THE DOLLAR INDEX MAY BE IN THE PROCESS OF BOTTOMING -- INTERMARKET IMPLICATIONS RESULTING FROM A STRONGER DOLLAR INCLUDE WEAKER COMMODITY PRICES -- A FIRMER DOLLAR MAKES U.S. STOCKS MORE ATTRACTIVE
INTERMARKET IMPLICATIONS OF A STRONGER DOLLAR... The monthy bars in Chart 1 suggest that the U.S. Dollar Index may be going through a major bottoming process. After peaking during 2002, the USD fell steadily until 2008 when it bottomed. Since then, it has been trending sideways in what appears to be a potential bottom. The 2011 dollar selloff bounced off its 2008 bottom which sets up a potential "double bottom". It has rallied since then, but still needs to clear its 2009/2010 highs just below 90 to turn its major trend from "sideways" to "up". But it's not too soon to start considering the implications of a stronger dollar. One asset class that would be negatively impacted is commodities. A stronger dollar would have a depressing effect on commodity prices. Another area that would be effected by a stronger dollar is the relationship between U.S. and foreign stocks. A firmer dollar favors U.S. stocks over foreign stocks.
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Chart 1
FIRMER DOLLAR HURTS COMMODITIES... One of the most consistent intermarket links is the inverse relationship between the dollar and commodity prices. Chart 2 shows that the collapse in the Dollar Index during 2002 coincided with a major upturn in the CRB Index (solid area). Since 2008, however, a firmer dollar has depressed commodity prices. The two CRB peaks during 2008 and 2011 coincided with dollar bottoms (see arrows). Commodities have established a pattern of "lower highs" between 2008 and 2011 (see trendline). And that's during a period when the Dollar Index has been trending sideways. Imagine what impact a dollar uptrend would have on commodity assets.
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Chart 2
RISING DOLLAR FAVORS US STOCKS... Chart 3 demonstrates how dollar direction influences the relationship between U.S. and foreign stocks. The blue line is a "ratio" of the MS World Stock Index - ex USA divided by the S&P 500. The direction of the blue ratio line tells us whether U.S. or foreign stocks are doing better. Notice that the blue line trends in the opposite direction of the U.S. Dollar Index. The foreign/S&P stock ratio turned up during 2002 when the dollar peaked and continued rising until 2008. The peak in the foreign/ US stock ratio coincided with the dollar bottom. The falling ratio since 2008 shows that foreign stocks have done a lot worse than those in the U.S. over the last four years. The firmer dollar has had a lot to do with that. If the dollar is in fact bottoming, that would suggest that U.S. stocks will be a better place to be than foreign stocks.
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Chart 3
CRB TESTS 2011 LOWS... Chart 4 shows the CRB Index in the process of retesting its 2011 lows after falling sharply since March. That's very important test for the asset class. A drop below 2011 lows would weaken the chart picture even further. That might also have a negative impact on stocks because both markets have shown a tendency to rise and fall together since 2008. The falling Correlation Coefficient (below chart) shows that their corrrelation has weakened over the last two months. I can't help but wonder, however, if commodity weakness is starting to weigh on stock prices. Both are barometers of global economic strength. Having said that, I think a case can be made that stocks are in a much better position than commodities which would reverse the trend of the past decade. That will be especially true if the dollar continues to strengthen.
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Chart 4
ASSET ALLOCATION TREND FAVORS STOCKS OVER COMMODITIES... Chart 5 plots a "relative strength ratio" of the S&P 500 divided by the CRB Index over the last 15 years. Stocks had been the stronger asset class in the final two decades of the last century. That started to change around 2000 when the stock/commodity ratio showed signs of peaking. The falling ratio between 2000 and 2008 meant that commodities were the stronger asset. During those eight years, the CRB Index gained 44% versus a 1% loss for the S&P 500. The ratio bottomed during 2008, however, and has been rising since then. Since mid-2008, the S&P has gained 6% versus a -36% loss for the CRB Index. The stock/commodity ratio has broken its decade-long downtrend line and has exceeded its 2010 peak. That rising trend suggests to me that stocks have become the stronger asset class and should continue to remain so. A stronger dollar may have a lot to do with the reason why.
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Chart 5
BRITISH POUND IS STRONGEST EUROPEAN CURRENCY... The Euro has been weighted down by problems in the Eurozone. Some Euro funds are finding their way to the safety of the U.S. Dollar. Some of it is staying in Europe, however, but not the continent. Chart 6 compares the falling Euro trend (blue bars) to a rising British Pound (red line). The divergence between the two currencies is most striking since the start of the year. Money leaving the Euro has to go somewhere. As I said, some is moving to the the perceived safety of the U.S. Dollar and some to the Japanese yen. Since Britain is not part of the continent (and isn't part of the EMU), its currency is more immune from continental problems. That's attracting funds to the pound as an alternative to the dollar.
