Trading around Christmas time generally gives you one of two scenarios.

The market can be boring and sideways, with traders taking a break over Christmas, or it can give you a really strong move heading into January.

WD Gann wrote that early January was an important time to watch for turns in the market. If you look back over any market, you will often see major moves start or finish early in January. This can be a great way to finish the year, with a nice Christmas bonus from the market!

How do you know whether you will get a good move or a boring, sideways market?

The answer lies with time analysis, which is beyond the scope of this article. However, those of you who have studied Gann would know that if your time analysis is showing you an early January date, you can be pretty confident you will see a turn.

My time analysis is telling me to watch for a turn in the first week of December on the US Dollar/Japanese Yen (FXUSJY in ProfitSource), running into another turn around the 5th or 6th of January, 2009.

Chart 1 below shows the current market action on the Dollar/Yen.

Chart 1

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After a very tradable move down from the August 15 high, the Dollar is trading in somewhat of a violent sideways pattern.

With moves like these, it can be difficult to know whether to expect a top or a bottom if we have a turning date approaching.

In this case, I am watching for a top around the 100.80 level. This was the 50% Retracement Level of the run down, and would give us a double top with the November 4 swing high, as shown in Chart 2 below.

Chart 2

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I am yet to meet anyone who can call every turn in the market, every time. Sometimes, it just doesn’t work out. David Bowden once said “when it comes to trading, the only thing you need to know about God is that you’re not him!” It’s important to remember that – if the market doesn’t give us a tradable signal on our pressure date, we simply wait for the next date.

Many people would prefer not to hold positions over Christmas, as this is traditionally a period of rest, and that’s fine – you can always come back early in the New Year and look to trade OUT of the early January date.

However if we see a Double Top come in early December, there is a very good chance we will see a 1000+ point fall in the Dollar/Yen, into a January low. With the exciting leverage of the FX market, a 1000 point fall equates to $US1000 for every $US100 US margin tied up in the trade.

Capital Flows ,Where the money goes ?

But honestly, that’s only part of it. The other reason there is always at least one currency rising is because of capital flows. As a currency trader, you’re constantly watching where capital is flowing, so you know where traders are dumping their money.

Every time markets suffer around the world, there’s always a line-up of investors ready to sell-off their positions.

Each time, those investment funds have to go somewhere. Even if that’s just back to cash – which pushes a handful of currencies higher. That’s exactly what happened in 2008. As investors ran from stocks, bonds and even CDs, certain currencies rose.

However, not all currencies (or markets) are created equal.

The US Dollar Index (USDX) has been now bouncing back by more than 18% since the bottom posted at mid-July. This low level was identified as the second leg of a “double-bottom” pattern which is a strong basis for a rebound (see on the daily chart). This is what happened and now the Dollar Index has already retraced 23.6% of the long-term bearish trend started in July 2001 and ended then at mid-July 2008.

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This long-term bearish trend (between points A and B on the weekly chart) drove the Dollar Index roughly from 125 to 72 therefore a loss in value of more than 42%. On the medium-term, the target is likely to be the resistance line plot just below the 38.2% Fibonacci retracement. It’s a previous high level where a “double-top” occurred (points C and D) that generated the second phase of the bearish trend, between 2006 and July 2008.

On the short-term, let’s use a system based a on multi-dimension oscillator to anticipate the price action. We use the Chande Momentum Oscillator (CMO).

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The CMO can be used to measure several conditions.

Overbought/oversold: the primary method of interpreting the CMO is looking for extreme overbought and oversold conditions. As a general rule, overbought levels are quantified at +50 and the oversold levels at -50. At +50, up-day momentum is three times the down-day momentum. Likewise, at -50, down-day momentum is three times the up-day momentum. Basically, these levels correspond to the 70/30 levels on the RSI indicator.

Trendiness: the CMO can also be used to measure the degree to which a security is trending. The higher the CMO, the stronger the trend. Low values of the CMO show a security in a sideways trading range.

Divergence: as is often done with other momentum indicators, divergences occur when the indicator does not confirm new highs or new lows posted by the price action.

Other: although not specifically dedicated to patterns recognition, the CMO may be also used to identify chart formations, failure swings, and support/resistance levels.

If we establish overbought/oversold entry and exit rules by plotting a moving average trigger line on the CMO, therefore alerts are triggered when the CMO crosses its 9-period moving average after being in an overbought or oversold condition.

It’s a short-term basic system that typically well identifies inflexion points.

Seven separate assets currently maintain an 85% correlation (or better) with the S&P 500 over the last six months.

This correlated group includes Reuters/Jefferies CRB Index, emerging-market bond spreads, and not surprisingly, the euro. I’ve been talking about the tight correlation between currencies and stocks for some time.

My reason is simple: As risk ebbs and flows, the amount of traders buying U.S. dollars also ebbs and flows - only in an opposite direction.

So that means, when the S&P 500 tested new lows and bounced sharply, the U.S. dollar did the opposite - the dollar tested new highs and fell back sharply. We watched this happen this past week. Then on Thursday stocks collapsed again. Stocks tumbled to new lows not seen since 2003, and dragged down the euro right alongside. Of course, the U.S. dollar index broke out to a new high.

These tight correlations often are simply risk, ebbing and flowing. But maybe we should look deeper to understand the true driving forces behind recent trends. If you look closer, you can see why these correlations are more dollar-bullish than you might think.

What “Tight Coupling” Really Means

Over time, the market process can consistently produce extremely efficient interaction among human beings in the marketplace, in the business place and in life.

I try to make it sound simple. I try to boil it down to the big ideas. But really the entire process and all that goes into it is extremely complex.

I’m in the middle of a book by Richard Bookstaber titled Demon of Our Own Design. He’s devoted an entire chapter to an idea known as “tight coupling.”

That idea alone explains the correlations I just mentioned. Tight coupling also explains why the financial system crumbled, why the global economy is sinking, and why the U.S. dollar is back in vogue.

Tight coupling is the design and labor that goes into building a house. Tight coupling is how rock climbers scale a mountain-side. Tight coupling is an idea that helps to explain the detailed processes that go into complex, everyday functions. It also explains why disruptions of these detailed processes can happen.

Tight coupling exists throughout the financial markets that currency traders stress over nearly every single day.

A good example would be the recent subprime-mortgage backed securities fiasco. Before the entire credit system went boom, there were quite a few things strung tightly together. These things supported the trend of issuing subprime mortgages, bundling them up with other assets and selling them to investors.

But then home prices started falling. Suddenly borrowers couldn’t afford loans. Bundled loans became less attractive. The market for this newly created product froze up. Losses started piling up for investors in these bundled assets.

And then investors isolated from these assets began losing on their investments. This happened as the tightly coupled financial industry became unwound and asset values of good assets and bad began deteriorating together.

‘Propagate’ is a good word here - it means to cause to spread out and affect a greater number. Bookstaber used this word on occasion to explain how market participants add to the complexity of the financial system, and how that can lead to accidents which can trigger a vicious downward spiral of asset prices.

And that’s all well and good. Even if you’ve not yet grasped the idea of tight coupling yet, you understand what’s happened with the subprime market by now. You also know that relatively solid assets have been impacted once subprime derivative participants, and the market, were no longer able to handle the complexity of what they created.

Gold is bouncing back. According to the World Gold Council, which has released its last statistics recently, the demand has surged on the third quarter: from the jewellery industry first, but also from investors through certificates and ETF’s.

The physical demand has surged in Europe and in the US, but despite those flows prices remained between $700 and $800 an ounce on the market during the last month. After several months of correction and sharp countertrends, the last 4/5 weeks have been a consolidation phase.

Despite the turmoil on the finance sector and the banking crisis, the equity markets’ plunge and the growing global recession, gold prices did not soar as it could have been expected. Indeed, the deleveraging of the hedge funds that have been facing large redemptions has capped prices on the upside.

Last but not least, the US Dollar strengthening and the lower concerns about inflation (as commodity prices all fell sharply) have weighed on Gold prices.

Technically, the price action found some support just below $700 (point D on the chart), which is a previous low level tested several times in 2007 (points A, B and C). The main support level, around $635, has not been tested. This level is a previous high posted in late 2005 and that became a new low several times in 2006. On the downside, gold prices are therefore well supported by those two levels ($700 and $635).

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This morning Gold is trading around $820, which is more than 16% higher than 12 days ago. A further rebound is expected. On the upside, the main resistance is the line that goes through the lower highs posted since the historical peak of March 2008 (points E, F and G). The target for the price action is consequently just below $900.

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On the short-term chart, the indicators argue indeed for a further rebound. First, the Bollinger Bands are bullish as sharp price changes tend to occur after the bands tighten, as volatility lessens, which is the case here (the bands therefore volatility tightened in November during the consolidation phase). Second, when prices move outside the bands, a continuation of the trend is implied. This is also the case here.

The MACD has also triggered a positive signal two weeks ago, and its rise shows that some bullish momentum is building up.

In this scenario, the level of $890 may be the target and the first significant resistance on the medium-term.

The recent fall in the value of the Australian Dollar, while painful for Australians looking to travel overseas, has proven popular with many traders whose trading accounts are denominated in US Dollars.

From a traveller’s perspective, every cent that the Australian Dollar falls means less spending money in their pockets when they convert their Australian Dollars into US Dollars.

However, the sharp falls have eased the pain of those traders watching their US Dollar accounts erode in value with the strengthening Australian Dollar.

Imagine you were a trader who wanted to trade options on the US market. You open an account with a US Broker in 2002 and send over $A10,000 to fund your account. With an exchange rate of 0.5000, you now have $US5,000 in your account.

Now imagine you are a conservative trader and over those 6 years you managed to double your trading account. Your trading account is now $US10,000.

Now you decide to bring the money back to Australia. However, it’s 2008, and the exchange rate is now 0.9800 (98 cents). Suddenly, you need 98 US cents just to buy 1 Australian Dollar, whereas six years ago, you only needed 50 US cents.

Now your $US10,000 – which was double your initial investment - is only worth $A10,204. Nearly all of your gains have been wiped out by the exchange rate fluctuations. Can you see the importance of managing your currency risk?

Chart 1 below shows the weekly bar chart of the Australian Dollar (FXADUS in ProfitSource)

Chart 1

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As you can see, it is not just Currency Traders who are faced with the risks associated with changes in the exchange rate. Of course, had the trader waited until October to bring their US Dollars back to Australia, the exchange rate would have been much more favourable for them.

Anyone with any exposure to overseas currencies, whether through their trading, their travel plans, or business transactions needs to manage their currency risk.

So how can we go about it?

The simplest way to lock in the exchange rate today is to open an FX trading account. Let’s say we have some US Dollars sitting in a bank account in the United States.

If the Australian Dollar rises in value, the US Dollars will fall in value, meaning less Australian Dollars should we decide to bring the money to Australia. To lock in the current exchange rate, we can open an FX hedge by opening a currency position.

In any FX transaction, we are always buying one currency, and selling a second currency.

So in this case we would open a position that would buy Australian Dollars, and sell enough US Dollars to cover the money in our US bank account.

As long as there is enough money in your FX trading account to cover the margin on the trade, you will be able to leave this hedge open until you are ready to bring your US Dollars back to Australia. If Australian interest rates are higher than US interest rates, you can even be paid interest on your position, in what is called a “carry trade”.

If you have US Dollar exposure and you don’t check the exchange rates very often, it can be a good idea to hedge your position and lock in your exchange rate, to remove the possibilities of any nasty surprises.

There are other methods for locking in an exchange rate using Forward Exchange Contracts and options, however that is a subject for another article.

If history is our teacher, it tells us that the dollar does respond to any crisis for a few months or so typically after the economy hits another rough patch. However, afterwards, it reverts back to the trend at hand.

If it went into the crisis in a downtrend, then it goes back into it again. And if it went into the crisis in an uptrend, then it tends to revert back to that uptrend too.

If history is any indication, then it’s very possible the dollar will simply continue the downtrend it’s been in for the past six years: crisis or no crisis.

But due to additional factors - namely the dollar being at a 30-year low point at the beginning of this predicament - I don’t think it’s going to be a very clear downtrend. At least not in the short-term.

I see the dollar ‘ranging’ (Forex speak for going nowhere at all) over the next few years, much like it did after the S&L crisis, as you can see below.

Bank Failures Mean the Bumpy Ride Will Continue

This is what I believe may happen this time as well. However, on a year-over-year basis, it won’t feel like a wide range. It will feel like very strong, sharp uptrends. It’s only when you look back on this era over 10-15 years that you may see the dollar ranged for several years after - what shall we call it? Perhaps - “The Bailout Crisis of 2008.”

So as traders all around the globe watch their bottom lines bottom out and their hedge funds blow-up, I’m flat-out loving this market.

Why? I have a secret weapon that lets me profit when markets are sinking, while my stock trading buddies can barely stay afloat with their stocks.

What’s that secret weapon? The Japanese yen. You see, when volatility increases in the markets and stock traders lose their shirts, their loss is my gain. The Japanese yen experiences an uptrend when almost every other asset class (even commodities) is headed downhill.

At times like these, I can pair the yen with almost any currency in the foreign-exchange market and I’ll win. I know the yen thrives off of volatility, so one of my buddies’ strongest tools works even better for me during bear markets.

Stock traders all over the country look to the VIX (Volatility Index) to gauge when the stock market may bottom. They wait until the VIX rises to an extreme level and then they go in and buy. However, I watch the VIX heading higher and I know it’s giving my yen trades another boost.

Then when the VIX appears to peak, and these stock traders are just beginning to make some headway in their trades; all I have to do is reverse my yen trade and I’m still making a killing the whole time. If they only knew it was so easy…

Take a look at the VIX in the chart below, and the Japanese yen price right above it. When the VIX hits extreme levels (above 30 but especially around 35 or higher), the yen starts to peak. At that time, I just reverse my trade and start shorting the yen.

The VIX and the Yen…Traveling Buddies!

As a currency trader, you can buy or short the yen based on what you see using the VIX, their so-called “stock tool.” If you’re a stock trader and you understand the VIX, then you also understand the yen whether you know it or not.

As you can see above, the yen’s run may be almost over because the VIX is showing an extreme reading (i.e. it’s soaring higher). So it may be time to reverse your Japanese yen trades.

Secret Weapon #2: Collect Daily “Dividends” from the Currency Market

But there’s one secret that would REALLY push my stock buddies over the edge if they knew about it. It’s one I use in “up” markets, when stocks are also doing well

Most traders know the S&P 500 hasn’t gone anywhere for a number of years. However, once you take into account these companies’ dividends, then you could have an overall gain even while stocks stay flat.
However, these stocks only pay out dividends on a quarterly basis, while currencies pay out interest on a daily basis. Yes, you read that right…

It’s like getting a dividend daily.

So I have 365 opportunities a year to profit, while my stock buddies get four. If they only knew…

Secret Weapon #3: No Commissions, So There’s Less Fees in Currencies

The third advantage I have over stock traders is my stock buddies have to pay a spread AND a commission for each stock trade, while I ONLY have to pay the spread.

And I pay a smaller spread than they do because I control more currency with less money down and because the currency market has more volume which leads to tighter spreads.

So while my stock buddies are trading in this bear market, losing money on their positions AND paying commissions along the way, I’m earning profits now and paying less in fees.

Let’s say my stock trading buddies and I place the same number of trades each year. My stock buddies pay a measly US$7 per trade (even though many firms charge more). If we both made only 10 trades each month, we’d both have 120 trades over the course of a year.

Now remember that stock traders are charged twice on each trade (when they buy and when they sell). So over the course of the year, my buddies must pay 240 different commissions, costing US$7 each. That’s US$1,680 in commissions. That doesn’t even count how much they also pay in spreads.

What do I pay in commissions for completing those same 120 trades? Nothing! I only pay my much smaller spread all year long.

My stock buddies have to earn that much more in profits before they even break even. So obviously, the deck is stacked in my favor. If they only knew…

You now know my three secret weapons that give me an edge in the currency markets.

In the midst of all of this market turmoil, our old friend during risky markets - the Japanese yen - is still rising. You can pair this gem with almost any currency in the world right now - especially the British pound.

The Japanese yen has been beating out every single one of the top 16 or so currencies. So this is the biggest place that money is running to right now.

Why is this happening? It’s not that Japan’s economy is so strong. In fact, Japan may be entering into a recession as we speak. So what’s going on? In the past, as stock markets grew strong and volatility stayed out of the markets, investors around the world bought high-yielding currencies with borrowed money in the lowest yielding currency in the world, the Japanese yen (0.5%).

Many of these currencies reaped 6-8% a year. As an investor, all you had to do was pay between zero and one half of 1% if you borrowed yen. When you add a bit of leverage to these positions, you reap even greater returns just by borrowing low and reinvesting those funds. This strategy worked for years during calm, cool, and collected financial markets.

However, as we know…since about a year ago, the markets have taken a turn for the worse. We’re now in a high-risk, volatile market. That’s obviously not conducive to this type of currency investing called “carry trading.”

So as these positions are closed out (or as they say in the industry - unwound), they sell the higher yielding currency like Aussie or New Zealand dollars or like the euro or pound and have to pay back that loan of yen. When they do this, they are “buying back” yen which causes the yen to pop up.

It’s almost like a short-seller in stocks covering his short-sell by buying back the shares to close the position out.
Long story, short: As long as the turmoil lasts, the yen will prosper. Traders will continue to unwind positions as many are either margin-called or flat-out scared out of their positions.

The first secret to trading currencies is pretty simple: Follow the fundamentals.

How do you do that? First of all, pay attention to what central bankers are saying about their economies. This is important. They may not always give you all the facts, but you can usually get at least an idea of what they will do next from their statements.

Central bankers will give you their thoughts on their respective economies. And if they don’t tell you outright, you can tell by their actions. For example, when central bankers raise rates, it means they’re fighting inflation. That’s usually a good sign for the country’s currency. However, if inflation is shrinking or if the central bank is in “rate cut” mode, then it’s bad for the currency.

If the economy is growing (according to its GDP numbers), then that’s another plus for a country and its currency. On the other hand, a falling GDP either means a country is slowing or the economy is shrinking rather than expanding. Either way, that’s a bad thing for the currency.

So to find the perfect currency pair to trade, you need to play “matchmaker.” Match up the best-looking country with high inflation and rising interest rates to the ugliest country with the worst fundamentals (lower inflation and slashed interest rates). Once you have your “best-of” and “worst-of” currencies, simply trade the good country vs. the bad country.

For example, let’s say you decided the U.S. dollar was the “ugliest” currency in the world because the U.S. is slowing and the Fed just cut rates. You also decided that the euro was the best-looking currency. In this instance, you would buy the EUR/USD pair.

In that context we were discussing the misfortunes of the Australian dollar during the last two months. But the same can be said for the stock market as well. During the current earnings season there has been a bit of a mixed bag with some showing excellent revenue and profits (BHP and Rio) while others have been woeful (Babcock & Brown).

At the moment, the outlook for a broad rise in the stockmarket doesn’t look good. Ever since the market topped out last October the S&P/ASX200 has continued to drift downwards, punctuated by false rallies on the back of over optimism.

But there is light at the end of the tunnel. The problem is that we can’t quite work out how long the tunnel is. There are positives that should ensure that Australia emerges from any economic downturn without too much agony.

As a resources led economy there is often talk that any downturn in the US economy will reduce demand for goods there, which will reduce demand for imports to the US from China which will reduce demand from China for Australia’s resources. Of course, this will have an impact but probably not to the degree that is feared.

Thanks to the massive demand for raw materials companies such as BHP Billiton, Rio Tinto and Fortescue Metals have been able to charge big premiums for their commodities. Any downturn in the US and Europe is bound to have some impact, however there is still ample room for Asian economies to grow without the need to rely on the US and Europe. Demand for Asian domestic consumption will be the next growth area as incomes rise and the standard of living rises with it.

Another insulator for Australia is the concentration of business in a small number of large companies. Many Australian sectors are in effect presided over by duopolies where the lack of major competition has allowed them to maintain healthy profit margins. The relevant smallness of the Australian economy makes it that much harder for new entrants on a large scale.

This allows them to maintain some of their margins without the fear of being undercut by competitors. And when competitors do come into the market they have to work fast in order to build up market share. A tough ask when consumers are comfortable the same brand they have used for years.

So what does that mean as investors? It really means that with the market having fallen so far since last year, the opportunities for value in this market are starting to present themselves so now is the time that investors should be starting to get back into the markets. Unfortunately, history tells us that for most retail investors they tend to exit the market just at the time when they should be getting back in.

As you may have heard, a foreign-currency CD is one of the simplest ways to buy foreign currencies.

You’re not really trading one currency for another like in the foreign-exchange market. Nor are you investing with leverage like a currency option.

Instead, you’re buying and holding a foreign currency - just as if you were holding an average dollar-based CD.

Really, it’s a simple four-step process:

1. Decide to invest in a certain currency
2. Call your bank
3. Apply for the CD in a particular currency
4. Forget about your CD until it’s time to report your holdings on your taxes each year.

In fact, it’s so similar to your average dollar CD that it’s easy to forget the extra benefits you’re receiving by investing in a foreign currency CD.

So we thought we’d review these benefits quickly.

Benefit #1: You can actually beat inflation with a foreign-currency CD. Right now, you’re average dollar-based CD only pays 2 - 4%. If inflation is soaring above 6%, then you’re actually LOSING money over the long haul. But with a foreign currency CD, you can choose a stronger currency that has the power to appreciate faster than inflation.

Benefit #2: Two ways to profit. A foreign-currency CD earns interest similar to a normal dollar-based CD, but you also get an extra profit bonus if your foreign-currency appreciates in value vs. the U.S. dollar. In this way, your foreign-currency CD actually gives you two ways to profit.

Benefit #3: Instant diversification. If your entire portfolio is in dollars, then a simple foreign-currency CD gives you instant diversification to other stronger currencies around the globe. It’s one of the best ways to inch into the currency markets, if you’re not interested in trading.

The US Dollar ended the week with a sharp rally that confirmed the recent breakout and the base building that began following the March 2008 low of 70.70, analysis at the time suggested that the Dollar was heavily oversold and projected a target towards $78, which is now in reach following the USD Index close of 77.15 on Friday.

Last weeks continuing rally is taking the US Dollar into a short-term overbought state, especially as it nears resistance at 78, on break of which the US Dollar will target a move towards significant resistance at 80, following which the Dollar is expected to consolidate, with the previous resistance levels turning into support levels i.e. Major support at 74.30 and 78, before the next leg up through resistance above 80 takes place towards a longer-term target for the dollar of 90.

Whether or not the Dollar has seen its final low that brings to an end the 7 year long bear market, what the recent price action does signal is that the US Dollar is now in a bull market that looks set to run for at least a year, by which time the longer term trend will become more apparent, in that respect the bullish dollar trend is expected to continue into at least early 2009, which confirms analysis as early as of March 2008 that concluded that the commodities markets would enter into a bear market during the summer of 2008 that would last for at least 1 year and possibly as long as 2 years.

On August the 8th, Russia declared war on Georgia. By the 9th, it was an all-out bloodbath. Reports show that over 2,000 people have died during that short time and over 100,000 people fled the conflict.

As you can see, war is never pretty.

This week, Russian President Dmitry Medvedev and Georgian President Mikheil Saakashvili are already planning to sign a peace plan. But still the damage has already been done – particularly to the Russian ruble.

Honestly, what happened to the ruble this week is pretty common during wartimes. So this begs the question: How does a war affect a currency?

Well, as I often say: Money hates instability. There is nothing more unstable and unpredictable than a war where anything can happen. You also never know how long one will last, who will win, and what will be lost along the way.

As an investor, you’re left to suspect the worst. That’s why most investors grab their money and run to safer, more stable countries until the coast is clear.

Russia Declares War and
the Ruble Sinks 4% in 5 Days

To this day, Russia still has a bad reputation for decades of shady dealings. As such, investors never seem to fully trust the Russian markets. If a conflict breaks out, investors rush in and grab their cash even faster than they would another country.

And that’s exactly what happened when Russia declared war on Georgia.

Check out the chart of the U.S. dollar vs. the Russian ruble below. You’ll notice the ruble tanked over 4% in just 5 days after war broke out.

With Leverage, You Can Turn that 4% move into 400% Profits

Now that may not seem like much to you. But you have to remember that small movements in currencies add up to a lot in trading accounts.

Spot Forex accounts are commonly leveraged 100 to 1 or even 200 to 1. So a 4% move can be magnified to equal a 400% to 800% move in just 5 days.

If you bet against the ruble just as the Russians declared war, then you would be sitting on some healthy profits right now. However, if you bought the ruble formerly because it has done well in this “energy/commodity” boom, then you probably watched your account sink into the negative territory over the last few days.

Most trading accounts can’t take 400% to 800% losses on their positions over a five-day period and survive.

So ruble traders really had a wild ride since this began.

Is the War Over Yet?

Let’s suppose for a moment that the war truly is over and things somewhat revert back to normal (a Russian normal anyway). If that happens, then Forex traders will probably see it as a buying opportunity and grab the ruble once again at bargain prices.

However, if the conflict isn’t truly over, or if another one erupts, then you will see the rollercoaster ride begin again.

It takes a strong stomach to invest in the ruble right now. Much of the time it has been a very profitable “one way bet” against the buck since 2003. However, in times like these, you never know what the Russians are going to do.

On the other side of the coin, if you’re pulling money out of Russia, you’d better hide behind another BIG country. So many traders ran to the U.S. dollar since it’s the “Big Brother” that might be able to protect them and their money.

However, other traders chose to run to the “risk adverse” currencies of the Japanese yen and the Swiss franc. Both of these currencies have torn a chunk out of most currencies over these same five days with the exception of the U.S. dollar.

Right now, the buck can’t seem to do anything wrong and is rallying against any currency I have on my screen.

So war really “stirs the pot” because it not only causes money to run away from the country at war but also it has to find a hiding place. That hiding place won’t be the same for every investor. It may be two or three of the other biggest currencies in the market.

Bottom line: Money tends to run for cover at the first sign of conflict and tiptoes back in later after the conflict ends. Something to keep in mind the next time a war breaks out…

Dollar Rally Won’t Last Forever

Fundamentally, there is nothing to support a long-term U.S. dollar rally. 

Unlike 1995 when the dollar established a secular bear market low against major currencies, this uptrend will inevitably run out of gas.

Bear market rallies appear quite convincing and can muster significant strength over a short period of time. But this one simply has no long-term muscle.

Let me explain. In the late 1990s, the United States posted consecutive budget surpluses, enjoyed massive foreign direct inflows and low consumer prices in an environment of accelerated disinflation. No major military conflicts occurred and oil prices crashed to US$10 a barrel by late 1998 amid the Asian economic crisis and the collapse of hedge fund Long Term Capital Management.

Today’s U.S. and global macroeconomic scenario is nothing like it was 13 years ago.

Soaring deficits, two major military conflicts, a distressed consumer, rising unemployment and a bear market in housing won’t lend support to a secular dollar rally. In fact, Bill Gross, PIMCO’s bond king, predicts lower interest rates in the United States over the next several months as deflationary pressures continue to drain economic growth. Lower rates won’t support the dollar.

Remember the Credit Crunch?

The Fed is in no condition to raise borrowing costs despite high inflation. The ongoing credit crunch has not abated with overnight borrowing costs still elevated and mortgage-backed securities still clogged.

Over the last 30 days the stock market is up almost 8% but most credit indices remain at the same level or lower ever since Treasury Secretary Paulson guaranteed Fannie Mae and Freddie Mac wouldn’t fail.

That tells me credit markets are still far from stable as the economy remains fractured across key industries like housing, retail, autos, and airlines.

Program Trading

One subject that has received widespread publicity in recent years is program trading. Perhaps, never in the history of financial markets has there been more criticism about a trading approach that was less understood. I would venture a guess that less than one out of ten people opposed to program trading even know the definition of the term. One source of confusion is that program trading is used interchangeably to describe both the original activity and as a more general term encompassing various computer-supported trading strategies. (for example, portfolio insurance).

Program trading represents a classic abitrage activity in which one market is bought against an equal short sale in a closely related market in order to realise small, near risk-free profits, resulting from short-lived distortions in the price relationship between such markets.

Program traders buy or sell an actual basket of stocks against an equal dollar value position in stock index futures when they perceive the actual stocks to be underpriced or overpriced relative to futures. In effect, program trading tends to keep actual stock and stock index futures prices in line.

Insofar as every program-related sale of actual stocks is offset by a purchase at another time and most program trades are first initiated as long stock/short futures positions, arguments that program trading is responsible for stock market declines are highly tenuous.

Moreover, since the bulk of economic evidence indicates that arbitrage between related markets tends to reduce volatility, the relationship between increased volatility and program trading is questionable at best.

Portfolio Insurance

Portfolio insurance refers to the systematic sale of stock index futures as the value of a a stock portfolio declines in order to reduce risk exposure. Once reduced, the net long exposure is increased back towards a full position as the representation stock index price increases.

The theory underlying portfolio insurance presumes that market pries move smoothly. When prices witness an abrupt, huge move, the results of the strategy may differ substantially from the theory. This occurred on October 19, 1987, United States of America, when prices gapped beyond threshold portfolio insurance sell levels, triggering an avalanche of sell orders which were executed far below the theoretical levels.

Although portfolio insurance may have accelerated the decline on October 19, it could be reasonably be argued that the underlying forces would have resulted in a similar price decline over a greater span of days, in the absence of portfolio insurance. This is a question that can never be answered. (It is doubtful that program trading, as defined above, played much of a role in the crash of the week of October 19, since the severely delayed openings of individual stocks, tremendous confusion related to prevailing price levels, and exchange restrictions regarding the use of the automated order entry systems severely impeded this activity.)