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What Will Third Quarter Hold for Dollar, Oil and China?


Reviewing past calls and looking ahead.


Unfortunately, the first half of 2008 has not been pretty for the equity markets, but hopefully as a Minyanville reader, you have navigated the market crisis well and protected capital.

Although the equity markets have been brutal, there have been several other good opportunities to make money this year in various other markets. Let's review some of my calls for 2008 and see if we can create a plan of attack for the coming quarter.

  • Call 1: Long PHO (PowerShares Water Resource Portfolio) – As I said in my article last December, Calls of 2007 and Ideas of 2008, if you must have some long equity exposure this year, the PHO is a great vehicle with a solid long term macro theme. Fortunately, the PHO has outperformed the broader markets this year and actually finished up the second quarter barely down for the year! Although I am bearish on equities in general, I continue to like the PHO for long equity exposure, and I would feel comfortable adding in the $18-20 range.

    See how well the PHO has held up this year in the chart below…certainly better than the Dow Industrials!

    Click to enlarge

  • Call 2: Long Japanese Yen – This has been one of my favorite trades for 2008, primarily as a hedge against the credit crisis and ultimate beneficiary of the big leverage unwind. The Yen rocketed higher and quickly tagged my par target in Q1, and I advised taking profits, which proved to be pretty close to the top. The Yen has consolidated in Q2 and has pulled back right into moving average support as well as a 50% Fibonacci retracement of the rally off the 2007 summer lows. I think the Yen is setting up as a great risk reward long trade again, although this time I won't be taking profits at par. Watch for a volatility expansion and move above 0.96 to signal a new bull leg in the Yen is beginning. Longer term I think we could see 1.25 Yen futures, which would coincide with the 1995 highs.

    Click to enlarge

  • Call 3: Gold! – I stated in the previously mentioned article that gold would be one of the most dynamic markets in 2008, and so far that has proved true. Up until recently, my call for a gold analog to the 1980 price action has worked well. I advised being long gold to start the year, and also to take profits at $1000 as gold hit my target in Q1 (like the Yen) sooner than I expected. However, the recent basing action in Gold must be respected, and we need to watch this market closely over the next couple months to see if the analog to 1980 is breaking down.

    If the analog were to hold true, I would expect serious downside to gold here and would not be surprised to see it below $700 before year end. Tensions in the Middle East and further dollar weakness have kept gold well-bid recently, so unless the yellow metal rolls over very soon, I would much rather be long gold. There's solid support in the upper $800's and the RSI downtrend is very close to being broken to the upside. I would give gold the benefit of the doubt to the upside as long as prices hold above $845.

    Click to enlarge

Now let's go over what I think will be some of the most important markets to follow in the coming quarter:

First off, we need to keep a close eye on the U.S. dollar. Unfortunately the dollar is still locked in an ugly long term downtrend, and keep in mind that surprises usually happen in the direction of the trend. It's pretty amazing that only a weak bounce developed from the positive divergence low in the spring, and also there were certainly too many optimistic dollar bulls on that brief bounce for a true low to be in. Sentiment just doesn't swing that quickly on a market in a major downtrend.

There's heavy resistance in the dollar index in the mid to upper $70's. We are on the verge of seeing the U.S. dollar break down to new lows and we could see some swift momentum to the downside if the prior 2008 lows are taken out. Obviously the election is going to be the major theme for the latter half of 2008, and, unfortunately, selling the dollar might be the only way foreign investors can voice their opinion on that matter. That, along with the Olympics starting in China barely a month away, should provide for some interesting currency headlines later this year!

Click to enlarge

I would be very careful with the bond market here. Bonds could remain well bid in a flight to safety trade, but technically they look challenged. This could be another key market in the latter half of this year, especially if foreign investors decide to vote by dumping our debt.

Higher yields are the last thing Americans need to hurt the already weak U.S. economy. Notice in the below TLT chart how bonds have rallied right up to the underside of the neckline in this head and shoulders topping pattern, which also happens to coincide with the 200 day moving average resistance. I am watching for a break below 89 in the TLT as confirmation that a new leg down in bonds will unfortunately push yields higher. That will be a tough headwind for the equity markets and also keep the Fed in a very sticky situation.

Click to enlarge

As far as equities go, you really only need to look at a chart of the Dow Industrials to see why I'm bearish. We have convincingly broken the neckline around 12,000 of this head and shoulders top, which unfortunately projects down to Dow 10,000. The large caps have really underperformed as of late, with tech and small caps holding up slightly better in the recent selloff.

Near term there is a possible positive divergence with the Dow Industrials breaking to new closing lows, while the S&P 500 and NDX have not. This could give us a decent short term bounce especially with potential new money coming in at the beginning of the quarter, but the trend is still down so I'm not going to be too cute trying to call the bounce. While I can't point out any single stock ideas I would just say that I like the IYE and IYM on the long side and the IYF and IYC on the short side. I would focus on those sectors for respective single stock ideas. The trend is your friend.

Click to enlarge

Oil is obviously the big headline market right now. You have to respect the uptrend, especially with the Middle East wild card. Anytime someone as experienced as Dennis Gartman decides not to trade a commodity market because it's gotten too volatile, you know closer attention is warranted. I would have to agree with him that oil is just too crazy right now, and obviously anyone caught short is in a tremendous amount of pain. The trend is up so I would not advise fighting it. Keep an eye for consolidation for better setups and risk/reward trades.

Click to enlarge

One last chart I want you to take a look at should be an interesting theme for the latter half of 2008: China. Take a look at the FXI and, as you can see, there's a potential head and shoulders top forming here as well, but I don't think we'll see this pattern work out to the downside. More likely this is a pullback in a longer term uptrend and an opportunity to add long exposure. I would only be worried about the FXI if it closes below 120.

Otherwise, I think you can take a shot on the long side here, and above 160 would confirm a rally back to the highs near 210 could be in order before year end. The Olympics are an obvious catalyst and we all know about the potential for Chinese growth.

Click to enlarge

In conclusion, I expect the fireworks to continue in the second half of 2008, and there should be plenty of volatility in many markets that will create money making opportunities. I'm very worried about another leg lower for the U.S. dollar, which could be severe. The main beneficiary, I think, will be the Japanese yen as leverage continues to be reduced across the spectrum. Stay defensive and preserve capital so that when the time does come to buy, you're well prepared.

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Position in yen through various vehicles.
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