FALLING DOLLAR BOOSTS COMMODITY PRICES -- RISING STOCKS ARE ALSO PULLING ENERGY AND INDUSTRIAL METALS HIGHER -- AGRICULTURALS ARE LAGGING BEHIND WITH PRECIOUS METALS -- STRONGER STOCK PRICES ARE DIMINISHING THE APPEAL FOR GOLD

FALLING DOLLAR BOOSTS COMMODITIES... My Thursday message showed the Power Shares Dollar Index Bullish Fund (UUP) on the verge of a technical breakdown. The weekly bars in Chart 1 show the cash version of the Dollar Index. It too has a bearish look by showing the US Dollar Index threatening to fall below a "neckline" drawn under its 2012 lows. That would signal a drop in the $USD to it 2011 lows. [Thursday's message showed most of the dollar weakness coming from rising European currencies]. One asset class that would benefit from a falling dollar is commodities. That partially explains why commodities ended the week on a strong note. The weekly bars in Chart 2 show the DB Commodities Tracking Fund (DBC) climbing to a three-month high (brown circle). [The DBC includes 14 energy, metal, and agricultural commodities]. Chart 2 also shows the dollar (top of chart) and commodities trending in opposite directions over the last two years. A "neckline" is drawn on the commodity index over its 2012 highs (which matches the bearish "neckline" on the USD). Commodities are also starting to play catchup to a rising stock market and stronger economic signals. In that scenario, economically-sensitive commodities like energy and industrial metals should be the biggest gainers. Agriculturals and gold are commodity laggards.

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Chart 1

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Chart 2

ENERGY AND INDUSTRIAL METALS ARE HIGHLY CORRELATED WITH STOCKS... Economically-sensitive commodities are the most highly-correlated to a rising stock market. That's because a rising stock market implies a stronger economy, which increases demand for industrial commodities. The two commodity groups most closely linked to stocks are energy and industrial metals. Chart 3 compares the PowerShares Energy Fund (DBE) to the S&P 500 (dashed line) over the last year. The tendency for both to move together is confirmed by a 60-day Correlation Coefficient of .71 (below chart). Crude oil has an even higher correlation of .91 to the stock market (while natural gas has negative correlation). Chart 3 suggests that energy prices are the biggest beneficiary of rising stock prices (as are energy stocks which have become market leaders). Industrial metals are also following stocks higher. Chart 4 shows the PowerShares Metals Fund (which includes aluminum, copper, and zinc) starting to follow the S&P 500 higher. The DBB has a positive correlation of .58 with the S&P 500 and is starting to rise. Copper has an even higher correlation of .78 with the S&P 500. That makes oil and copper two of the commodities most likely to lead commodities higher. Agriculaturals and precious metals may not do as well. [See next paragraph].

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Chart 3

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Chart 4

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Chart 5

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Chart 6

AGRICULTURALS AND PRECIOUS METALS LAG... Chart 5 (above) compares the PowerShares Agricultural Fund (DBA) to the S&P 500, and shows a weak correlation between the two. Agricultural commodities have barely bounced with stocks during 2013. In fact, the 60-day correlation with stocks is -0.76. [Agricultural markets also show the weakest historic correlation to a falling dollar]. In most cases, agricultural prices are determined more by weather conditions and crop sizes than the economy. Chart 6 (above) shows that a negative correlation (-0.64) also exists between stocks and the PowerShares Precious Metals Fund which includes gold and silver. Although gold usually benefits from a falling dollar, gold is negatively impacted by a rising stock market. Gold usually does better when stocks are weak. It does worse when stocks are rallying strongly -- as they're doing now. [Palladium and platinum (which aren't included in the DBP) are positively correlated with stock prices and are rallying accordingly. A strong auto sector is also adding to their appeal].

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Chart 7

NEW HIGH BY S&P 500 WOULD DIMINISH APPEAL FOR GOLD... I suspect that a major allocation shift is taking place out of gold and back into stocks for the first time in more than a decade. Chart 7 (above) shows that the major upturn in gold (up arrow) started during 2001 just as the stock market was entering a decade of stagnant prices at the turn of the century (red circle). Stocks have trended sideways since then which included two major bear markets. Gold was the world's top performing asset during that "lost decade" for stocks. The S&P 500 is nearing a test of its 2000 high. An upside breakout (which appears likely) would end a 12-year trading range and signal a much stronger outlook for stocks. That would diminish the lure of gold. Chart 8 (below) plots a "ratio" of the Dow Industrials divided by gold over the last two decades and shows the relative performance between the two assets. After rising for 20 years (starting in 1980), the Dow/gold ratio peaked in 2001 and has fallen in the decade since then. The last decade favored gold over stocks (falling ratio). The ratio has risen over the last year and broken a down trendline starting in 2007. It still needs to break the longer-range resistance line starting in 2001, but I suspect a bottom in the Dow/gold ratio has already been seen. That suggests that common stocks have become a better investment than gold.

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Chart 8

LONG-TERM PENDULUM SWINGS BACK TO STOCKS... With confidence in global stocks strengthening (and a likely "great rotation" out of bonds into stocks just starting), stocks should become the most favored asset class in the years ahead. Industrial commodities like copper and oil should benefit (along with stocks tied to them). Treasuries will probably be the biggest losers. Gold may benefit from a falling dollar to some extent, but probably won't do nearly as well as it did over the last decade because of rising stock values. As I suggested on Thursday, deflationary pressures (mainly coming from Japan) have dominated intermarket trends over the last decade, as well as Fed policy. A resurgent Japanese stock market (and tumbling yen) may be signalling a more reflationary global environment in the coming years. That would favor stocks and commodities over bonds. Rising Treasury bond yields in the years ahead should also dampen the appeal for gold.