USD and Stocks Will Soon Reverse Roles

04/19/2011 7:00 am EST

Focus: STOCKS

In what will be a tremendous shift, an upside reversal for the dollar will send stocks and commodities sharply lower. Traders will have to be nimble and quickly shift longs to shorts, and vice versa.

So far in 2011, the equities market has made some sizable whipsaw-type moves, and even veteran traders have had difficulty being on the right side of the price action.

The year started out with equities being very overbought and overextended, making it virtually impossible for a low-risk trader to buy on pullbacks. This was primarily due to the fact that there were no real pullbacks other than for a day or two, which was immediately followed by prices continuing to grind higher.

In March, we finally had the pullback everyone was waiting for, and we caught 4% of the selloff using an inverse ETF. Then we saw the bottom a few days later and caught a 3% gain from near the lows during a rally higher.

So as you can see, there have been three trends in the S&P 500 so far this year, and we are about to see another sizable move unfold in the coming week.

In the past eight sessions, we have seen the market pull back slightly, and the big question everyone is asking is whether we get long or short here? Below are my thoughts and analysis.

US Dollar Index Daily Chart

The dollar is still in a very strong downtrend. As long as it continues to fall, we should see higher stock and commodity prices. I do feel as though there is more downside for the dollar, but it’s nearing an end.

Stepping back and looking at the longer-term chart of the dollar, it is very clear that it is getting oversold and a sizable bounce should take place. If we see the dollar break out of this falling wedge and start to rally, you will want to be short stocks and commodities.

chart
Click to Enlarge

NEXT: See Latest Technical Outlook for S&P 500

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S&P 500 Index Fund (SPY) Daily Chart

When comparing the Dow Jones Industrial Average and the Russell 2000 indexes, it is rather obvious that both have performed well this year and have broken above the February highs.

The Dow was strong because it is exposed to energy stocks, and with oil rocketing higher, it has helped those energy-based stocks lift the index higher.

The Russell 2000 consists of small-cap stocks, and with the general public still being so bullish on the equity markets, investors are buying volatile, high-risk small-cap stocks to help boost their gains.

Now, looking at the S&P 500, it has yet to break the February high, and this is because it holds several large technology and financial stocks, which have been lagging the overall market so far this year.

Tech stocks and financials tend to lead the market, and the fact that they are not is of great concern to me.

So going back to the US dollar, I feel as though it has a little more downward motion left, which will help get the S&P 500 to a new yearly high. Once the dollar rally starts, it will crush stock and commodity prices for several months.

chart
Click to Enlarge

In short, I favor the long side for both stocks and commodities, but that can change on a dime once the dollar starts to rally. There are many negative factors coming together that give me a negative outlook on stocks and commodities for the next two to four months. Those factors are:

  1. Quantitative easing is ending, thus promoting a rising dollar

  2. Investor sentiment is at an extreme bullish level, typically a bearish sign for stocks

  3. The time to “sell in May and go away” is almost here

  4. Earnings season is here, and this is typically a time when stocks get sold, producing lower stock prices

My final thought is to keep positions small and be ready to flip positions from long to short and vice versa, depending on what you trade.

By Chris Vermeulen of TheGoldAndOilGuy.com

For more on the important inverse correlation between the dollar index and stocks and commodities, see “One Thing Is Key for Gold, Oil, and Stocks.”

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