Expect the Dollar's Uptrend to Be Negative for Stocks

Stock market trends generally run for several months at a time, which is why the Wall Street saying "the trend is your friend" has so many adherents: Go with the trend, and your odds of reaping gains are higher.

But the market is often coy about announcing its next direction, especially when the trend is about to reverse. These periods are often marked by indecisive, range-bound trading or trendless swings up and down that give off mixed technical signals.

Nonetheless, technical analysis offers tools for discerning potential trend changes. For instance, back on June 30, I wrote about technical reasons why a market rally was likely, and the market began a multiple-month surge a few days later. In August, I laid out the technical case for a continued uptrend, shortly before the heady September rally exploded out of the gate.

More recently, the charts have been issuing caution flags, as I discussed in November.

A technical case can be made that the key relationship to watch now is the dollar-stocks see-saw: In the past, when the dollar has dropped, stocks have risen sharply, and when the dollar has risen, stocks have fallen. Recently, as the eurozone debt crisis has once again come to the fore, the dollar has surged and stocks have dipped. The see-saw seems to still be in effect.

Dollar Goes Up, Stocks Go Down

The see-saw is easily visible if we pull up two charts: one for the U.S. Dollar (DXY), and one for the Dow Jones Industrial Average (DJIA).

Despite the market's recent resilience around the psychologically important 11,000 level, the Dow chart is displaying obvious signs of weakness:

• The moving average convergence-divergence indicator (MACD) and the relative strength index are both declining.

• Both indicators have broken through the neutral line. Note how the MACD breaking below the neutral line has presaged significant declines.

• The Dow has fallen below both the 20-day moving average trendline and the technically critical 50-day moving average (MA). The last time the Dow broke below the 50-day MA, a major decline followed.

The chart of the dollar index below is nearly the reverse image, showing major signs of a strong uptrend:

• The 20-day moving average has crossed through the 50-day moving average, a bullish cross that reflects a rising trendline. The last time this bullish cross occurred in December 2009, the resulting rally ran for six months. The current dollar rally has run for less than a month, suggesting the uptrend has lots of room to run.

• The chart of the relative strength index indicates that a strong uptrend is under way.

• The MACD has crossed above the neutral line. When this has occurred in the past, major rallies have followed.

• The last eurozone debt crisis triggered a dollar rally to the 88 level. Many analysts see the current eurozone debt crisis as much more serious than the first one in May, so we should anticipate that the current rally in the dollar could exceed that high.

What would such a powerful rally in the dollar do to U.S. stocks?

While the dollar-stocks correlation is imperfect -- for relatively brief periods of time, both can rise in tandem -- the long-term trend is clear: Dollar weakness is correlated to stock market strength, and vice versa. There is little technical evidence to suggest this correlation will break down in the near term.

For further technical clues about the market trend, let's look at a five-year chart of the Dow.

Trading Bands

The Dow has reached a trading range which has technical significance going back to 2006 and even to 2001 (not shown). This range, roughly 11,000 to 11,400, has marked a band of resistance and support, meaning that the market has found support around the 11,000 mark and resistance around the 11,400 level.

In 2006, the market bounced around this band for months before finally breaking into a yearlong rally to new highs.

In 2008, the July jitters found support around 11,000, but late-summer rally attempts could not break decisively above the trading band. When the global financial crisis hit in September, the Dow pushed downward through the 11,000 barrier and subsequently lost 40%.

With global financial worries once again on the rise, there are strong technical reasons to view 11,000 as a "line in the sand" for the market. Many technicians see the precise line as the 200-week moving average, currently around 10,935.

Were the Dow to punch down through this key line of support, another trading band between 9,000 and 9,500 comes into play. This trading range offered support and resistance on the way down to the March 2009 lows and also on the way back up through the 9,000 level.

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Were the Dow to settle back to the middle of this range, that would be a roughly 16% decline from its current level.

It's always possible that the see-saw relationship between dollar values and stock values will abruptly end, but until we see solid evidence for this, it's smarter to let history be our guide, and recent history suggests the stock market downtrend will last as long as the dollar rally persists. The visibly weakening long-term chart of the Dow adds further credibility to this hypothesis.

So keep an eye the "round number" level of 11,000 and the technically significant level just below at 10,935 for clues about the market's trend for the next few months.