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Playing with the Masters

The following is from our April 9, 2006 report....

With the final round of the Masters on today I'd like to share with you an analogy to trading. This weekend I had the pleasure of playing golf at the newly opened Mayakoba resort in Playa del Carmen with a friend. This course will host the first ever PGA money event in Mexico next year, which is testament to its caliber. My friend, Dean, is a PGA professional who happened to be in the majority of professionals who did not get invited to the Masters.

Over 18 holes I averaged just one stroke more per hole than Dean, which doesn't feel like much when you are playing. Jokingly, I pointed this out and we then had a fun conversation about the similarities between what it takes to be a successful money manager and being a pro golfer on tour.

We first agreed that one of the parallel keys to success was the ability to accept losing and being wrong. You will lose more than you win. Period. Once you have accepted that you will lose more than you win, you minimize your losses. Do this and you are ready to win. But to run with the best you need to know how to win the big purse, because that is what carries you through to a successful year.

A very good professional golfer might at most win two tournaments a year, he said. The analogy here is that you have maybe two chances a year for an explosive trade. Today's final round is very close and we agreed that any of the top 10 players could win but to do that they have to be aggressive and manage risk today. If you can't do this as a trader at the right times you will remain stuck in a rut because failure to capitalize on your best chances means that you will have to average out that failure with your expected losses, which for most pros exceeds their wins by a wide margin. Knowing this we designed our services to alert traders to points in the market that can win the big prize. When we see a great opportunity we get aggressive and right now we see a big move coming in the US dollar.

Stock Focus: Conventional wisdom has it that the end of the Fed's rate hiking cycle will be bearish for the dollar and bullish for stocks. As usual, this is not exactly supported by past rate hiking cycles. Instead, stocks normally peak before the top of the rate cycle while the dollar will continue to run until its interest rate advantage is significantly eroded.

Readers will recall that we expected the market to roll over last year, but with earnings and jobs numbers continuing to encourage the bulls the market has seen a series of "ending diagonal" triangle patterns since peaking at our expected high of 1,250 in 2005. This marks the 61.8% Fibonacci retracement of the all time high to the 2002 lows.

The target retracement level for an ending diagonal pattern in "wave 5" is back to its point of origin, usually the "wave 4" low. Since we have two diagonal triangles back to back in the chart above the first target is 1,250 followed by 1,170.

With such obvious momentum divergence going on in the daily charts, Friday's bearish daily reversal from new multi-year highs gives traders a great risk reward profile to go short on a sustained move below trendline support at 1,300 with risk limited to Friday's high at 1,314. As we said last week, "We will turn outright bearish on a move below 1,250," (the key Fibonacci level we mentioned).

Bond Focus: We saw a spike in 10-year note net longs two weeks ago to near record highs that equals in magnitude the new all time low in 30-year net shorts (not shown)!?! Sentiment readings we collect suggest the market is especially bearish on bonds which means the long positioning in the 10-year note is the bizarre anomaly. For weeks we have maintained the bearish bias on bonds to great success, but we now think traders should look to exit their shorts initiated at our recommended level of 109 around the 104-106 level as we now expect a relief rally to get under way in the coming weeks.

We first showed the chart below three weeks ago, indicating that a reaction in yields would come off of the 5% level. With yields having rallied 50 basis points since then to a high of 4.96% on Friday, we consider our first target to have been reached. We now see a pullback to 4.5% followed by further chop and flop over the next year until we see a sustained move above 5%. Only a move above here keeps us as bearish on bonds as we have been.

Currency Focus: Longtime readers will recall that we correctly forecasted not only the US dollar rally for 2006-2006 but also said the rationale as reported by the media would focus on rate differentials. Over the course of the dollar's rally, each and every significant setback can be related to market "expectations" of when the Fed would end its rate hiking cycle, not data. While the market is busy following conventional wisdom you know that large rate differentials in low inflationary environments have always supported the dollar even after the Fed rate peaked and the rate advantage eroded.

Each of these setbacks on "expectations" has seen a surge in euro bullishness. For that reason we pointed out one month ago that changing rate expectations could drive the euro above 1.21 to 1.23; above 1.23 we said would target 1.25/26. While this was contrary to our dollar bullish position, we said a euro rally would be an excellent opportunity to buy the dollar on the cheap as euro longs would likely reach unsustainable levels.

While a final rally to 1.25/26 cannot be ruled out just yet, the sharp bearish weekly reversal from the 1.2330 highs last week (shown below) suggests that the last of the dollar bulls' stops were hit on the 10 pip move above the previous January high of 1.2320. But euro bulls got crushed following the ECB's dovish statement and the bullish US payrolls numbers.

As we said, each time the euro net long positioning spiked based on a perceived shift in interest rate expectations, the result was an opportunity to buy the dollar when the market was later determined to have guessed it wrong. So is the market wrong?

Yes. With the market now expecting a 50/50 chance of a peak in the Fed funds rate at 5.25% (an additional 50 bp of rate hikes) following last week's payrolls numbers and fading expectations for the ECB to deliver a series of hikes, euro bulls are again sitting on thin ice following a spike in longs.

Readers will recall that we turned aggressively bullish on the dollar in late January after the spike in EUR net longs set up a nice opportunity to go against the crowd. As subscribers to our FxSignalZone™ service can see from our trading blotter, the bulk of our swing trading profits came in February when we were leveraging into our wining long dollar positions. We then took to the sidelines in March and made an average of only one trade a week - each of them with the minimum allocation we allow. Almost all of those traders were bullish on the dollar and most of them were losers.

We mention this because our opening statement indicated you must know when to be aggressive and how to minimize your losses in order to be a good money manager.

The first chart below we first showed you three weeks ago, indicating that despite the dollar selloff and potential rally in EURUSD we were still targeting a move to 95/100 in the dollar index. Our favorite spot FX trade was in USDCHF because of the large rate differential. As we indicated three weeks ago, we have a large inverted head and shoulders pattern in the making. A move above 1.32 targets 1.42.

Recall that as we explained in our workshop at the Forex Traders Expo last week, the inversion of the yield curve has no lasting near term effect on the overall rate differential advantage. Therefore, a peak in the Fed-ECB rate differential may now not come until July, 2006, which gives the dollar plenty of room to run in the near to medium term.


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