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Monday May 16, 2005 - 11:18:36 GMT
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Currency life cycle and the big swing


“The psychological crowd is a provisional being formed of heterogeneous elements, which for a moment are combined, exactly as the cells which constitute a living body form by their reunion a new being which displays characteristics very different from those possessed by the cells singly.”

Gustave Le Bon, The Crowd

FX Trading – A bit of the “best of” this morning

With many experts now beginning to warm up to the dollar trend, we decided not to repeat ourselves this morning and reprint a couple of past pieces we think are most appropriate again. The first is from January 14th and the second is from January 5th of this year.

Based on our reading of the market, we are somewhere between 3 & 5 in the Currency Life Cycle we first presented in Currency Currents on January 14th 2005:

Currency Life Cycle

…But earlier I mentioned “conversion flow.” Here is a roadmap of a typical currency cycle. It should help put the term “conversion flow” into perspective for you.

1. Extreme bearishness—this is the stage where “shoe shine boys” are shorting the currency and can articulate the rationale to anyone and everyone who will listen. This is when things seem the most bearish, but are in reality most bullish (as later can be seen with the elusive gift of hindsight).

2. Conversion flow—this is the stage when bears start to question their “so obvious” rationale for being short. It is the stage where the flaw in perception of the crowd begins to be recognized by members of the crowd. Conversion flow has an early stage and a more advanced stage. It is why we see increased volatility when the trend changes. The players begin to realize something has changed. But they realize it at different times.

3. Perception of the trend—this is the stage where the crowd recognizes that a new trend may be underway. They have discarded the old rationale and are beginning to accept the new one.

4. Capitulation to the trend—now the trend is fully underway. The crotchety old diehard bears can’t hold out hope any longer—they capitulate and buy into the new trend. Often this is a sign that the new trend is actually becoming a bit stale, for now even the diehards are along for the ride.

5. Extreme bullishness—now the “shoe shine boys” are buying the currency and are articulating the rationale to anyone and everyone who will listen. This is when things seem the most bullish, but are in reality most bearish.

That is typically the five stages of the currency life cycle. I think we are through stage one in the dollar and early in stage two—conversion flow. But, as I said, I have defined a typical cycle. The market is rarely typical in real life. However, if we are going to play, it can be helpful to have a framework. In the end, we are simply laying down our money and taking our chances. But if we can identify where we are in the life cycle, I think it can inch the probabilities of winning in our favor.

And our view from Currency Currents on January 6th 2005 I think is a reminder that the “big money must necessarily be in the big swing”:

We wake, at least on this side of the pond, to find the dollar in rally mode once again. And despite the protest from the “current account deficit is the only story” crowd of strategists, the buck continues to punish all comers.

I think as “traders” or “speculators” we need to drive a stake through the heart of the notion one can determine the direction of the dollar based on the current account. Long-term, I am not denying it MAY not be healthy. But, when it comes to any conceivable time-frame in which we base our dollar trading decisions THE CURRENT ACCOUNT IS AN UNRELIABLE INDICATOR. And if it is unreliable it is useless.

In hindsight, once the “strategist” capitulate to the new dollar trend, we will probable be subject to their new enlightenment, which will be nothing new at all. I think it was Jesse Livermore who said “There is nothing new in Wall Street.” We should extend that to say, “There is nothing new in the currency world.”

The new enlightenment will probably be what your already know or should know—underlying conditions. Back to Mr. Livermore (as chronicled in Reminiscences of a Stock Operator) for help here:

“I began to realize that the big money must necessarily be in the big swing. Whatever might seem to give a big swing its initial impulse, the fact is that its continuance is not the result of manipulation by pools or artifice by financiers, but depends on underlying conditions. And no matter who opposes it, the swing must inevitably run as far and as fast and as long as the impelling forces determine.”

And what are these underlying conditions? Nothing new to Currency Currents readers:
1) Yields
2) Inflation rates
3) Economic growth

It may be argued there is a whole bunch of “short-squeeze” driving the dollar move in the New Year. There may be some of that. But it is not the “underlying condition.” Here is the primary underlying condition…


Coupled with the next underlying condition (inflation) remaining tamer than the FOMC would have us believe…


And we get the payoff of RISING REAL INTEREST RATES.

Despite our consistent inability to forecast interest rates, we can often get a good “feel” for the trend. And in this case, the trend is the friend of the buck (which until just a few days ago had very few friends.)
Now back to Mr. Livermore:

“The way to make money is to make it. The way to make big money is to be right at exactly the right time. In this business [speculation] a man has to think of both theory and practice.”

Have we seen a “bottom” in the dollar? No one can answer that, except your run of the mill guru/charlatan; there are many to choose from as they run rampant in the newsletter world. But I think if we pose the question this way: “Have we seen an intermediate-term [multi-month] “bottom” in the dollar? The answer is yes, at least based on the flawed theory of the current account and the underlying conditions.


5-16-05: We thought back in early January we had seen a bottom in the dollar. Few in the crowd believed us. But that’s OK. Our natural inclination is to feel more comfortable when our view is a bit out of the mainstream. Now, with more and more players warming to the dollar trend, we are getting a bit anxious. But, as we said recently, we may have only seen the tip of the iceberg in this move.

As usual, hindsight will be our measuring stick.

Jack Crooks
Black Swan Capital


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