Tactical look at EM and the USD.

Please read the Disclaimer before reading this article.

Last week, I explained my bullish long-term thesis on Emerging Markets.

This week, I want to have a look at the short term price action we are seeing.

To start off, we saw a weekly breakout in emerging markets this week, just as I was expecting.

My expectation is that the price will now go significantly higher in the short term.

When the Russell 2000 broke out in November last year, it increased almost 25% in 3 months’ time. If the Russell 2000 can do this after a breakout from a 2-year base, then I think Emerging Markets can do the same when they break out from a 10-year base.

I can understand that for a lot of people it’s probably scary to buy something at it’s highest price ever.

But take a look at the following chart from Nick Maggiulli.

The chart shows the evolution of the Emerging Markets stock index since the late 1980’s. Each new all-time high is given a red dot. You see what follows a red dot? Another red dot, and then another, and another,…

The fact is that once a market breaks out, overhead supply is gone and there is a lot of room for prices to go higher as the following chart shows beautifully.

Source: ofdollarsanddata.com, Should you buy an all-time high?

According toNick Maggiulli, the average performance over the next year when you buy EEM within 5% of an all-time high is 16,8%. When you buy it at a point when it’s more than 5% away from it’s all-time high, the average return for the next year is only 8,4%.

So, let’s go all-in, right?

Not so fast. One thing I don’t like about the current set-up is the extremely positive sentiment we are seeing in markets in general. The following chart shows the NAAIM US equity exposure. It indicates how bullish or bearish active investment managers are for the moment. As you can see, they have never been more bullish.

Source: Dana Lyons, lyonssharepro.com

The next chart from MacroCharts shows the daily sentiment index for the S&P500. As you can see, sentiment is extremely bullish and historically this hasn’t been good for the market.

Source: @MacroCharts

If you look at equity flows and option activity for Emerging Markets, you’ll see the same extreme sentiment readings.

So, what should we do?

First thing to note is that sentiment indicators are much better in capturing a bottom in the market than a top.

We should also note (and this is extremely important) that we are seeing broad participation in markets across the world:

-The Dow Jones Transportation Average has reached new all-time highs. (It was flat since the beginning of 2018.)

-The Nikkei 225 is breaking out of a 30 year base. (Yes, it has basically done nothing for 30 years.)

-The Russell 2000 has broken above all-time highs. (See earlier chart, it was flat since the summer of 2018.)

-The FAANG stocks, which have been basically flat since early September last year, are starting to break out again.

This is all indicative of broad market participation. Stock markets worldwide are all giving the same signal: you should own stocks.

This is in stark contrast to the middle of 2018 (when a 20% decline followed) and early 2020 (when we saw the covid crash and markets lost 30%) when we were seeing a lot of divergences between all of these markets.

Another point I want to discuss is the dollar. The dollar peaked in the middle of March last year and has been declining strongly since then.

We are currently seeing a countertrend bounce in the USD as shown on the following chart.

Notice the positive divergence between the USD and its RSI that formed when the bottom was developing. It was the exact same pattern as we saw in August last year. (Price keeps declining but the RSI doesn’t confirm it. Once the RSI doesn’t get oversold anymore, that’s the bottom.)

Also notice how in late September last year the RSI of the USD failed to get overbought? This was to be expected when the USD is in a bear market. The countertrend rally in the USD in August-September last year took place in 3 phases as indicated by the orange line below the USD price.

My expectation is that we will see the same thing happening this time. This final (relatively small) leg higher in the USD will hopefully put some pressure on risk assets. If the RSI of the USD can get to the top of it’s range (without getting overbought!) and we see a correction in risk assets, that will be the time to go all-in.

The following chart shows my trading plan:

Please note that this is conditional on the price action I see in the USD. If the USD bounces and its RSI manages to get overbought, this would indicate that something more is potentially in store for the USD. I’m not expecting that but we should always prepare for each outcome.

This trade has a profit potential of 20% in a rather short time with a risk of 4% (If you buy it at the upper red circle and put a stop at the lower red circle.). That seems pretty good to me.

Why am I rather confident that the USD will continue its trend lower after this bounce?

Isn't it possible that we see a new big move up just like in early 2018?

The reason I’m not expecting a big new upmove is because the fundamental picture is now completely different. I wrote about this in my previous article (see here) and also in an article a few months ago where I explained the rise in the USD in 2018 (see here).

If you look at the following chart, which shows the Chinese credit impulse, you can see that it’s a leading indicator for the EURUSD (and thus also for the USD). In 2018, it was clear that surprises in the USD were to the upside. Now, surprises should be expected to come to the downside.

Source: Nordea, Andreas Steno Larsen & Martin Enlund, FX weekly: The year of the Ox

In a bull market, surprises come to the upside. For this reason, I’ll ignore the short term sentiment and positioning risks I’m seeing. With all markets breaking out worldwide, it’s difficult to be bearish bigger picture (Remember that in the middle of 2018 and early 2020, we were seeing divergences between these markets, they were warning you of risks to come. This time, they are all agreeing.).

I’m hoping that a USD bounce can put some pressure on risk assets, thereby giving me a good entry point to go all-in.

If not, I’ll buy once we break out above the former daily high as indicated on the previous chart.

In all circumstances, I’ll sell when the price action tells me I’m wrong. (Note that this only works when your timing is good. If you just buy at a random point, there are no clear points where you can say that your thesis is incorrect, you are just guessing. In this instance, it’s rather clear when my thesis will be proven wrong. As Peter Brandt puts it: “Charts will give you the idea of the path of least resistance, but charts do not forecast. There is a danger when people start thinking of charts in terms of forecasting. Charts are wonderful in finding specific spots for asymmetric risk/reward trades.”)

Good risk management will help me to protect my capital when I’m wrong. It’s one of the easiest concepts to read about, but one of the most difficult to execute, as legendary trader Mark Minervini states: "The goal with stock trading is to make money consistently

by taking trades that have more reward potential than risk. The problem for

most investors, however, is that they focus too much on the reward side and not enough on the risk side. Simple as this sounds, few will follow the advice I’m about to impart to you.

…

Over time I have learned that investors don’t lose money or fail to achieve superperformance because of bear markets or economic hazards but because of mental hazards, the types of personal failings that cause you to say to yourself in retrospect, why didn’t I sell that stock when I was only down 10 percent?"

Thank you very much for reading my article.

You can follow me on twitter: @adaptiveinvest