Dollar Calls the Tune for Stocks

To help us anticipate what the big money is thinking and how they’re plotting, the main chart to keep an eye on this autumn is the U.S. dollar. We’re always trying to find indicators that are good forecasters of behavior. That’s the main reason we look at charts: Not just to understand what happened in the past, but to look for clues as to what might happen in the future. 

The dollar fulfills this role pretty well for long stretches of time because most commodities are still denominated in dollars, and they must be paid for in advance through a process that paradoxically involves selling the greenback short. Another common ploy for investors is to sell the dollar to generate funds to buy higher yielding currencies and assets, a trick known as the “carry trade.” Since both of these force the dollar lower, and essentially happen ahead of the next step, which is the purchase of risky assets, the direction of the buck has offered a good portent of what’s to come.

Now please look at the chart below of the PowerShares US Dollar Index (NYSE: UUP), which tracks the progress of the U.S. dollar against a basket of foreign currencies. I know it’s a little complicated, but bear with me. I’m just trying to show a sequence: 

dollar chart

In June the market was weak but the dollar was falling. The decline of the buck was a positive forward omen, especially once it dropped down through its 50-day average. This meant that carry traders were getting ready to buy the risky assets that were sliding at the time.

At the (1) is a crossing of the dollar under its 50-day average on the first day of July. This was the culmination of all that had preceded it, and the decline of the dollar then led to the big advance in July. You may recall that I put on all our overseas ETFs at the start of July for exactly this reason.

The dollar then started to stabilize and rise in early August, then broke above its trendline at (2). This lead the way to the start of the big August decline in the second week of the month. We kept our overseas positions because they continued to perform well despite the slide in the U.S. markets.

The dollar approached its declining 50-day average in the fourth week of August, but failed to break through it on four tries (3) as carry traders kept shorting it. That was the a great signal that September might be a positive month, and led me not to recommend any inverse ETFs in our portfolios yet, as well as to add more risk via iShares Turkey ETF (NYSE: TUR) and SPDR High Yield Debt (NYSE: JNK). And that is still the case.

So what’s next? As long as the dollar stays under its 50-day MA — as simplistic as this may sound — the “risk rally” can continue. But if we see the dollar cross over that level, which is now $24 on Sept. 10, and remain above for a couple of days, then it will be time to go on high alert to avoid the risky assets.

The dollar and U.S. stocks both rose together in March this year, so there is not a perfect 1:1 relationship between the two. But it’s one of the best clues — in conjunction with other indicators of valuation, breadth, sentiment, fundamentals and momentum — in our toolbox. The message for now is to stay positive.

A key reason for this view is politics: The Obama administration has been focused on extending most of the Bush administration tax cuts, and the Federal Reserve remains accommodative at a time of low inflation and stout global growth. Moreover the Republicans stand a good chance of making gains in the midyear elections in November, and it’s a plus for stocks whenever the balance of power in Congress swings away from majority rule of either party.   

For more insights like this, check out Jon Markman’s daily short-term newsletter, Trader’s Advantage, and long-term investment letter, Strategic Advantage.

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