What the Stocks vs. Dollar Seesaw Is Saying Now

Dollar-stocks seesaw
Dollar-stocks seesaw

Readers of DailyFinance may recall that I highlighted bullish technical evidence in late June, just before the rally gained its footing, and again in July when sentiment was still negative. That's because when the majority of commentators and investors are leaning heavily one way, a contrarian strategy often offers a better return than running with the herd.

Recently, I reported that bullish sentiment had reached nosebleed heights. And with the market soaring last week to new annual highs, that only makes contrarians more nervous about the uptrend.

Contrarians are also skeptical of the overwhelmingly bearish sentiment for the U.S. dollar, which has plummeted 15% since the Fed announced its plans for QE2, or second quantitative easing program, this summer. The Federal Reserve's explicit policy goal of creating inflation has fueled dramatic rises in gold, silver and commodities such as wheat and corn as investors flee the dollar in anticipation of inflation ahead.

By at least one measure, the percentage of dollar bulls has fallen to a wafer-thin 3%, while bullish sentiment on stocks has risen to multiyear highs.

Are the two sentiments related? The short answer is yes. The dollar and equities have been playing seesaw for some time: When the dollar spikes up, stocks drop, and when the dollar falls, stocks soar.

We can see the correlation in the charts of the S&P 500 ($INX) and the dollar.

This seesaw is called inverse correlation, and it suggests that these alignments aren't just random coincidences. Though no correlation between two markets with vast numbers of inputs is ever perfect, it's nonetheless striking how the dollar rose in late 2008 as equities crashed. Each reached its extreme at about the same time: early March 2009.

In early 2010, as murmurs about a brewing sovereign debt crisis in Europe grew louder, the U.S. stock market continued chugging higher, paralleling the dollar's ascent. For a couple of months (March and April), it seemed as if the inverse correlation had been broken, and that equities and the dollar could rise together.

In hindsight, the dollar's steady rise was a warning that the eurozone's debt problems weren't as "under control" as EU authorities were claiming. Once the deteriorating situation exploded into crisis, U.S. stock markets fell as the dollar rose.

Once again, the dollar topped and stocks hit their lows at around the same point -- this time, in June. Under the influence of the Federal Reserve's announcement of another round of unprecedented monetary intervention, the dollar has sagged almost 15% since June, while stocks have climbed an impressive 19%.

Dollar Bears Are Stock Bulls -- and Vice Versa

This long-term correlation makes sense when we consider how many major U.S. corporations earn 50% or more of their revenues overseas. If the dollar declines, then the euros that U.S. companies earn from sales in Europe will translate into more dollars when that company reports its earnings. Thus, it's little wonder that corporate earnings have been so strong as the dollar lost value against the euro, the yen and other major currencies. Actual overseas revenues may have barely budged, but when reported in dollars, the numbers rose smartly.

This is another reason for contrarians to be skeptical of the stock market's powerful September-October rally. How much of those fatter profits were the result of foreign exchange rates rather than actual growth in revenues and margins?

Given the inverse relation between stocks and the dollar, then market bulls are almost by definition dollar bears. And the few dollar bulls are thus bearish on stocks. Other than a during few brief periods now and then, the two will stay on that seesaw.

Dollar May Not Be Doomed

The chart of the S&P 500 (above) displays both a measure of simple volume and a volume oscillator (PVO). The oscillator reflects the strength of a trend, be it bearish or bullish. Note that the sharp rise in stocks from February through early May registered a very strong volume trend. In comparison, the rally in September and October was weak.

If "volume is the weapon of the bull," as the Wall Street truism has it, then this chart suggests a weakening bull trend.

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Those expecting the dollar to fall further have another truism on their side: "Don't fight the Fed." But the dollar's value relative to other currencies isn't controlled solely by the Fed: Other nations can "push back" by buying dollars. And as the world discovered in late 2008 and mid-2010, when financial crises start popping up in other parts of the world, the U.S. dollar starts looking rather safe and attractive in comparison.

When global capital decides to flow into dollars, the limits of the Fed's quantitative easing program to manipulate the dollar are revealed. After all, the Fed's first easing program was in full force during the first half of 2010, and the dollar responded to that massive attempt to suppress its value by rising about 15%.

The idea that the dollar is doomed to further erosion because the Fed wills it is also called into question by the long-term chart of the dollar below. Since bottoming in mid-2008, the dollar has traced out a classic uptrend of higher lows. At the same time, its highs have been slightly lower as well, setting up a potential "flag pattern," in which the range narrows and then breaks out higher or lower.

As sovereign debt issues heat up in Ireland, the Europe-wide government debt crisis is flaring again. Given the dollar's deeply oversold condition and the reemergence of eurozone debt as a crisis-in-waiting, it wouldn't take much to spark a reversal in the dollar that would knock the legs out from under the stock market rally.

We've seen that very same scenario play out twice in the past two years -- a third repetition is far from impossible.