When the chorus of investment commentary gets so strong in one direction, I start to question the collective wisdom of the market. I’m a believer in general market efficiency, that most news is recognized in prices.
But occasionally, herd mentality sets in and the market outlook clearly needs to be reevaluated. It’s in this ability to step back and question the herd’s stampede in one direction that investors can find huge opportunities.
It was obvious when pundits argued that valuations didn’t matter during the tech bubble.
It was obvious in 2007 when subprime defaults exploded and mortgage lenders started going bankrupt, even as analysts still predicted higher prices.
That same collective wisdom is starting to skew to one side again, despite strong evidence to the contrary.
Traders and analysts alike are nearly unanimous in a trend that could unravel and become one of the biggest surprises of 2017.
The Market’s Love Affair With The U.S. Dollar
The greenback made a run at fresh highs in late 2016 and closed the year out strong on the prospect for faster U.S. economic growth and rate hikes. Net long positions by traders in the U.S. dollar reached $25.4 billion on January 3 and have been rising since early 2016.
The USD has bucked the long-term trend lower since mid-2014, with the dollar index against a basket of currencies rising more than 25% over the 18 months through 2016. The near-certainty of higher rates and hope for economic growth is driving most of the market to one side of the trade. Three of Goldman Sachs’ six trade themes for 2017 revolve around a stronger dollar this year.
That one-sided bet may make a weaker dollar the best contrarian trade of the year. Uncertainty over U.S. policies and isolationism are already causing the greenback to weaken. The dollar index has come down 3.2% since its high on January 2 and long dollar positions have started to come down over the last two weeks.
Even if the President is able to push through policies to spur economic growth, uncertainty over foreign policy may cause foreign investors and governments to shy away from holding dollars and dollar-denominated investment in Treasury securities. Faster economic growth will also bring inflation, which weakens the dollar unless inflation heats up abroad as well.
The new President himself has a very strong incentive to see a weaker dollar to boost U.S. export competitiveness overseas. A weaker dollar would drive inflation higher and devalue the fixed debt owed by the government as well.
Trump told The Wall Street Journal before the inauguration that the strong dollar is, “killing us,” referring to U.S. export competition overseas. The President’s Treasury nominee, Steve Mnuchin, has also warned of the excessively strong dollar in his senate confirmation testimony.
How To Zig When Everyone Else Is Zagging On The Dollar Trade
The lop-sided nature of the dollar bet is making a contrarian play a good bet for investors. The rush to unravel long positions on the dollar in early 2016 exacerbated a weakening greenback for a 5.7% loss through April.
Central banks in Europe and Japan are still stimulating their economies with monetary easing and haven’t seen inflation expectations rise much. Any growth abroad or reluctance to hold U.S. assets could cause the dollar to drop quickly. The USD index fell 40% over the seven years to June 2008 as strong global growth and rising asset prices drew money away internationally.
The most direct play against the dollar might be buying put options on the PowerShares DB U.S. Dollar Bullish ETF (NYSE: UUP), currently trading at $25.75 per share. Put options expiring in January 2018 for a strike of $26 cost just $0.91 per share. The put gives investors the option to sell the UUP for $26 at expiration next year.
If the dollar weakens and the ETF trades down to its 2016 low of $23.96 then the puts would be worth at least $2.04 each for a 124% gain. Option investors can sell their position at any time to take advantage of near-term gains.
The iShares MSCI Mexico Capped ETF (NYSE: EWW) has dropped 38% since its high in 2014, including an 18% plunge the week of the U.S. election. Lower oil prices and uncertainty around U.S.-Mexican relations have meant trouble for the country. The fund holds 62 companies for a diversified investment in the country’s rebound and pays a 1.8% dividend yield.
A weaker dollar would help support oil prices which would improve the country’s fiscal situation. The economy is already set to benefit on strong growth in the United States and progress on trade negotiations could remove some uncertainty, giving investors confidence to move back into Mexican assets.
One look at a chart of the dollar and energy prices shows a clearly negative relationship, with the price of a barrel of West Texas Intermediate falling on dollar strength. The United States Oil Fund (NYSE: USO) has had a correlation of -18.5 with the US Dollar fund over the last five years. Planned production cuts from OPEC and Russia, along with a weaker dollar, may help send shares of the USO significantly higher this year.
Risks To Consider: The tug-of-war between the monetary and fiscal policy, and other economic factors, makes any dollar direction difficult to predict.
Action To Take: Too many investors are piling into the dollar bet against factors that could push the greenback lower this year. Position in one of these ETFs to take advantage of one of the best contrarian plays of 2017.
— Joseph Hogue
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Source: Street Authority