one has to just shut up and sit on the sidelines waiting for opportunity to present itself. It’s not what you don’t know that causes the most pain it’s what you think you know that usually causes the most damage.
Conclusion
One notices immediately that there appears to be a pattern with the Dollar and the Dow in that they tend to generally trade in the same direction. One also notices that the Dollar has corrected considerably in the last 7 years and it has hardly mounted a strong rally in that time period. One also notices that the high the Dow set in April 06 is actually higher then that set today. Even though the Dow is still in a bear market; all bear markets mounts very strong rallies in between and these rallies can be so strong that they can fool even the strongest of bears. The problem here is that this bear market has been cleverly disguised by a plunging dollar.
Since the Dow appears to be mounting a strong rally in what appears to be taking place in the context of a long term bear market, one could conclude that the Dow technically could trade much higher and still be in a bear market. The key to determining the length of this rally will be the currency markets. One has to understand how these markets work and also be in a position to somewhat predict their direction for the next 6-12 months. In this instance it’s the direction of the U.S dollar that will be key in possibly determining what the Dow will or will not do. As stated before this something that we usually reserve for our subscribers. In addition it would take too much time to go over it here, a separate essay would be needed.
Thus a declining dollar does not bode well for the markets in the long run; in the short term time frames the negative impact might not be huge but the long term pattern can be clearly seen in the above charts. Every serious bear market has always experienced some sort of rather strong relief rally and this has not yet taken place with the dollar. Hence it’s possible that this could still occur. If this were to take place then it means that the markets could go on to put in a series of illusory new highs. We will examine the possible reasons if any for a dollar rally next week and new support and resistance points for the Dow based on the adjusted value of the Dow and not its current new value.
Bottom line
The next few months are going to be packed with extreme volatility; expect the volatility to increase by a factor of 2 to 3. So if you think the last 9 months have been volatile wait till you see what the next 9 months could bring in. These types of markets are great for playing the indices via options or futures which is what we have been doing via the issuance of higher risk plays.
Two other positive factors from the Dow chart. Note that it has broken its long term down trend line and its still trading above the main up trend line. Under perfect conditions it would not be inconceivable for the Dow to trade close to its all time high before resuming its downward trend. Conditions are from perfect but 900-1200 points would not be out of the question if the dollar had to stabilize.
Final note
We see no reason to celebrate this so called new high that the Dow put in this week. In fact we were expecting this and warned our subscribers in advance that the coming highs would be nothing but illusory highs. While the penguins on Wall Street are flapping their flippers and expanding their lungs to scream about this all time new high, get some popcorn find a comfortable seat and watch this new reality comic show unfold. There is an old saying once an idiot always an idiot.
It takes 50000 nuts to put a car together, but only one to scatter them all over the road.
Darryl Somers
-- Posted Sunday, 8 October 2006 | Digg This Article
