Fundamental analysis is based on the premise that fair value is a measureable item. By examining financial statements, forecasting future business prospects, and making adjustments for unknown risks, we determine a range of values wherein a stock is cheap and look to buy at a discount to that number,
With respect to currency trading, though, no such framework exists. Some people will argue that based upon econometric modeling they can determine at which prices currencies should trade, but that is folly. With the worldwide monetary system backed by nothing of intrinsic value, currencies tend to take on personalities of their own. Instead of calculating what prices should be, we determine the trends and look for correlation across instruments to deliver profitable trades.
Consider the U.S. dollar. As the world's reserve currency, the dollar holds a special position in the international monetary system. It is seen as a safe haven where people flock when times are bad. During the financial crisis, the dollar rallied strongly as people ran from risk and sought safety. When the equity markets bottomed in March, the dollar reached its peak. As the stock market rallied, the dollar carved out a traditional head-and-shoulders reversal and has moved lower since. In fact, with the current decline, the dollar has now reached the initial downside target (blue box) that I identified in the May 25 newsletter.
To benefit from a declining dollar, I took two different positions in my weekly newsletter EPIC Insights. The first was a currency ETF that benefits directly from dollar weakness-the Brazilian Real Fund (BZF). As the dollar falls in relation to other currencies, BZF rises. The other has a more indirect connection-the Powershares DB Commodity Index Fund (DBC).
Since most commodities are priced in dollars, a declining dollar leads to higher commodity prices. A change in the rate of the dollar alone does not change the level of underlying demand. Instead, since the demand of foreign purchases of commodities is the same and these foreign currencies have gone up in value versus the dollar, a falling dollar will drive commodities higher in order to make the net expense the same.
Given the decline in the dollar, our investments in BZF and DBC are higher by 27% and 7%, respectively. With these profits accounted for, my attention is fixated on where the dollar goes from here. My guess is higher.
Based on market sentiment and trade activity, it appears that nearly everyone is short the dollar. While I remain concerned over rising deficits and a left-leaning government, I think the trend has moved too far. Charts of BZF and the British pound tell a familiar story of foreign currencies running up long trends that are on the cusp of being broken. Combine the pending trend breakdown with the dollar having traded to the reversal price target and we are seeing the setup of dollar strength.
The dollar may eventually drift somewhat lower, but the next dramatic move will be to the upside. Having correctly called and profited from the decline, I will not stand idle and watch gains morph into losses. Instead, I will act as I often do and move to the sidelines while awaiting the next opportunity. I recommend selling the positions in BZF and DBC as this week's fundamental trade.