Don't Put Your Money on the Dollar Yet

11/30/2009 1:00 pm EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, editor of The Option Advisor, warns that the dollar is still weak technically, and a rebound doesn’t look like it’s in the cards any time soon.

Numerous “gloom and doom”-type gurus (whom one would normally expect to be touting gold) have instead embraced the idea of a dollar recovery. [Recently,] Barron’s Onlineused the occasion of Treasury Secretary Geithner’s obligatory declaration in favor of a stronger US currency to present a noted technical analyst’s  (i.e., Martin Pring—Editor) case for a dollar rebound.

In addition, option buyers have been feverishly accumulating call positions in the PowerShares DB US Dollar Index Bullish ETF (NYSEArca: UUP).

So, why would the “Nouriel Roubini crowd” be embracing the dollar these days? My take is that it’s because the dollar has become the instrument of choice to finance the so-called “carry trades,” in which money is borrowed in dollars to purchase “risky assets” such as equities, junk bonds, and precious metals.

Roubini and company have been scolding us for many months now about how the stock market has gotten way ahead of itself and that another day of reckoning is near. And if they are correct, the carry trades will experience forced liquidation, and the dollar—which is in effect shorted to finance these trades—will experience a huge short-covering rally as occurred in late 2008 and early 2009.

A basic tenet of my contrarian philosophy is the “countertrend sentiment” rule, which states that the effectiveness of taking a stance in direct opposition to prevailing crowd sentiment is significantly enhanced if the crowd is betting against the current price trend.

When an asset that sports performance as dismal as the US dollar is being touted as a solid “turnaround play,” we have countertrend sentiment in action, which argues for the resumption of the prevailing trend (down, in this case), much to the dismay of the crowd.

Why? Because bullish sentiment in the face of weak price action indicates that the condition required for a market bottom—a “washout” under which the bulls have liquidated their positions—is not in place. And it is likely that the ultimate bottom will occur only when the prevailing bullish chatter has ended.

If in fact the dollar has not yet bottomed, is this an “all-clear signal” for the US stock market? Not necessarily, because there is no guarantee that the simple inverse correlation between the dollar and US equities will continue, as this relationship has certainly not always prevailed.

That being said, I do feel that a full-scale resumption of the dollar’s downtrend would create a bullish backdrop for stocks in the months ahead, due in large part to the big overlap at this stage between the dollar bulls and the equity bears.

Put another way, capitulation by the dollar bulls is likely to be accompanied by a parallel capitulation by many equity bears, which would add short-covering fuel for further equity gains.

(Editor's Note: In an interview with Paul Kangas on Friday's Nightly Business Report, Schaeffer said he thought the Dubai financial crisis would result in no more than a 5%-6% correction in the market.)

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