Ailing Dollar Should Drive Stocks Lower

Includes: SPY, TLT, USO
by: Deric Cadora

Back in mid-August I suggested to Members of The DOCument's subscription letter that stocks would decline to about SPX 1040 amid deeply negative sentiment and then launch a terminating rally into the vicinity of SPX 1140 that would then slowly roll over into a more extended decline. Thus far, the path taken by equities has been true to that view. Here is the current SPX chart overlayed with the conjecture I provided back in August:

S&P 500 daily chart

For Members who are reading this post, the original chart can be found in the August 15 letter.

Now, if equities are going to fall, they are going to have to do so as the dollar plunges into its 3-year low next spring. There are some very keen minds who believe continued dollar debasement will keep funds flowing into equities for the time being and push prices to new highs. I happen to disagree, and rather believe that the dollar decline will cause a crisis in and of itself that will drag down dollar-based assets, equities included, in its wake. Today's loss of DX 80 may be a key turning point in that shift in sentiment:

U.S. Dollar Index daily price chart

The loss of DX 80 has very bearish implications in my cycle analysis, and suggests that the dollar has at least 8 more weeks of generally lower prices ahead. A test of the 2009 low near DX 74 will likely occur by year-end and a crash below the 2008 low near DX 71 by spring will be the end move of the coming dollar crisis. Regardless of how much money the FOMC shovels into the banking system, I don't see how a plunging dollar will inspire big money to keep chasing dollar-based assets.

Although a top may be presently forming for stocks, I do not think it is time to go rushing heavily into a short trade. We will receive confirmation of this interpretation with plenty of time to get in front of the move. If I am right, price action should roughly take the following form:

S&P 500 bearish outcome

If I am wrong, we can expect price to test the April high in coming weeks:

S&P 500 bullish outcome

Given the bearish outcome, stocks could easily decline to test last summer's pivot around SPX 880 and perhaps further. We therefore have no reason to jump the gun. Sacrificing 50 handles or so is a small price to pay to take a higher-probability trade, and I suspect we'll have our answer by mid-to-late October.

In the meantime, keep an eye on oil and bonds:

Crude Oil daily price chart

Energy is the largest sector of the S&P 500 and stocks are not likely to resist an extended decline in crude price. Oil therefore acts as an important indicator ahead of any price confirmation we may receive from the S&P.

Treasury bond price chart

If big money is to flee dollar-based assets, their actions will certain show in the mother of all dollar-based assets: Treasuries. I suspect, however, that by the time the congestion zone fails, the S&P 500 action itself will have confirmed my view.

Disclosure: Short S&P 500 Calls