The Way Of The Dollar Part 2

4) In this event, interest rates will peak when the currency troughs; and falling interest rates will coincide with a rising currency. Why? Because by this time everyone is expecting interest rates to fall tomorrow and they stay up longer than expected a"i.e. rate cuts tend to lag expectations in these circ.u.mstances (e.g. Pound, Can $ and Aus $ in 1990-91). In other words, interest rates are higher than expected and this supports the currency.

5) When currencies are led by interest rates, their movement is directly related to the unexpectedness of interest rate levels, rather than to their rate of change (e.g. $ in 1983-4, pound and SF in 1990).

Rule 4) is an exception to rule 1) and there are others. For example falling interest yields call for rising bond prices. The result, in the case of the major investment currencies, can be a tug-of-war, when falling interest rates might discourage international investors but rising bond prices attract them a"as they did in the case of the dollar in summer 1984 to spring 1985.Finally rules) is a cardinal rule. It is often the acid test of whether any given interest rate will lead a currency: it only does so when unexpected or unseen. When observers are ignoring an important s.h.i.+ft in interest rates for any reason a"because they expected it to be short-lived or because they are preoccupied with other things a"you can bet it will only be a matter of time before the currency is led inexorably in the direction of the interest rate s.h.i.+ft. What matters, as I say, is the background, not the foreground a"because the foreground is where everyone is looking. What matters in financial markets a"and in life? a"is not what you see straight ahead but what you glimpse out of the corner of your eye.

Inflation and Real Yieldsa*

There is another exception to rule 1). If US interest rates are being pushed up because of a perception that US inflation is headed up, or if they fall because inflation is seen to be falling, you have another tug 0' war,between the short time-frame and the longer time-frame. To short-termers, higher rates may seem to support a currency: but over time, inflation corrupts a currency. So a movement in interest rates that is led by inflation is suspect: areala interest rates may be unaffected, or even moving in the opposite direction.

This idea of real, inflation-adjusted interest rates may sometimes seem a bit academic. And indeed itas a hybrid invention, for its two const.i.tuents occupy different time-frames. Interest rates can fluctuate violently over the short term: inflation can have big swings measured in years. But inflation is the one and only sufficient modulator of a currencyas value over time a"any currency. Given sufficient time and/or a sufficient divergence in inflation rates, currencies do and probably must tend inexorably to follow inflation differentials in due course. We can see it happen before our eyes with the hyper-inflationary currencies: for the reserve* currencies, with their smaller inflation differentials, itas a bit like watching plants grow.

Just as we can adjust interest for inflation to get at something closer to the areala picture, so we can do the same thing for currencies. Itas another academic exercise. And itas very difficult to see how we can use areala inflation-adjusted currency histories for any practical purpose. But it may at times be helpful for perspective. Itas difficult, for example, to look at these charts of the areala dollar without leaping to the conclusion that the big bull market in the dollar in 1981-5 was a strange aberration in the long-term picture. In this light, the slump in the dollar from 1985 to 1987 is seen merely as a return to normal.

Although areala yields are a hybrid, the const.i.tuents are, as it were, incestuously related. For inflation expectations are a major determinant of interest rates over time; in fact they area key determinant of long term yields all the time. Hence, the declining trend in US inflation provided as good (or better) an account of the bull market in the dollar in 1981-5 as real long-term yields.

In short, yield differentials and inflation differentials seem to be basic fundamentals of currency a.n.a.lysis.

As we know, the thing that makes prices move is change. And itas axiomatic with all financial instruments that the change in question is change in expected total return. In the case of commodities, expected total return is confined to price; and the value benchmarks are usually concerned with supply and demand. In the case of bonds, total return to maturity is interest coupons plus (or minus) the difference between price and redemption value a" usually apara*: if you expect to sell before maturity, redemption value is unknown; either way, the value benchmarks are yield and the degree of certainty that interest and princ.i.p.al will be duly paid. Stocks fall in between: most investors nowadays focus on price, with dividend returns counting for little: still the main value benchmark is usually earning power, or the ability to payout dividends in the future.

In currencies, changes in real yield differentials are a basic value bencmark.

And I think this has been true ever since currencies began to float freely in 1973. Admittedly the professionals didnat quite see it that way in the old days. But while weare at it, we might as well blow their secret. The professionals made a bundle of money in the 1970s, and the way they made it was very simple. They only had two rules. One has been valid as far back as the memories of currency traders went: asell the crisis. aWhen a currency got into trouble, all you needed to do was wait until the central bank came in to support it and then sell for all you were worth. It always worked: for sterling, the lira, French franc, whatever. The other rule, when the dollar went off the gold standard, was even simpler: asell the dollara.

Always, but especially if the central banks supported it. Following these two rules, the professional! cleaned up and the central banks lost a bundle.

In the 1980s, the roles were reversed and it was the central banks that cleaned up, with much loss of s.h.i.+rts among the professionals. Part of the trouble was that traders were introducing all sorts of complications into the currency equation to do with intrinsic values, and trade compet.i.tiveness; and they were obsessed with forecasting interest rates.

We know that expected total return has to be the ultimate value bench. mark for the currencies. If we know how to judge the set-up conditions tha1 precede significant moves in the dollar, and how to evaluate the back. ground of s.h.i.+fts in real yield differentials, we shall usually be able to spot the underlying trend in the dollar .

CHAPTER FIVE.

The key equation for turning points in currencies, as in all financial markets, is: extreme consensus + extreme speculation = extreme price.

During the 1980s, currency observers discovered that the currency markets resembled other markets much more closely than they had imagined. They were ruled by hope and fear. They trended more or less like other markets, and got overbought* or oversold*, just like other markets. The similarities are so great, in fact, that itas easy to err on the side of forgetting the dissimilarities. Here are some dissimilarities.

1) The main market for the currencies is made by the worldas banks a"the so-called inter-bank market* . It has no statistics. The princ.i.p.al vehicle for quotations is the video screen. It operates 24 hours a day.

2) The currencies are a pure zero-sum-game* , the only one in fact. It means nothing to say a currency has risen except that another has fallen.

3) The forex* markets are the only financial markets in which there is official intervention* a" by central banks. No wonder: for every country but America, a rise or fall in the currency raises or lowers dollar GNP in proportion.

These differences have various implications. 1) For statistics we have to go to Chicagoas IMM, the main futures market. Although it only turns over some $10bn per day, as against a purported $6OObn+ in the interbank markets, the IMM accounts for a significant fraction of all non-bank activity, especially speculative activity. This is important, since most bank activity is merely a clearing function, i.e. just froth.

In a pure zero-sum game 2), there is no such thing as a crash. Taken as a whole, the players are never wiped out a"in fact their wealth stays the same all the time. You win or lose only by playing better or worse.

Finally 3), intervention. Though those central banks are high rollers, they are swamped by the ma.s.sed ranks of traders. Also there is a strange phenomenon with intervention. After the initial shock of the first round of an intervention phase, traders a"especially big operators on bank dealing desks and multi-national treasury departments a"seem to love ataking ona the central banks. This means the struggle is more even than you might think, at least in the early stages of a prolonged intervention. On the basis of experience to date, I believe the following rules will payoff .

1) Most intervention is against the trend. It is best to ignore it completely at the outset (and stay with the trend).

2) In due course sustained intervention will absorb all the opposition, including a lot of speculative opposition. This will show up in various sentiment gauges (see below).

3) At this point the trend will be on the turn. And the imperative rule for intervention in the same direction as the trend is to go with it at all times.

That lot boils down to a very simple formula. Ignore all intervention unless/ until itas in the direction of the trend, in which case go with it.

The Tao of Markets

The key to trading financial markets successfully is to be on the right side of the abig movesa, which are often measured in years. Thatas easily said, but to do that we have to be able to locate the start of the big move and also its end. In the currency markets, as with all financial markets, the extremes of the big moves are invariably attended by certain psychological characteristics, reflecting degrees of hope and fear among the players.

But the big moves a"or underlying trends a"are composed of smaller multi-week or multi-month moves. And the extremes of these moves too are marked by the same psychological characteristics or behaviour patterns. So there may be no way of knowing whether a turning point marks a change in the major underlying trend or just a correction which leaves the main trend intact. Moreover, these minor moves are usually made up of smaller multi-week or multi-day moves with similar attributes. And you can go on. Within a single day, you find the same pattern of alternating fluctuation between bullishness* and bearishness* measures in hours and minutes and even seconds.

The mathematician Benoit Mandelbrot coined the word afractala* for this phenomenon of patterns that contain similar patterns within them, somea" times ad infinitum. It has also been called a scalinga , because of the way such patterns recur on different scales, up and down the dimension spectrum. The fractal phenomenon seems to lie at the very heart of nature a"within the genetic process itself a"though one of the first places Mandelbrot saw it was in series of soybean prices.

In all markets, price extremes are usually attended by a consensus that the trend, be it up or down, will continue; and by a peak of speculation in line with the trend. Hence the excruciating paradox of financial markets, that sentiment is most bullish at the peaks when prices have only one way to go which is down; and most bearish at troughs vice versa: at the top thereas noa" one left to buy, and at the bottom n0-0ne left to sell. This paradox is absolutely central to the working of all financial markets and we need all the help we can get to understand it so thoroughly that it becomes part of our nature. The more bullish things are, the more bearish they are. Bullishness is born as hope in the midst of despair. Hope swells to confidence and confidence swells to euphoria, and the process contains the seed of its own destruction and the birth of its opposite, fear. Fear is nurtured by falling prices and the two feed on themselves until they swell to despair. And so the cycle is completed a"and ready to begin again with the birth of hope. This is both the way things are and the way they have to be. We havenat understood the process until we have grasped that. The despair creates the price trough: the price trough creates the despair. The price extreme is the definition of the extreme of despair, which is in turn, by definition the moment when hope comes to prevail; hope feeds and is fed by rising prices until the peak of price and euphoria leave prices with only one way to go, which is down. This circular process underlies every price fluctuation in free markets from the smallest one measured in seconds or minutes to the largest measured in years or decades. So it has always been and so it will always be, because it must be. The ancient Chinese symbol called Taai-chi Tau or asymbol of the ultimate realitya, more commonly know as the yin yang symbol, is delightfully appropriate to the way markets are a" and uncannily appropriate to the way currency markets are. It is up to each of us to see anything in it we find helpful. This exquisite symbol of the Tao* works at many different levels, in many dimensions. You choose your own levels and dimensions. We can see the light and the shade as representing opposites like bullishness and bearishness, hope and fear, sympathy and antipathy, consensus and dissension, speculation and prudence, euphoria and despair, illumination and benightedness, yin * and yang*. We can see the thin and thick ends of each tadpole as representing the beginning and end of something; the wax and wane; the birth and death. The light is born out of the pitch of the dark, and the dark out of the fullness of the light: the small circles within each half represent the seed of the other half. The whole is a circle, with no time scale. It can be accomplished in seconds or in years. It goes on and on, round and round, scaling. This is precisely the way of markets and market sentiment. It is the Tao* of markets. Any time you should find yourself a.s.sailed by extreme confidence or despair, remember the Taai-chi Tau symbol. Or take a look at CBas logo, in which the dollar sign becomes the interface between the light and dark. In securities and commodity markets, you have a cycle of bullishness and bearishness as prices rise and fall; and speculation (and activity) is notably greater at price peaks than at troughs. But in the currency markets, thereas no difference between peaks and troughs. A peak in the dollar is a trough for the pound, DM or whatever, and vice versa. Hope for the dollar equals fear for the other currencies. They are two aspects of the same thing a" just as the yin and the yang are two aspects of the same thing (see Glossary). So, as one would expect, speculation in the currencies tends to be similarly extreme at both peaks and troughs in the dollar.

This is something we have to remember when it comes to a.n.a.lysing the way of the dollar. Price cycles in the dollar, as the symbol may help us see, can be ana lysed exclusively in terms of the ebb and flow of sentiment among partic.i.p.ants. But we need a system to help us gauge where we are in the cycle of hope and fear. And this system must of course draw on the data that are available for the currencies, CB has cla.s.sified four gauges of sentiment. They overlap so some degree; they are arbitrary; and there is no pretence that they are exhaustive, let alone perfect. But they have served well and stood the test of several years and several multi-year cycles.

The four Sentiment Gauges

The recurrence of certain behaviour patterns at price extremes is most fortunate. We know from long experience of the financial markets what these behaviour patterns are like. So if we can gauge them, we can in theory perform a continuous diagnosis of the market, by locating its fluctuations all the way up the time scale from days through weeks and months to years. In practice we are limited by the availability of hard data: for instance some data exist on a daily basis, some only weekly, but most only irregularly.

Currency Bulletin uses four gauges of sentiment, which are designed to help identify these price extremes which are also extremes of consensus and speculation. They are: 1) IMM* open interest 2) The consensus 3) Perception of the trend 4) Reaction to news.

Two of the 4 sentiment gauges a" the consensus gauge and the open interest gauge a" are supposed to locate extremes in consensus and speculation, hence peaks and troughs in the dollar. They are used in a contrarian manner. They are early warning indicators which tell us to cut back exposures or eliminate them. The other two a" reaction to news and perception of trend a" aim to tell us when the correction or reversal has started, i.e. the moment when it is appropriate to open positions in the opposite direction.

Open Interest

Speculation and activity can be measured statistically in the IMM. For sure, the IMM accounts for a very small fraction of activity in the worldas forex* markets. Yet, as explained, it is significant out of all proportion to its relative size, because it is a distillate of speculative activity around the globe; and it excludes the afrotha of the interbank clearing process. The open interest* is effectively speculative interest. The IMM open interest is simply the number of contracts open at the end of the day on the Chicago exchange. The theoretical problem with this is that for every buyer there is a seller. This apparent problem disappears if you consider that the trader who wishes to trade is never refused. For every deal there is an initiator, and the counter party always shows up.

Traders, as noted, can be divided into two categories: a) those who buy on a price rise and sell on a fall (aprice-leda* traders), and b) those who sell a rise and buy a fall (avalue-leda* traders). And in fact, the party we are looking for a"the party whose action marks and indeed causes the extremes of a price trend a"is not just the speculator, but the aprice-leda speculator who buys the rise and sells the fall. They are the initiators of positions opened in the direction of the trend. We have our price extreme when the number of these parties peaks.

In real life, we find that the IMM open interest (01) tends to move faithfully in line with the perceived trend a"as you can see from the charts here. It increases as the price trend progresses, and contracts whenever the trend is checked or corrected.

In the 01 figures, we are looking for an open interest rising in line with the trend to tell us when we have an increasingly overextended position. What happens when speculators think a trend has reversed? At that point the 01, which has been declining as the trend is seen to have been checked, begins to increase as the players change sides and begin to speculate on the new trend. So the 01 is giving you valuable information here. You have to decide which side you are on. If you think the original trend is intact, this is a signal to get ready to plunge on that side.

We can see these situations easily enough in retrospect. Itas not so easy before the event. n.o.body said it was easy. But when the open interest gets above certain historical levels, we have a warning light. For example we could say the lights turn yellow when the open interest in the O-Mark gets above 80,000 and red when it gets above 90,000. We have to watch the other currencies contracts too. Sometimes the Swiss franc will give a warning signal a"or the pound or the Yen. And sometimes the message only comes across when you take all the four major currency contracts together. For example, when traders are playing the non-dollar currencies against each other (the cross-rates*), the open interest numbers tend to get higher: we need to make a mental adjustment for this too. For example, when there has been heavy cross-trading in the DM, the open interest has sometimes risen to 120,000, whereas otherwise 100,000 has represented an extreme in speculative interest.

NOTE. You have to make an automatic mental adjustment for those big drops you see in the open interest charts in March, June, September and December. IMM positions tend to concentrate in the earliest month, which is called athe front month a. As the contract month approaches maturity, margins are increased and many traders roll their position over into the next month. However, these positions are mostly taken on by members or locals on the floor of the exchange: so they do not tend to drop out of the overall open interest figures until the very final expiry of the contract, which is the Wednesday following the second Friday of the expiry month. That day often produces a sharp price movement, usually against the trend. See aopen interesta in the Glossary.

Occasionally, a peak in daily activity or trading volume in the IMM contracts will mark the exact extreme of a trend, providing a valuable confirmatory indicator of the open interest pattern. Some examples can be seen in the Swiss Franc IMM chart in 1990. Such peaks come out of the blue, and if they happen to mark a price extreme, this is only apparent with hindsight. You get the same phenomenon in other financial and commodity markets. As a thermometer of price extremes itas wise to use volume sparinglya" and only in retrospect.

In the currency markets the open interest gauge is uniquely valuable, I would say a"and not just because itas equally valid at both extremes, top and bottom. The open interest is just one of the sentiment gauges we have. Its advantage is that itas objective. But remember too that speculation, which is what the IMM open interest tracks, is not just a barometer of price fluctuation; it is a cause of price fluctuation. Commercial or investment demand may drive price action in the middle stages of a price movement; and this kind of demand is not necessarily price-led. But as trends gather momentum, speculation becomes the dominant driving force behind price and causes the extreme. A price chart can tell us that a price has had an extended move, and thatas all it can tell us; whereas the open interest can indicate to us whether the move is over-extended. It can tell us whether a currency is overbought*, or oversold*.

In the terrible UK bear market of 1974, Burmah Oil was forced to dispose ofits giant stake in BP, since it had borrowed hundreds of millions of pounds on the security of its BP share-holding, and the slide in the price of BP was literally threatening Burmah with bankruptcy .The day after Burmah sold its holding early in 1985, the whole stock market turned on a dime; and within a few weeks the price of BP had doubled again. This wasnat chance. The threat of Burmahas forced sale was itself responsible for the last burst of pessimism and bearish speculation in that long bear market. Hence news of the sale turned the tide.

Remember the last time you sold a currency at what proved to be the bottom, or bought at the exact top? That wasnat just bad luck a" nor even just foolishness. You and the crowd caused the bottom, or the top.

The Consensus*

I know of one top equity fund manager who has no other rule for handling the currency markets than to go against the consensus. Itas common sense. We must be acontrarians*, if we are to survive in financial markets in general and the currency markets in particular. During the great bull market in the dollar in 1981-5, it was the one single rule that a.s.sured survival. If you have any problem with that, I suspect there is no solution but to observe markets till itas no longer a problem; for the s.h.i.+fts from pessimism to optimism and back are what bull and bear markets are about.

The difficulty is to define athe consensus*a. The crowd isnat always wrong. When a price movement gets going, the crowd as often as not will line up in the direction of the movement. But standing against the crowd, at times can be as desirable as standing in the way of an express train. This is the drawback of such objective measures of opinion as Market Vane* a" a well known American service which measures bullish opinion among traders. If you poll traders, most of them will point in the direction of the trend. Bullish opinion as measured by Market Vane tells us the direction of prices over the past week, but not necessarily a lot more.

Perhaps Bruce Kovner*, of Caxton, nailed the problem when he said (see Chapter 8) that what he was looking for was the consensus that is not confirmed by price action. That covered the entire 1981-5 bull market in the dollar when the consensus was constantly bearish. It also covers the price extremes* , when the consensus is wrong by definition.

Whether we are looking at the underlying multi-month/multi-year trend, or the intermediate multi-week moves, there are usually two phases when the consensus is not confirmed by price a"early in the move and at the end of the move. Soon after a price reversal, majority opinion is usually aligned with the previous trend, i.e. the consensus lags. Similarly, majority opinion strengthens along with the on-going trend, tending to reach peak consensus at the price extreme. So the ideal position is to be contrarian at the beginning and end of a move, and pro-consensus in the middle. Nice work if you can get it so right.

Never forget that the consensus usually includes you.

The consensus gauge is a subjective gauge. We read the papers and specialist commentators and we talk to people, and we conclude that most punters are facing one way. If we are facing the same way, we have to reconsider the situation in the light of our other sentiment gauges and cut back if they are flas.h.i.+ng yellow. In the heat of a powerful favourable price move, we are often lulled into complacency: at that point, consulting the consensus is an essential discipline a" it often comes as a shock to discover that we are in with the herd, and it can be very costly if we fail to make this discovery. When we diagnose a situation where the consensus is not confirmed by price, we should not just cutback but try facing the other way, to see whether anything clicks. If the market action* feels right; if the open interest is extended; and if we can find a fitting rationale, we can reverse our position.

Perception of the trend

The disadvantage of the fractal nature of market fluctuations is that you can get in a muddle over the underlying trend and its minor and medium corrections* and extensions. One solution is to simplify and reduce the problem to just two const.i.tuents a"the major underlying trend and its main corrections, which are the medium-term, multi-week/multi-month corrections. That way all we are concerned with is the main trend and corrections to the trend.

The art of a.n.a.lysing financial markets is always to be able to reduce the problem to a simple black and white, yes or no issue. That way, if our a.n.a.lysis tends to be right, what we are doing is s.h.i.+fting 50/50 probabilities into 55/45 or 60/40 probabilities in our favour. And if we can always do that, we must win in the long term. (The temptation is to make complex bets that X will happen and that y will happen: those are 25/75-type bets, of which we should have no part). What happens when a market trends is that more and more partic.i.p.ants are being converted to the view that the trend has changed. Our perception of the trend gauge is designed to measure this conversion flow*. We have no statistics to go on a"just feel. We can, of course, see the past direction of prices in charts, and we would be foolish not to use charts for all the help they can give us in gauging the perception of the trend. For a start, they can help us gauge the perception of chartists, who are significant players. But what weare interested in is the changes in perception; and we try to feel these from anecdotal evidence before they are apparent in price histories a" using price histories for corroboration.

When a trend is ready to change a" from up to down, say a" everyone is afacinga up: everyone is projecting higher prices. Normally it takes time for the perception to change. Instead of higher prices you get a adouble topa, or a couple of descending highs and lows. The perception of the trend does not change at the extreme of the old trend, but progressively after it. We have been alerted to the extreme by our open interest gauge, with luck. Then our monitoring of trader sentiment tells us that a s.h.i.+ft is taking place: the consensus is being converted from bullish* to bearish.

Reaction to news

An early sign of a change in the perception of the trend is the way the market reacts to news. During the bullish phase, prices tended to rise on good and bad news alike. Then there is a change and good news fails to help the market. Finally, prices fall on good and bad news alike, and the trend has well and truly changed from up to down. The same applies in mirror image in bear phases.

Let me say that I am proposing nothing original here. This sentiment gauge is second nature to all old hands in financial markets. When traders say athe market is acting badlya, this is what they mean: they are not as resilient as they should be in the circ.u.mstances. And conversely, when prices rise on bad or indifferent news, traders say the market is acting well. If we are facing the wrong way, it should be second nature to all of us to cut back when the market is reacting the wrong way to the news or to the circ.u.mstances a"and to be rea.s.sured when the market is acting right.

In certain cases, market action* is about all we have to go on a" not just in alerting us to major speculative peaks and troughs (see below). Sometimes price action conflicts with our script for weeks on end, perhaps mandating that we stay out of the market. This gauge isworth looking further into.

Helpful Images

There is another description of the consensus-thatas-not-confirmed-by-price. It consists of two images that have become part of the ancient lore of Wall Street, the Wall of Worry and the River of Hope. II A bull marketa, we recall, aclimbs a wall of worrya; and aa bear market flows down a river of hopea .In point of fact, the description normally only applies to the early and middle stages in bull and bear markets. So we can be very comfortable when we diagnose a wall or a river a"a.s.suming weare climbing and flowing respectively.

In the later stages of the trend, things change. The worriers capitulate to the up-trend; and the hopers throw in the towel and give up the fight against the bear. At thisstage, in a bull market, we find die-hard bears saying that, well, we are heading for a collapse, but prices are going to go up further before they head down. And in a bear rnarketl die-hard bulls a.s.sert that prices are far too low a"but they can go lower still. The lconversion* processl is nearing its end. Now we have to get a little wary, for obviously we are in the region of consensus. And this is a very dangerous regional because no body on earth can tell how far things can go. Currencies, stocks, commodities a" it makes no difference. In this respect theyare all the same.

It is said of Joseph Kennedy, father of President John Kennedy, that when he was having his shoes s.h.i.+ned one day in autumn 1929, he was astonished to hear the shoe s.h.i.+ne boy tip him a hot stock that was sure to go from 160 to 2000 or whatever. That was all Joe K needed. If shoe s.h.i.+ne boys (or elevator attendants, or hairdressers, the cover of Newsweek or whatever) were tipping stocks, it was time to get out. So Joe K started selling short and thus laid the foundation of the family fortune a"so the story goes. But if itas true that Joe K went short at that moment then he was lucky. The sucker buys at the top of the market; geniuses and liars sell at the top of the market; but the super-sucker sells short at what he thinks is the top of the market.

In 1979, the then financial editor of Britaina s Daily Mail newspaper, Patrick Sargent (later to be a founder of Euromoney), called the top of the gold market at around $450. It was a perfectly sound call, in the light of the speculative heat in gold at the time especially from one who had been bullish of gold for a good time. Yet gold was to climb a further $400 by early 1980, when speculation turned from red-hot to white-hot. Imagine being short at $450! As I say, no-one on earth knows where a speculative trend will end a" except with hindsight.

Over time these four sentiment gauges* have proved invaluable in pinpointing the region of the price extreme in the currency markets; and they pa.s.sed the test more than adequately in the case of the most extended speculative extreme that has been seen in the currencies since they floated free in 1973, namely the peak of the dollar in February 1985.1qey allowed the ultimate peak to be categorically identified, in retrospect, in September 1985 when the D-Mark stood at 2.90 and the Yen at 230. (Some observers were smarter than this: they identified the ultimate peak within days of the top. But most of them had also identified the ultimate peak on numerous occasions in 1984,1983,1982 and even 1981!). This brings us to the question how you can distinguish a minor multi-week extreme from a major multi-month or multi-year extreme. The late stages in that great dollar bull market of 1980-85 provide a clue: you watch the way the conversion process trickles down through the different categories of currency observers. In mid-1984, the world was still full of die-hard dollar bears who had considered the currency overvalued ever since 1981. Who were they? It wasnat the dealers, who are not and do not need to be overly concerned with underlying value; nor was it the trend-followers. It was the value-oriented a.n.a.lysts a"researchers and economists by profession a" with a long-term orientation. What happened was that some time during the autumn of 1984, the bearish consensus among this category turned round; and it happened relatively suddenly. You will see it quite clearly if you go back over the research material turned out by major banks at the time. aThe dollar is grossly overvalued at DM 3.00, but we think it will head further up before it collapsesa, that kind of thing.

In other words, itas just as you would expect. When the long-termers who were formerly sceptical at last capitulate to the trend, then you have a total consensus and the end is nigh for the major multi-month/multi-year move. Nigh, but not necessarily over. At this point one of our sentiment gauges comes into its own. We have to watch market action:: the way the market acts in relation to the background and to news events.

CHAPTER SIX.

Listen to what the market is saying about others, not what others are saying about the market.

With apologies to RICHARD D. WYCKOFF At times chartists are the predominant influence on currencies. Itas unrealistic not to recognise this. At times, charts can help all of us trade: they tell us what the patientas temperature is, even if they donat give a prognosis. And on occasions they may give that too.

Traders in all markets are divided into those who know what they are doing and those who do not. That doesnat mean that those who know what they are doing are right: they just know what they are doing. The rest operate by chance; and, it must be said, the rest are in the great majority . Those who have a system to which they adhere consistently know what theyare doing. Of this small knowing minority, a largish proportion are chartists*, or at least rely more or less on price history. And this generalisation seems to apply as much to the currencies as to other markets, or maybe more so.

Moreover on the evidence, price-oriented traders have tended to be rather more successful performers than the more numerous afundamentalistsa. The so-called commodity fund industry a"the futures funds a"is dominated by price-based, trend-following systems. Contrary to widespread opinion, the industry chalked up significant gains over the 1980s a"net of substantial dealing costs.

The commodity markets are broadly a zero-sum game*, like currencies. They get little help from a secular rise in prices, as the equity business did over the 1980s (and in certain earlier decades). For a whole industry to make significant profits in a zero-sum game, after hefty dealing costs, that is strong prima facie evidence of expertise: and the whole futures industry beat the market. By contrast the equity management industry has over many years, and certainly over the 1980s, trailed behind the broad stock indices as is known to one and all. In a zero-sum game, that would be the equivalent of making losses year after year. So on the face of it, the trend-following futures funds have been doing something right.

On closer examination, what we find is that a few fund managers have been successful in compounding profits over many years, while most have shown an erratic performance. The successful ones have, naturally, attracted new funds and grown geometrically until they have come to dominate the industry. In other words, the performance of the whole industry has been ruled by the performance of a few managers who have produced outstanding track records. In fact, just three of these, Mint Group, Caxton Corporation and Paul Tudor-Jones, manage about a quarter of the entire futures fund industry a"and only one of them, Mint Group, follows a strictly chart-oriented, trend-following system.