The Euro's Post-Breakdown Positive Divergence

01/25/05 10:51:54 AM

by David Penn

How soon after a breakdown is it time to think about buying?

Security: EUR/USD
Position: N/A

Economist and financial analyst Marc Faber (gloomboomdoom.com) is quick to remind investors that it is never enough to talk about the depreciation of the US dollar. After all, the dollar is, among other things, a unit of exchange, Faber observes. So for the dollar's value to fall, it must be "falling" against the value of something else. It is worth noting, as Faber did in a recent roundtable discussion in Barron's, that against the currency of Poland, the zloty, the US economy actually contracted in 2004!

While many people get this much of the equation, they often forget that while the dollar might be falling in value against one thing, it might be gaining in value against something else. The classic contemporary example--at least up until recently--has been the price of gold. True, the price of gold has been in a cyclical increase in value against the dollar, but against the euro, the rise in the price of gold has been significantly more muted.

Figure 1: The euro. The 7, 10 stochastic suggests that any follow-through to the upside could create a strong positive divergence that would send the euro higher against the US dollar.

Graphic provided by: eSignal.

I thought of this as I looked at a chart of the euro versus the US dollar (EUR/USD). In the same way that we often look at a market and compare its performance to the stock market (that is, "the stock market is watching crude oil prices ..."), it seems as if the EUR/USD has mirrored the performance of the broader US stock market over the past month. Peaking in December, the EUR/USD suffered a sharp correction going into January--as did the Dow industrials and transports, the Standard & Poor's 500, the Nasdaq, and the Russell 2000.

In fact, the EUR/USD perhaps most resembles the Nasdaq in the way that it too has broken down completely beneath its multimonth trend channel (the EUR/USD channel shown here extends from the October 2004 lows; the channels in all of the stock markets mentioned above extend from the August 2004 lows--save for the channel in the Dow Jones industrials, which extends from the October 2004 lows).

But could that breakdown be all there is to this bearish fire? The euro--not unlike the other markets mentioned previously--has been working on a positive stochastic divergence that, if confirmed, could mean at least a temporary end to the current declines. The positive stochastic divergence is based on the difference between the sequentially higher lows in the stochastic from early January to late January, and the sequentially lower lows in the EUR/USD during the same period.

Confirmation of this positive stochastic divergence would appear in the form of the EUR/USD trading at or above the 1.3250 mark. This level represents the high of the "day" ("24-hour period" is more accurate with foreign exchange) during which the 7,10 stochastic made its initial low on January 7. This method of "confirming" the validity of stochastic divergences was discussed in more depth in my article for Working-Money.com, "Confirming Divergences," from December 22.

In the context of the breakdown from the trend channel, it would be difficult not to see any move up in the euro as a bounce rather than the resumption of a bull market in the European currency. The EUR/USD has spent much if not all of January 2005 trading below its 50-day exponential moving average, which is an especially bearish sign given the general trendliness of the EUR/USD. At the same time, it is worth noting that a breakdown in the EUR/USD as it approaches potential resistance at the 50-day could do more than lead to new lows below 1.2920. Note that corrections in the bull market in the euro have tended to take at least 10 cents off the top. The corrections in the first half of 2001, the middle of 2003, and the first half of 2004 all saw 10-cent losses before bottoms and reversals developed. Such a 10-cent haircut from recent highs would land the EUR/USD in the vicinity of the 1.26 level.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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