Today's comment is by Jack Crooks, our Currency Director and Editor of The Money Trader and Crooks on Currencies.

Dear A-Letter Reader:

In my last A-Letter , I explained the dollar would likely fall if the U.S. economy enters a "muddling through" stage. That seems to be where we're headed.

Last week the U.S. dollar broke down sharply from a seven-month trading range. The buck literally tanked overnight while here in the U.S., we were all still digesting our turkey and stuffing.

But the big question is does this set the stage for a new low in the U.S. dollar? It's definitely possible. Let's take a look at the fundamentals.

Yesterday, the U.S. durable goods orders report for October showed a plunge of 8.3% for the month. So that means that most of us aren't running out to buy a new washing machine, refrigerator, or a new car... the way we used to. This news provides more confirmation to the market that the U.S. economy is decelerating, more quickly than many had believed possible.

This is terrible for the U.S. dollar because while the U.S. economy slumps, the European economy is taking off. European growth is proving stronger than expected right now, and the relative comparison is killing the dollar. That's why we are seeing a sharp rally in the European currencies against the buck. It may be a bit early to say this dollar move is the continuation of a its multi-year bear market, but it something to consider.

Long-term Trends in the Currency Market

It's always difficult to pinpoint where we are in terms of a trend. Long-term trends in the currency markets have historically ranged from six to ten years. Dollar trends have been measured by the various bull and bear markets since President Nixon made the dollar a free-floating currency market back in 1971.

Here's the pattern of long-term bear and bull markets in the dollar as measured by the US$ Index:

• 1971-1978: Seven-year bear market (President Nixon closes the gold window closed)
• 1978-1985: Six-year bull market (Fed Chairman Volcker squeezes inflation)
• 1985-1992: Seven-year bear market (Triggered by the Plaza Accord)
• 1992-2002: Ten-year bull market (Tech boom and money flow to U.S. assets)
• 2002-   ?   : Presently the dollar is in the fifth-year of a bear market

No one can say when the current multi-year bear market in the dollar will end. The best we can do is keep these price moves in perspective so we can better evaluate conditions as they develop that may indicate the potential for a change in the trend. I use the boom/bust cycle of price action to put these longer-term moves into perspective.

The dollar, especially from a longer term perspective, moves in waves. These are discernable waves based on human emotion and supported to differing degrees by the underlying economic fundamentals at various stages along the way. It sounds complicated but it's not. Here's an example of the waves or stages of the dollar in a boom/bust price cycle...

• Stage 1: The unrecognized trend - This is the early on stuff. It represents the beginning of a new trend that is recognized by only a few of the major players. 
  
  
• Stage 2: The beginning of a self-reinforcing process - This is the stage where the consensus begins to realize there are real underlying fundamental reasons why this "new" trend has legs. This is the most powerful and longest leg or wave of the trend.
  
  
• Stage 3: The successful test - This is the pull-back that challenges the consensus view, it represents a significant retrace of the prior wave "self-reinforcing" wave.  In the case of the dollar, the bear market correction we witnessed during 2005 is an example of a "successful test." 
  
  
• Stage 4: The growing conviction, resulting in a widening divergence between reality and expectations - This represents the last major leg or wave of the trend.  It is supported by real fundamentals or expectations of how the fundamentals will play out. But it also represents the stage in which the currency is either overvalued" or "undervalued" on a pure fundamental basis. 
  
  

The current example is the leg-up we are seeing in the British pound. It is supported on strong growth in the UK economy and an aggressive Bank of England. But on a purchasing power parity basis (a key long-term indicator of real value) the pound is very "overvalued," relative to the U.S. dollar. But that doesn't mean the move is over. We still have the climax stage before it ends. 

• Stage 5: The flaw in perceptions - This is the stage in the cycle when some of the major players begin to realize the currency cannot be supported by the fundamentals, as highlighted above.
  
  
• Stage 6: The climax - This is the final stage of the move, and represents the "overshoot" we often see in currency markets because they tend to be more sentiment driven and price-led than other asset markets.   
  
  
• Stage 7: A self-reinforcing process in the opposite direction - The trend begins in the opposite direction.

So where are we now in terms of this dollar bear market? I think we are late into Stage 4.  On a fundamental basis the euro and pound appear "overvalued" against the dollar. But, there are still very good reasons why it makes sense to be short the dollar. And after all, this bear market is only 4 1/2 years old. 

When the "climax" stage is reached you will know it. That's when everyone in the world will hate the U.S. dollar everyday all the time. Shoeshine boys will be playing the FX market, and making a killing. That's then you know we are very close to Stage 7, time to  start looking in the other direction.

JACK CROOKS, Currency Director
On behalf of The Sovereign Society

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