Watch the dollar! While the medium and longer-term trend is still down, the U.S. currency is looking like it wants to bounce

10/11/2010 12:02 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

When the IMF (International Monetary Fund) and the U.S. dollar go head to head, the dollar wins.

On October 6, in the second of its “World Economic Outlook” reports for 2010 the IMF was bullish on commodities, especially on base metals such as copper and tin.

“Commodity pries are projected to remain high by historical standards over the medium term, with risks tilted to the upside.” In other words we think commodity prices are going up, the IMF said, and the odds say that if we’re wrong, we’re wrong because prices will go up more than we project.

“The current era of higher scarcity, rising metal price trends, and a balance of price risks tilted toward the upside may continue for some time.”

Not surprisingly that day tin for delivery in three months rose by 3.1% on the London Metal Exchange to a record high of $26,790 a metric ton before dropping back slightly at the close. Copper climbed to $8,326 a metric ton, the highest price since July 2008.

The next market session, however, just one day later, copper was down 2.1%, gold is down 1% and silver is down 2%.

What happened? The IMF met a rally in the U.S dollar and the dollar won.

I still think the medium term trend for the U.S. dollar is downward but in the very near term of the next few weeks the dollar looks like it is staging a technical rally from an extremely oversold position. The dollar—actually anything from dollars to stocks to commodities—can fall so far so fast that traders see a chance to make money by going against the trend. In the short-term, a market that has fallen quickly can stage a rally that corrects part of the decline—and sets up the market for a further decline in the future. It’s the mirror image of the correction to a rally that sets up the market for a continued rally from a new base.

What can we expect from the dollar here? A replay of the dollar’s oversold bounce in early August seems a reasonable guide.

Back then the dollar had been falling like a stone since mid-May. Finally the currency got an oversold bounce in the first week of August. That bounce ran until August 23 or so before the dollar resumed its fall.

If that pattern repeats itself, investors can look for something like a dollar bounce of two to three weeks. And that would take us to something like October 21 to 28 before the medium term downward trend reasserts itself.

Note that this year several of the stock market’s strongest moves have been connected to the dollar. The top of the market in April coincides, roughly, with an end to the falling dollar. The rally that began in late August coincides, roughly, with the end of the dollar bounce and a resumption of the dollar’s fall.

Commodity prices and the prices of commodity stocks are the biggest drivers of that connection When the dollar is falling, commodity prices (this year anyway) climb and the price of commodity stocks go up with them. That sector—oil stocks, copper stocks, coal stocks, gold stocks, iron ore stocks, diversified mining stocks and then agricultural commodity stocks like the fertilizer group—is certainly big enough to get stocks moving up. If investors jump into other sectors, looking for other ways to participate in a climbing market, we get the kind of rally that covered most of September.

If I’m right about this—that we’re seeing a two to three week dollar oversold bounce—and the IMF is right not in the short term perhaps but about the upward direction of commodity prices in the medium term, then investors ought to use weakness in commodity stocks as a buying opportunity in October.

Watch carefully. It’s hard to predict when an oversold market will bounce, and it’s just as hard to predict how long an oversold bounce will run.

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