I always keep the dollar index front and center on one of my six screens. The direction of the dollar gives us invaluable clues about the state of monetary and fiscal policies — or at least the perception thereof — and global risk appetites.
First, a little history: During the past 30 years, the U.S. dollar has been in a continuous downtrend — one that’s unlikely to be over just yet, if we consider the Federal Reserve’s monetary policies. This chart shows the performance of the dollar index (DXY) versus the S&P 500 during the past 30 years:
It’s important to remember this long-term trend; however, also realize that in the nearer-term, the dollar often has moved inversely to commodities and stocks. Because most commodities are priced in dollars, when the dollar moves higher, those commodities must move lower accordingly (since in this case, the dollar’s move higher has nothing to do with the fundamentals of these commodities).
Stocks often have moved inversely to the dollar more recently as a result of monetary policy. More accomodative policy — either in the form of lower interest rates or quantitative easing (money printing) — is then often viewed to be supportive of stocks and a further devaluation of the U.S. dollar.
Since August 2011, the dollar index and the S&P 500 have both moved higher. However, the inverse relationship in the time frames of a few weeks to a couple of months are clearly visible by the many crossings of two lines on the following chart:
Currently, from a technical perspective — as well as a seasonal point of view — the dollar index is in a bearish position. For the better part of 2012, the index has traced out a head-and-shoulders pattern which has its neck-line around the 79 mark. Last Friday’s dollar strength hasn’t changed the chart much, and the dollar’s rally since mid September also can be viewed as a bear flag formation. (As a side note, a rally beyond 81 would nullify these bearish dollar formations.)
I’m watching for (but not counting on, should the aforementioned technical pattern play out) a dollar break below the 79 level. Such a move would be bullish for equities and commodities, at least for a few weeks.
I have calculated the correlations of all S&P 500 stocks to the dollar index, and I will be focusing on buying those with the biggest inverse correlation should the dollar slide again.
Energy services and exploration stocks have a large inverse correlation to the dollar index. The stock with the largest inverse correlation to the dollar index there is Schlumberger (NYSE:SLB) — hence, I’ll be looking at SLB from the long side in the event the dollar stumbles.