The main source of pressure on stocks and other risky assets over the past two weeks has been the rise in the U.S. dollar. This has contributed to an unwinding of the dollar-drop driven risk rally that saw all types of assets — including foreign stocks, gold, crude oil, and base metals — climb higher in unison. But it hasn’t been a smooth climb.
Relative to the euro, the dollar has had two days this week in which it changed by more than 3% up or down. With currency volatility increasing, this should translate into increased risk aversion and profit taking in stocks and commodities. The last time the dollar-to-euro exchange rate showed this kind of volatility was back in early May when the stock market was sliding off a cliff.
I’ve illustrated the relationship in the chart above. The top pane is simple the S&P 500 index. The lower pane is showing two things. The grey line is just the one-day rate-of-change in the dollar-euro exchange rate. You can see how we’ve had two big spikes over the last two trading sessions.
But here’s where it gets interesting: The black line represents the amount of volatility — or the width of the standard deviation bands — of the dollar-euro exchange rate.
As you can see, periods of currency volatility like we have now, have been associated with market corrections this year as the prices of stocks and commodities have been heavily influenced by exchange rate movements. So if the big swings in the dollar continue, it should have a negative influence on risky assets.
At the same time currencies are bouncing around like crazy — stocks have been stuck in a tight trading range since October 12. Eventually, one of these market forces will win: Either the volatility of the dollar or the calmness of stocks. Since currencies have led the way during the last two market corrections, my guess is that the dollar’s undulations will upset the delicate balance in the stock market. And that means now’s the time to look at pulling in long trades and looking for opportunities on the short side.
One of my favorite short ideas at the moment is selling the Market Vectors Gold MIners (NYSE: GDX), which is down more than -7% from its high last week. I first warned of trouble for the gold miners back on September 30, and see more losses ahead for the industry. A number of the stocks I recommended back then as good looking shorts have had significant falls: Minefinders (AMEX: MFN) and Northgate Minerals
(AMEX: NXG) are both down -10%.
Disclosure: The author does not own or control a position in any company mentioned.
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