QE2 is the most fashionable word in the financial world right now. It is the acronym for the second round of quantitative easing. Quantitative easing is just a fancy word that describes the Fed’s effort to increase liquidity, often considered “money printing.”
What does quantitative easing mean for investors and how can they profit? QE2 has created a very persuasive opinion that liquidity will increase, which will lift stocks and further depress the U.S. dollar. Headlines such as “U.S. stocks soar on quantitative easing hopes” (October 5, MarketWatch) reflect this sentiment.
This seems logical enough, that’s why it’s become such a permeating train of thought. However, just because something is popular doesn’t mean it is right. Most of the time there are logical arguments to support a point of view.
Economists and analysts had plenty of good arguments for stocks to rally in 2000 and 2007. Real estate was viewed to be a never-losing investment just a few years ago.
At times it pays to buck the trend and take a stab at real contrarian developments. Betting on a dollar rally would be the mother of all contrarian trades right now. But it may very well make a lot of sense, here’s why:
The Mother of all Contrarian Trades
Take a moment to browse through the below headlines and guess when they first appeared:
– “Dollar to weaken as reserve status erodes”
– “Buy stocks because the U.S. dollar will be worthless”
– “Strong dollar turns relic”
– “Dollar loses reserve status to yen & euro
– “Dollar is dying a slow death”
These headlines graced the news in the fall of 2009. Just as negativity about the greenback reached a crescendo, the dollar bottomed and rallied nearly 20%. To be exact, the U.S. Dollar Index reached a green candle low on November 26, 2009 at 74.21 and rallied as high as 88.90.
Despite the persuasive pessimism about the U.S. currency, the ETF Profit Strategy Newsletter was on the lookout for a major reversal and stated the following on November 13: “The U.S. Dollar Index has been bouncing around 75 for over a month now and seems to have found or be close to a bottom.”
After a 15% rally, the ETF Profit Strategy Newsletter noted on May 14: “We can’t help but notice that the extreme dollar pessimism has turned into extreme euro pessimism. Often this is an indication that prices are due for a temporary correction.”
This correction started mid-June and seems to be in its final stages now. The U.S. Dollar Index has retraced slightly more than a Fibonacci 61.8% of the previously gained points and has reached a strong support cluster surrounding the 78 area.
Those Who Learn From History
Regardless of whether history repeats itself or just rhymes, we know that extreme sentiment (in either direction) tends to result in a trend reversal at some point.
Extreme sentiment in late 2009 resulted in a 20% rally for the U.S. dollar. Similar pessimism right now should have a like effect. Whether the dollar will bottom today, tomorrow or next week, chances are that the greenback will be valued at higher than present prices in a month.
The PowerShares DB US Dollar Bullish Fund (NYSE: UUP) benefits directly from a US dollar rise. Its bearish cousin, the US Dollar Bearish Fund (NYSE: UDN), does exactly the opposite.
A dollar rally will inevitably result in a euro decline. The UltraShort Euro ProShares (NYSE: EUO) aims to deliver twice the inverse performance of the euro and stands to rally big, if the dollar moves up. The Ultra Euro ProShares (NYSE: ULE) is the counterpart to EUO.
The Dollar – Lynchpin for Stocks
As the chart below shows, there’s been a rather consistent inverse correlation between the dollar and U.S. stocks. A falling greenback tends to translate into rising stocks and vice versa.
A rising dollar in late 2008 paralleled a waterfall decline that shaved more than 30% of the Dow Jones, S&P 500 and NASDAQ. Conversely, the 2009/2010 stock market melt-up was aided by a falling dollar. Needless to say, a rising dollar would not bode well for equities.
Not only stocks dance to the beat of the greenback. Commodities do as well. After a mini melt-up, gold (NYSE: GLD) and silver (NYSE: SLV) are due for at least a temporary correction. This might very well coincide with a dollar bottom.
The initial stages of a trend reversal are usually considered to be just a “correction.” A correction gone too far captures investors’ attention as it morphs into a full blown reversal.
In 2008, the correction seen in stocks, gold and commodities morphed into a “red across the board” decline that dragged down even bonds. Most investors today view this as a very, very low probability event. Contrarian investors will have their guard up and watch unfolding events very carefully.
Formulating contrarian profit strategies is always tricky business. However, TrimTabs research shows that investors could have made money in a “lost decade” just by going against the herd.
This takes guts and patience, but it generally has played out. The ETF Profit Strategy Newsletter looks at the prevailing trends and analyses various indicators to formulate ETF profit strategies, which tend to be contrarian in nature.
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