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Whatever happened to purchasing power parity as a means for valuing currencies? Unfortunately this way of evaluating currencies seems to be a lost art. Today FX markets seem to be driven by technical analysis and news flow. Our approach has been to analyze what investors have been doing, rather than what they say they are doing. To accomplish this, we compare the Euro currency against data taken from the Commitments of Traders (COT) reports.

The chart below depicts the Euro (black line) against the net speculative long open interest of COT reported data. Note that we’ve converted the net speculative long data into a 50 day (blue line) and 200 day (red line) simple moving average as well. This COT data essentially reflects how the hedge fund and active investor universe is positioned. Several things stand out here.

First, there is a strong correlation between these two data series. Second, by our lead/lag analysis, the net speculative long series typically leads the price of the Euro by 20-40 days. Last, as of January 12, 2012 the net speculative long series has declined to a significant low, or 2.20 standard deviations from its average over the past few years. This implies that traders are extremely short the Euro, and a significant Euro rally may be at hand within the next couple of weeks.

Click to enlarge

Euro vs Net Spec Long Open Interest

Back-testing our analysis through moving average cross-over statistics adds conviction to our thesis. When the 50 day moving average crosses above the 200 day moving average for the net speculative long open interest series, performance on average for the Euro has been a positive 11.29% until the moving average crosses back down. Conversely, when the 50 day moving average crosses below the 200 day moving average, performance of the Euro during this same period averaged -8.18%. We would be cautious on becoming too negative toward the Euro at this point, and believe that a counter trend rally may be coming soon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: The Euro Is Poised For A Reversal