'Dead Reckoning' Led Me to a Bullish Trade Most Will Miss

The current market environment is tough for traders. There's a plethora of indicators that are either disconnected or conflicting, making the market difficult to navigate.

But I've seen incongruities such as this many times before. It's analogous to piloting an aircraft with only minimal gauges, using the "feel" of the airplane and whatever you can see on the ground to navigate (which I've also done). When the technology in your airplane goes awry, it's best to revert to the basics to find your way.

Some pilots actually do this all the time, using only simple, tried and true gauges -- a compass, a watch and their knowledge of certain reference points -- to estimate their current position, and calculate the distance and direction to their destination.

They call this method " dead reckoning."

Just like pilots, traders can become dependent on technology and the seemingly endless amount of data. When that happens, it's easy to lose sight of the biggest disconnects in market valuation.

We can apply this idea to the stock market, using objective reference points and gauges -- earnings trends; fundamental ratios like price-to-earnings (P/E), PEG and others; and even price charts -- to give us an idea of the market's current position. From there, we can then look back and analyze how all these factors have been related to one another in the past in order to find their probable location in the future.

Using this type of dead reckoning, I've stripped out all the noise, hype and conflicting indicators and uncovered something interesting.

There's been a trend emerging in the U.S. dollar (USD) for the past few weeks that makes little sense. At a time when the dollar should be gaining momentum, its value has been drained quicker than a keg of cheap beer at a frat party.

To put it simply, I don't believe the USD is fairly valued here.

According to several sources, the drop can be at least partially attributed to technical and algorithmic trading, which are both akin to broken indicators in an aircraft pointing us in the wrong direction.

When you strip out the commotion and look only at the real data, it seems there could be a fair amount of upside in the USD over the next few months. 

Economic Factors All Bullish for Dollar

The U.S. dollar can have dramatic effects on basically everything in our economy, including the value of other assets. On the flip side, economic and fiscal pressures can also affect the USD's value.

Sometimes, these complex relationships can trigger a "chicken or the egg" paradox that confuses investors and throws the USD's cause-and-effect balance off kilter.

A rising dollar is typically a sign of an improving economy. As increasingly positive economic data is released, the value of the dollar (typically) rises in response.

Two things basically control the value of the U.S. dollar:

1. The real strength of the U.S. economy (GDP, employment, etc.)
2. The Federal Open Market Committee's fiscal policies (value of USD increases when the Fed raises interest rates and falls if rates turn lower)

While our economy might not be breaking any records for growth, economic data has been improving, and the unemployment rate remains low after several strong labor reports. GDP is also expected to take a turn for the better in the back half of the year, and consumer sentiment remains strong.

These are all bullish for the U.S. dollar. Yet. in the past month, the USD's value has declined.

This is even stranger when you consider that the Fed's statements have been increasingly hawkish (in favor of a rate increase) lately.

In a recent interview, Stanley Fischer, the vice chair of the Federal Reserve, said the economy is close enough to all of the Fed's targets to warrant a hike. The minutes from the FOMC's most recent meeting also showed a Fed that sees economic progress -- a Fed prepared to hike rates this year -- but traders don't seem to buy either theory.

On Friday, Fed Chair Janet Yellen said in her Jackson Hole, Wyoming speech that the chances of a rate hike this year have "strengthened." While the USD did close higher after the remarks, we haven't been seeing the kind of bullish sentiment for the dollar that you'd expect.

The CME's Fed Watch Tool still shows a nearly 50% chance of a hike, with some pros even betting on an increase of more than 25 basis points. The probability of a rate hike has been rising steadily and sharply since June, but none of that has been reflected in the value of the dollar.

New York Fed Chief William Dudley even said that the market is "complacent" regarding the Fed's likelihood to raise rates. This kind of outright statement is atypical for a Fed member and quite hawkish in my opinion.

Again, this should be bullish for the dollar.

But, even though both the data and the Fed's sentiments have been increasingly hawkish, the USD's value has been falling.

I believe its drop is more of a temporary bearish momentum force, driven by computers, rather than a real dollar/economic demise. Here's why... 

Commodity Rallies Reveal Economic Improvement

The dollar's drop over the past few weeks seems to have helped fuel a sharp rally in oil and some soft commodity prices. But when you look at the oil and commodity rally another way, it could mean that traders and economists see real economic improvement and demand.

I say this because the price of crude wasn't anywhere near its high when the dollar index was at its 52-week low back in early May. That was also a time when the price of oil should have been extremely high with the summer driving season about to kick into high gear.

Oil's lack of performance back then, and its major rally over the past month or so (even though the dollar did not return to previous lows), prove that economic fundamentals are strengthening.

I believe the confidence and strength we are seeing in the commodity and stock markets should come full circle and help push the dollar back up to reasonable levels. 

Because a large number of traders still don't believe a hike will come this year, there's an immense amount of investment dollars not committed to the USD... yet. And that could be a big catalyst.

The Perfect Play on a Bullish Trend

Traders can use the PowerShares US Dollar Bullish Index (NYSE: UUP) to trade the USD. This fund tracks the value of the U.S. dollar versus six other major currencies, with more than 92% of its value being derived against the euro, Japanese yen, Canadian dollar and British pound.

While you could purchase shares outright, there is another strategy that could turn a 1% move in UUP into a 17% profit in two months or less. Best of all, you risk just a fraction of what traditional investors do.

In the past year and a half, I've used this exact same strategy on UUP three times to book double-digit gains in a matter of weeks on small moves in the ETF. 

While my strategy may not be for you, if you have just six minutes, you can see for yourself.

[Market Outlook] Why I Can't Stop Talking About The 200-Day Moving Average
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