Dollar Holds Clues To Direction Of Equities

One of the key indices I always have front and center on my six screens is the dollar index.  The direction of the dollar gives us invaluable clues as to the state of monetary and fiscal policies (or at least the perception thereof) and global risk asset appetites.

Allow me to first briefly discuss some history of the dollar index before going into more detail on how I use the dollar index as an indicator.

Over the past thirty years the U.S. dollar has been in a continuous downtrend, one which if we consider the Federal Reserve’s monetary policies is unlikely to be over just yet.  The first chart shows the Dollar Index (DXY) performance versus the S&P 500 over the past thirty years.

While this long-term trend is to be kept in mind, in the more near-term time-frames the dollar often moves inversely to commodities and stocks.  Because most commodities are priced in dollars, when the dollar moves higher those commodities must move lower accordingly to compensate for the rise in the dollar since in this case the dollar’s move higher has nothing to do with the fundamentals of these commodities.

Stocks often move inversely to the dollar in the nearer time-frames as a result of monetary policy.  More accommodation monetary policy, either in the form of lower interest rates or as of late by way of quantitative easing (money printing) is then often viewed to be supportive of stocks while a further devalution/destruction of the U.S. dollar.

Since August 2011 the dollar index and the S&P 500 have both moved higher, yet the inverse relationship in the nearer time-frames of a few weeks to a couple of months are clearly visible by the many crossings of two lines on the following chart;

Currently, from a technical as well as a seasonal point of view the dollar index is in a bearish position.  For the better part of 2012 thus far the index has traced out a head and shoulders pattern which has its neck-line around the 79 mark.  Last Friday’s dollar strength (equity weakness) hasn’t much changed the chart and the dollar rally since mid September can also be viewed as a bear flag formation.  As a side note, a rally beyond 81 would nullify these bearish dollar formations.

What I am watching out for but not counting on should the aforementioned technical pattern play out is a break on the dollar index chart below the 79 level.  Such a move should then, at least  for a period of a few weeks, be bullish for equities and commodities.

I have calculated the correlations of all 500 stocks in the S&P 500 to the dollar index and hence will be focusing on buying the ones with the biggest inverse correlation should the dollar slides again.

The oil and gas services and exploration groups of stocks have a large inverse correlation to the dollar index.  The stock with the largest inverse correlation to the dollar index there is Schlumberger (SLB), and hence a stock I would be looking at from the long side in case the dollar index begins to slide again.




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