If the Dollar Stops Falling, the Stock Rally Could Be Over

As the U.S. dollar declines, U.S. stocks rise. As the dollar rises, stocks fall. The see-saw correlation between the two has been strong in the past month as the dollar tanked and stocks soared, but let's look at a 10-year chart of the Dow Jones Industrial Average (DJIA) and the U.S. dollar index to see if the correlation has held over time (see below).

Back in 2001, the U.S. economy was in a recession that officially ended that November. But unemployment continued to be high and growth sluggish long after the GDP bottomed in late 2001. In response, the Federal Reserve kept interest rates at unprecedented low levels for years.

As a result of this "easy money" low-interest policy, the dollar fell as money flowed into riskier, more lucrative investments in real estate and stocks. As we can see in these charts, the dollar's long decline was matched by the stock market's five-year Bull ascent.

That is a significant correlation over a significant period of time. Indeed, as the dollar plumbed multi-year lows in late 2007, stocks hit multi-year highs: when one end of the see-saw is up, the other is down.

The global appetite for risky assets purchased with highly leveraged credit created a bubble in real estate that popped in spectacular fashion in the 2008 global financial crisis. Suddenly all those high-flying assets purchased with borrowed money weren't worth enough to cover the loans, and all those "safe" derivatives based on those assets were revealed at not very safe at all.

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In the resulting "flight to safety," the dollar rose smartly while the stock market tanked. Investors exited risky assets for the safety of cash.

As governments around the globe responded to the crisis with massive stimulus spending and quantitative easing (flooding the financial markets with low-interest liquidity), the "risk trade" returned and stocks rose as the dollar slid.

The reason is risk and return: As the return on cash fell to near-zero, and the cost of borrowing money also fell to near-zero, then large financial players were encouraged to borrow money to buy higher-return assets such as stocks and higher-risk corporate bonds. This resulted in the dollar sliding as stocks and bonds rose in unison.

But then another financial crisis occurred in 2010, this time localized in Europe as the sovereign debt of smaller European Union nations fell perilously close to default. Once again, despite record-low yields on cash, risk-averse money flowed out of stocks and Euros and into dollar-denominated cash assets. Unsurprisingly, the dollar rose sharply and stocks swooned.

Now that the European debt crisis appears to have been averted (though a strong case can be made that the underlying problems remain unresolved), the dollar has declined and stocks have resumed their bullish climb.

This see-saw can be seen in these shorter-term charts of the Dow and the dollar starting in 2008.

In this closer view, the wild swings in the dollar become more apparent. In a currency market which usually trades in a range of a few pennies in any given a day, the dollar shot up over 20% in a few months. Once the crisis cooled, it fell just as precipitously.

Volatility: The New Normal?

Is such volatility in the dollar "the new normal"? The action in 2010 would certainly support such a contention, as the dollar leaped 19% in the Eurozone crisis and then entered a free-fall it has yet to pull out of.

Technically, there is key support around 74, not far below its current level around 77.

This tight negative correlation of the nation's currency with its stock market is troubling. Does the stock market only rise when the nation's currency goes into free-fall? A weak currency may be in vogue at the moment, but over time strong economies (think the British Empire in the 19th century and the U.S. in the 1950s and 1960s) have strong currencies and stable equity markets.

Gambler's Mentality

Wild swings up and down are not signs of stability or strength; rather, they are evidence of uncertainty and a gambler's mentality of getting in and out of various markets in response to rapidly changing perceived risk. Flooding the economy with nearly-free credit has certainly juiced the stock and corporate bond markets, but it has denied savers a decent return on their capital and reduced the nation's currency to volatility more befitting a penny stock than a strong global currency.

All this led me to joke with a friend recently that the dollar falling to zero would really drive stocks up. Clearly, destroying the nation's currency would not be good for stocks, or the nation's economy, yet this see-saw correlation is pointing to just such an equity-market dependence on a devalued dollar.

There are numerous technical clues that this unhealthy negative correlation may be unraveling. While the Dow has recovered most of the ground lost in the Eurozone debt crisis, it is now banging up against the key resistance of the 200-day moving average (MA) around 10,900.

Is the Rally in Stocks Sustainable?

The rally's declining volume has called its sustainability into question, as rising volumes are a key feature of enduring bull markets. The MACD (moving average convergence-divergence) indicator has been declining since January, further suggesting weakness in the rally, which is now extremely oversold on the stochastics reading.

While the current "story" on the dollar is that the Federal Reserve's next round of quantitative easing ("QE") will continue to push the buck down, there are technical clues that the dollar's presumably ordained demise might not be as guaranteed as many seem to believe.

Technically, the dollar is tracing out a potentially bullish series of higher lows on the long-term chart. While the MACD indicator is in a steep decline, suggesting further short-term weakness, the stochastics indicator is so oversold that a reversal may be order.

Technically, these are intriguing signs that the dollar, despite its current weakness, may be carving out a long-term bottom. If the dollar index holds at support around 74, that would offer further evidence that the dollar may be ending its long decline.

If the see-saw correlation with stocks hold, that would suggest strength in the dollar and weakness in equities going forward.