DOLLAR SURGES ON STRONG JOB REPORT -- DOLLAR STRENGTH EXPLAINS COMMODITY WEAKNESS -- AND WHY FOREIGN STOCKS ARE LAGGING THE US -- CANADA AND JAPAN ARE BEING HURT BY FALLING COMMODITIES

EURO AND YEN TUMBLE ... The dollar is having one of its strongest days in months. Part of the reason is the drop in the U.S. September unemployment rate and some upward revisions in recent job creation. The report diminished hopes for rate reductions by the Fed in the near future. In addition, Japanese reports of a possible North Korean nuclear test over the weekend also weakened the yen and caused some flight to dollar safety. The bottom line is that the Euro is falling to the lowest level in three months (Chart 1), while the yen touched a new six-month low (Chart 2). Having said that, I'd like to revisit a couple of other bullish factors for the dollar that I wrote about a couple of weeks ago. One has to do with the recent drop in commodity prices and the other which is recent underperformance by foreign stocks. Both trends are consistent with a firmer U.S. dollar.

Chart 1

Chart 2

WEAK EURO AND YEN LEAD TO LOWER CRB... On September 21 I wrote two articles on the U.S. Dollar. The first had to do with the fact that a firmer dollar was reponsible for falling commodity prices. Although I showed the inverse relationship between the Dollar Index and the CRB Index two weeks ago, today I'd like to show the positive relationship between commodities and foreign currencies. The blue line in Chart 1 is the Euro and the orange line is the yen. The black line is the CRB Index of commodity prices. They all bottomed together in early 2002 (as the dollar peaked). During 2006 the CRB Index reached a new multi-year high. The Euro, however, peaked in early 2005 as did the yen. Neither foreign currency confirmed the 2006 CRB recovery high. That was an early warning of commodity weakness. Chart 2 shows the 2006 intermarket correlation between the Euro (blue line) and the CRB Index (black line) more clearly and the failure of the Euro to confirm the 2006 CRB high. There are two ways to look at their combined weakness. One is that weaker foreign currencies warned of weaker commodities. The other is that weaker commodities supported a stronger dollar. Another side-effect of a stronger dollar is that it favors U.S. stocks over foreign stocks.

Chart 3

Chart 4

FOREIGN WEAKNESS MAY SUPPORT THE DOLLAR... This is the same headline that I used in a September 24 report on the dollar. In that case, I was trying to make a bullish case for the U.S. currency based on recent weakness in foreign stocks. That's because a stronger dollar is usually associated with foreign underperformance. Today I'm comparing the U.S. Dollar Index (green line) to a ratio of the Europe Australia and the Far East ETF (red line) to the S&P 500. A rising EFA/SPX ratio means that foreign stocks are outperforming U.S. stocks. Chart 5 shows the ratio bottoming in early 2002 just as the dollar peaked. Foreign stocks outdid U.S. stocks until the spring of 2006 as the dollar remained relatively weak. Notice that the spring 2006 low in the Dollar Index (up green arrow) was higher than the previous low in early 2005. Just as was the case with the 2006 high in commodities, a firmer dollar (or weaker foreign currencies) no longer supported foreign stock strength. The result since May 2006 has been foreign stock underperformance. Chart 6 shows the 2006 intermarket action more clearly. Notice that the May trough in the Dollar Index (green line) coincided with a peak in the EFA/SPX ratio. That's another reason why I'm watching the dollar so closely here. A firming dollar not only weakens commodity prices but makes U.S. stocks a better place to be than foreign stocks.

Chart 5

Chart 6

FALLING COMMODITIES WEAKEN CANADA ... In the September 24 article I also touched on how falling commodity prices could start to have a negative impact on Canadian markets. That's because Canada's boom over the last four years has been tied to rising commodity prices. Not surprisingly, the Canadian stock market has been one of the world's weakest markets since May. Chart 7 shows the Toronto 300 Index still trading below its 200-day moving average. The TSE/SPX ratio has fallen to the lowest level in nearly a year. The Canadian Dollar has also softened since May (which has helped boost the U.S. Dollar). Chart 8 shows the CDW moving down toward its 200-day moving average. Two other countries that have performed badly since May have been Brazil and Japan. Brazil is tied to commodities, while Japan has shown a recent correlation with the price of gold.

Chart 7

Chart 8

WHY JAPAN IS TIED TO GOLD ... I've written in the past about the possible link between rising gold prices and Japan. That idea stems from the rising inflation pressures signalled by rising gold and Japan's emergence from deflation. The view seems to be supported by Chart 9 which plots a ratio of Japan iShares divided by the S&P 500 (black line) compared to the price of gold. Notice that Japan started to outperform the U.S. market at the start of 2002 just as gold (and other commodities) were starting to rise (and the dollar was peaking). The two lines rose together from the start of 2002 until this spring. Both have fallen since then (down arrow). Chart 10 gives a closer look at their correlation. The price bars show the Japan iShares (EWJ) trading more than 10% off their May high. The blue line is the EWJ/S&P ratio which has tumbled to a new yearly low. The gold line is bullion. The chart seems to suggest that falling gold prices have had something to do with the recent underperformance by Japan. The rising dollar has also hurt the EWJ since May because the EWJ is weakened by falling Japanese stocks and a falling Japanese currency.

Chart 9

Chart 10

WHAT'S THE MESSAGE OF A FIRMER DOLLAR ... The direction of the U.S. dollar (which is pointing up) will help determine the direction of commodities and interest rates. A firmer dollar weakens commodities and puts downward pressure on U.S. interest rates. That should help U.S. stocks and rate-sensitive stocks in particular. It would, however, be bad for basic material, energy, and precious metal stocks. It should help stocks that benefit from falling commodities like retailers. A firmer dollar also makes U.S. stocks more attractive than foreign stocks. Foreigners usually prefer larger U.S. stocks to smaller ones. Which brings us back to the recent theme of favoring large cap stocks and especially those that pay dividends. All we're adding here is the idea that they also be U.S. stocks instead of foreign ones.