DOLLAR DIRECTION IMPACTS FOREIGN STOCKS AS WELL AS GOLD -- BOND YIELDS BACK DOWN AS UTILITIES BREAKOUT -- FALLING SOX WEIGHS ON NASDAQ -- INTERNATIONAL PAPER AND MEADWESTVACO JOIN PAPER RALLY

FALLING DOLLAR FAVORS FOREIGN STOCKS ... One of our readers asked why I haven't mentioned the impact of the dollar on foreign stocks. Actually, I've done so several times. Since the dollar is at a crucial juncture, however, this is as good a time as any to revisit the issue. The basic idea is that a falling dollar favors foreign stocks over U.S. stocks. That's because American investors get a double benefit from foreign stocks. They benefit from the rising stocks themselves. And they get a boost from a rising foreign currency. If they're investing in foreign Exchange Traded Funds, they also get a currency benefit. That's because ETFs are quoted in U.S. dollars, and do better when the dollar is weak. Chart 1 demonstrates the relationship. The green line is the U.S. Dollar Index. The red line is a ratio of the EAFE iShares (EFA) divided by the S&P 500. [The MSCI EAFE Index is the international stock benchmark and stands for Europe Australasia and the Far East]. A rising red line means that foreign stocks are doing better than U.S. stocks. Notice the generally inverse relationship between the two. Since the Dollar peaked in early 2002, foreign stocks have done much better than American stocks.

Chart 1

COMPARISON SINCE DOLLAR BOTTOM ... The U.S. Dollar hit bottom at the start of 2005 and has traded sideways over the last two years. Chart 2 shows, however, that dollar direction still has had an impact on foreign stock relative performance. Here again, the green line is the Dollar Index and the red line the EAFE/S&P 500 ratio. A generally inverse relationship is still visible. Two downturns in the dollar during 2005 (green arrows) coincided with upturns in the EAFA/S&P 500 ratio (red arrows). In May of 2006, a dollar rebound caused a drop in the ratio. Another dollar drop starting last October pushed the EAFE/S&P ratio higher. Generally speaking, a weaker dollar since late 2005 has given a boost to foreign stocks. Let's see what's going on now.

Chart 2

FOREIGN STOCKS ARE SLIPPING ... Chart 3 compares the Dollar Index (green line) to the EAFE/S&P 500 ratio (red line) over the last year. The inverse relationship between the two lines are clearly visible. Two things are worth noting. One is that the Dollar Index has been bouncing since December (green arrow). The second is that the EAFE/S&P ratio has stalled below its May 2006 high (red arrow). That suggests that recent dollar firming is causing some hesitation in foreign stock leadership.

Chart 3

DOLLAR IS TESTING 200-DAY AVERAGE ... Chart 4 shows why the Dollar Index is at a crucial chart point. It's in the process of testing its falling 200-day moving average. The USD has been trading below that long-term resistane line since last spring. The last rally attempt during October failed at the 200-day line (first red arrow). What the dollar does from here should influence whether foreign stock outperformance continues (a weaker dollar) or if U.S. stocks stage a comeback (a stronger dollar). What the dollar does from this point may also determine what commodities do.

Chart 4

GOLD STILL TESTING RESISTANCE BARRIER ... Last week I showed gold testing chart resistance at its summer peak just above $660. After backing off from that barrier on Friday, it's bouncing again. Chart 5 shows that the direction of the Dollar Index (green line) has an influence on gold prices. Gold does much better when the dollar is falling. Both markets are now in a testing phase. While gold is testing its summer high, the dollar is testing its 200-day moving average. One of them is going to fail that test. That's another reason to keep a close eye on the dollar.

Chart 5

BOND YIELDS BACK DOWN ... One of the factors influencing the direction of the dollar is U.S. interest rates. The rally in the dollar started last December just as U.S. bond yieldd started to climb. Chart 6 shows, however, that the 10-year Treasury Note yield (TNX) has fallen back below its October high (near 4.85%) and its 200-day moving average. That's giving a short-term boost to bond prices, but may also help weaken the dollar. The drop in bond yields may also explain this week's upside breakouts in rate-senstive groups like financials and utilities (Chart 7).

Chart 6

Chart 7

SOX IS PULLING NASDAQ LOWER ... The Nasdaq is the only major stock that didn't hit a new recovery high over the past week. Part of the reason for Nasdaq underperformance is a weak semiconductor group. Chart 8 shows the positive correlation between the two indexes over the last five years. The Nasdaq Composite (black line) has done much better than the Semiconductor Index (red line) since both bottomed in the autumn of 2002. But they have tended to rise and fall together. In other words, the Nasdaq does better when the SOX is bouncing. The vertical bars in Chart 8 are drawn at six SOX bottoms since 2002. Each SOX bottom concided with a Nasdaq bottom (although the Nasdaq rallies were stronger). Chart 9 compares the two indexes for the last year. The focus here is on the two negative divergences between the two. Last May, a falling SOX Index (red line) failed to confirm the upside breakout in the Nasdaq (black line). Both corrected downward. The second red arrow shows the SOX failing to confirm the January 2007 breakout in the Nasdaq. That tells us that the Nasdaq is unlikely to join other stock indexes in new high ground until the SOX Index starts to strengthen.

Chart 8

Chart 9

INTERNATIONAL PAPER PLAYING CATCH UP ... Basic materials have been the strongest market sector in the new year. Most of that leadership has come from chemicals and steel, which we've commented on before. Paper stocks, which have been sector laggards, are starting to play catchup. International Paper is one of the top material performers over the last week. And it's chart looks promising. The daily bars in Chart 10 show that IP has been trading sideways since last spring in an apparent "symmetrical triangle". [That occurs when price trades between two converging trendlines. Since the prior trend was up, it's a bullish pattern]. What caught my eye was this week's break of the upper trendline. And also the notable pickup in trading volume. Another stock in the same group that's already reached a new 52-week high is MeadWestvaco. The weekly bars in Chart 11 show that stock breaking through the highs of last spring. Finally, the point & figure boxes in Chart 12 show the Dow Jones US Paper Index achieving a "spread triple top" breakout. The green box shows the DJUSPP trading at 158 for the first time since May.

Chart 10

Chart 11

Chart 12