Doubling Down on the Dollar

08/26/2008 12:00 am EST

Focus: FUNDS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of Global Bull Market Alert, says the dollar’s rally is for real and suggests two ways to play it.

After flirting with record lows against the euro as recently as July 15th, the US dollar hit a six-month high against the euro and a two-year peak against the UK pound sterling as the economic slowdown outside the US gathered pace.

The popular “decoupling theory,” that the rest of the world's economies can continue to thrive while the US economy slows, has proven to be bunk. As it turns out, other global economies, not the US, are flirting with recession.

The 13-nation euro-area economy shrank in the second quarter, as the economies of Germany, France, and Italy all contracted. And because inflation in the euro zone is far too high for comfort, few expect the European Central Bank to cut interest rates before 2009. That means that you can expect European economies, and the euro, to stagnate during the foreseeable future.

With a bigger housing bubble and even greater consumer credit expansion than the US, the United Kingdom and its pound sterling currency have every reason to continue their downward trends, too.

[Meanwhile], the US economy grew at 1.9% in the second quarter, and a surge in export sales in June probably means that GDP growth for the most recent quarter will be revised upward.

The Economist magazine recently published its annual “Big Mac Index”—a tongue-in-cheek measure of “purchasing power parity“ (PPP)—the relative over- and undervaluation of the world's currencies. Based on that measure, the euro is among the most overvalued currencies on the planet.

The US dollar also tends to move in six- to seven-year cycles [from] extreme undervaluation to overvaluation. In 2002, the greenback was as overvalued as it had ever been in the then-15-year history of the Big Mac Index. So, after six years of relentless decline, the dollar is due for a strong bounce back.

How far would a dollar rally go? A further 20% rally from current levels seems not a question of “if,” but “when.”

The best way to play the dollar rally is to buy the Direxion Funds Dollar Bull 2.5x Fund (DXDBX)—a leveraged fund that seeks daily returns of 250% of the performance of the US dollar against [six major currencies]. That means a 20% gain in the dollar should translate to a 50% gain in the fund. Place your stop at $28.25. (It closed below $34 Monday—Editor.)

[Another way] to profit from the dollar's recovery against the euro [is to] buy the Market Vectors Double Short Euro ETN (NYSEArca: DRR) and set your stop at $37.50. (It closed above $43 Monday—Editor.) As the index is two times leveraged, for every 1% weakening of the euro relative to the US dollar, the level of the index will generally increase by 2%.

So, if the euro declines 10% from its current level of $1.50 to the US dollar to, say, $1.35, you can expect to lock in a gain of [about 20%] with this ETN.

(Short selling and leveraged funds are only for risk-tolerant investors who can afford to lose the money they invest in these vehicles—Editor.)

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