Momentum In A Mean Reverting World

By: Michael Coolbaugh, Chief Investment Officer

Last week, we shared our view that 2025 will be a year of mean reversion.

We probably should’ve been clearer about this stance as it’s primarily aimed at US equities. Valuations, sentiment, an off-the-cuff style administration, rates. You get the gist – there’s just an awful lot of crosswinds at play.

So, while buying dips and selling rips is likely a good approach for US equities here in 2025 (look no further than the first three weeks of January), I do want to expand a bit on a few possibilities.

As big fans of momentum, this naturally begs the question of, “Are you abandoning your strategy?”

The short answer is, No!

Let’s take a look at the US Dollar. If we go back to late September, there was a noticeable turn in betting odds for the presidential election. After trailing by a significant margin, various betting markets began to surge in favor of Donald Trump.

At the same time, the US Dollar Index (DXY) took off to the upside and hasn’t looked back since. Sure, the strength of the US economy versus rest-of-world (RoW) has played a part. But there’s no question that traders have been piling on to their bullish bets due to tariff expectations from the incoming administration.

We’ve witnessed the sensitivity of the dollar to the possibility of a less aggressive tariff policy on two occasions. First, when the Washington Post ran an article on January 6th, which Trump immediately refuted. And second, when Bloomberg ran a story on January 13th, suggesting tariffs could be implemented in a gradual progression.

Well, here’s where that theory of mean reversion comes into play.

If we look back at the 2016 election, the US Dollar exhibited similar behavior to what we see today. Following Trump’s victory, the US Dollar went on an incredible run, only to top out at the beginning of January 2017. Part of this was due to Trump’s interest in bolstering the competitiveness of US exports on the global stage.

Source: Strom Capital Management LLC, TradingView

For momentum traders, this is the danger. As early as January 2017, President-elect Trump blamed China for manipulating its currency to be weaker versus the dollar. Tweets were bountiful and on April 12, 2017, the Wall Street Journal ran a piece quoting President Trump as saying, “Dollar getting too strong.” He went on to say, “It’s very, very hard to compete when you have a strong dollar and other countries are devaluing their currency.”

Today, the US Dollar is as strong or stronger against most major currencies than it was at any point during Trump’s first term as President.

How long do we think it’ll be until the tweet storms start flying that the dollar is “too strong”? What if the worst-case scenario of 60% China tariffs on Day One is not realized and the news reports of gradual tariffs are indeed correct?

More importantly, how is the market positioned? Are they expecting a worst-case scenario? Even if that does come to fruition, how much fuel is left in the tank to propel things even higher?

Source: Kobeissi Letter, CFTC, Bloomberg

According to CFTC, hedge funds are the most bullish on the dollar since 2019 – right before it went on to lose ~10% over the course of 2020. Now, yes, one might look at this chart and say, “Hedge funds were extremely bullish in mid-2021 and they were proven correct!” That would be correct.

However, most of the bullish positioning was unwound by May of 2022, just before the DXY Index took off for a gain of a little over 11%. In fact, they piled back in right at the top in October of 2022.

But here’s where I think this set-up, plus our thoughts about mean reversion, are so relevant…

One school of thought is to sit back and say, “Play the mean reversion and short the dollar.” We’re not great mean reversion traders and, as I said at the outset, I’m not interested in abandoning my core strategy.

The other school of thought is to look for trades that might benefit from a dollar reversal but is still within our wheelhouse of trend and momentum trading.

That brings me to gold.

Over the past 4-5 months, gold has defied two of the primary drivers that have historically predicted its performance – real rates and the US Dollar. Generally speaking, whenever you see an asset defy historical logic, it should send up a warning flag. A flag that might be suggesting a major regime change.

Source: Strom Capital Management LLC, TradingView

What I like about gold is that it still fits within our methodology of trading in unison with long-term trends. It’s also an asset that has been consolidating for the past two months after an extremely strong run (consolidation is often a sign of disinterest as short-term traders become frustrated with the lack of progress).

Furthermore, much of the recent backup in “real rates” has been driven by an expansion in ‘term premium’. In other words, the rise in rates has not been driven by an increase in inflation expectations. This is another market narrative that the new Trump administration will continue to blow out fiscal deficits with numerous pro-growth policies.

As I sit here today, Scott Bessent, Trump’s nomination for Secretary of the Treasury, is sitting before Congress. And, in his own words, “The US does not have a revenue problem, we have a spending problem.” Does this sound like a financial expert keen on advising President Trump to blow out the deficit when we’re near peak employment?

Long-term rates have been surging due to this “fear factor” and, after two more benign inflation prints (PPI on January 14, 2025, and CPI on January 15, 2025), interest rates are violently reversing in the opposite direction. And, yes, throughout Mr. Bessent’s confirmation hearing, bonds have continued to rally (interest rates falling).

Rounding this all out, we have the following cocktail…

The dollar has been extremely strong for two primary reasons: higher US rates versus RoW and tariff fears. If we are entering a period of mean reversion (our theory for 2025) in both bonds and, by extension, the US Dollar, those are two headwinds for gold that may soon turn into massive tailwinds.

And, yes, we also have the possible “tweet effect” where President Trump might wake up one day and decide that the “dollar is too strong.”