by David Stanowski
21 August 2007
The previous article, Inflation: the Big Lie, demonstrated the fact that the Dollar has lost 95% of its value, i.e. purchasing power, since the FED was created in 1913! History shows that there is every reason to believe that the value of the Dollar will continue its march towards zero, barring some sort of revolutionary change in our financial system. However, purchasing power is only one way to look at the Dollar.
The Dollar also trades against all of the other currencies in the world. Like the Dollar, these currencies are also manged by their central banks, and they are also inflating away their values at differing rates. Therefore, even though the value of the Dollar is in a long-term downtrend, at times, it may be falling at a lower rate than the value of other currencies. When this is the case, it makes sense to own the Dollar, instead of other currencies. This can be accomplished by buying or selling the Dollar against any one currency, or against a basket of currencies.
Since 1973, the U.S. Dollar Index has served as the benchmark for the Dollar's strength against the other major world currencies. The weighting is: Euro 57.6%, Japanese Yen 13.6%, British Pound 11.9%, Canadian Dollar 9.1%, Swedish Krona 4.2% and Swiss Franc 3.6%.
The following long-term chart of the U.S. Dollar Index, shows the price action from December 1985 to August 2007. The Dollar Index peaked at 121.90 in July 2001, and then bottomed at 80.48 in July 2004; a loss of 33.98%. This steep 36 month decline is why the sentiment has turned so negative towards the Dollar. From this low, the Dollar rallied for 11 months, but then fell back to 79.86 this month. The fact that the 80.00 level has acted as support in 1991, 1992, 1995, 2004, and 2007 begins to make the case that the Dollar Index may be ready to rally.
One of the best ways to measure value versus price is to construct a long-term moving average of closing prices. For example, a 24-month average of prices represents the average price that investors were wiling to pay for the investment over the last 24 months. A moving average simply updates the average each month, by dropping the price from 25 months ago, and then adds the current month.
The first time frame currently of interest is when the Dollar Index rallied off its 1995 low, and moved above its 24-month moving average (green line). Over the next 76 months, prices (red line) exceeded value (moving average, green line) in all but 9 months. This represents a time frame of persistent over valuation.
Over valuations usually produce a reaction towards under valuation, which has been happening for the last 63 months, where prices have been below value in all but 10 months. This has been a time of persistent under valuation which should eventually lead to prices pushing higher.
Click Here for larger image
This is a close up of the graph shown above
during the two time frames of interest:
1995 to 2007
The best way to see the relationship between price and value is by computing the differences. Note how the persistent over valuation in the first period, in both duration and percentage difference sets up a strong reaction in the other direction. Now that we've had an even more persistent undervaluation, this should be setting up a base for the Dollar Index to move higher.
When looking for confirmation for this price versus value study, the next most important factor is sentiment. The news has been uniformly bearish on the Dollar, with the vast majority of analysts expecting further declines. This is an excellent Contrarian climate in which to start a rally!
In addition to this, the Daily Sentiment Index (a survey of analysts and traders), registered 7% bulls at the December 2004 low, and is currently reading around 10%. This confirms the extremely low level of bullishness seen in financial news stories.
Finally, the Commitment of Traders (a breakdown of positions in the Dollar Index futures contract) is showing that the Commercials are heavily net long the Dollar Index (red line), while the hedge funds are heavily net short (green line). The Commercials are insiders, so they are on the correct side of the market more often than any other group of traders.
There are two types of events that might take place as the Dollar Index moves higher. The other major currencies could simply start losing value faster than the Dollar, or their could be fewer Dollars available, which would increase the value of those remaining. This is what happens in a credit contraction, when prices plunge, and wealth is destroyed. During the credit collapse of 1929-1933, the Dollar gained 32% in value!
If you are interested in investing in the Dollar Index, you should do your own research, and consult with a registered investment adviser or broker. Ask your adviser about investment vehicles such as the Dollar Index futures and options (DX), and the mutual fund RYSBX.
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