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For mainstream media there is a daily need to "explain" what happened in the financial markets. Even if the daily change is modest, the world wants to know the cause. If you are a financial journalist, you are expected to come up with an answer.

Here we can take a more leisurely approach. In particular, we do not need to impose a theory of causation on some recent pattern of trading. This allows us to observe with a clear conscience:

It's all about the dollar.

The causal arguments come from all sides. For now, let us just observe the key relationship and work further on the causal model.

Background on "Weighing the Week Ahead"

There are many good services that do a complete list of every event for the upcoming week, so that is not my mission. Instead, I try to single out what will be most important in the coming week. If I am correct, my theme for the week is what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.

In most of my articles I build a careful case for each point. My purpose here is different. This weekly piece emphasizes my opinions about what is really important and how to put the news in context.

Last Week's Data

As usual, there was plenty of discussion about last week's data. There was really nothing significant.

The Good

  • Market action. The market continues to react postively, even when economic news is weak. The assumption of Fed action remains in full force.
  • Early earnings reports have been excellent, including positive comments on the business environment. We are seeing an 83% "beat rate" and an increase in forward earnings forecasts. Despite some skepticism, the forward earnings forecasts have been very good in the last decade.
  • We are about to see the "Golden Cross" in the S&P 500. This means that the 50-day moving average moves above the 200-day average. It is a good read for those wanting to be on the side of the major trend.
  • Limits on the foreclosure problem. We'll eventually know if the predictions are correct. For now, the consensus opinion is that there is a limit to the impact from the "robo-signing" issue.

The Bad

The economic news was somewhat negative. The factors related to signficant improvement in employment where unimpressive.

  • Initial jobless claims moved slightly higher, but remain at levels that do not signal improvement in the overall employment picture.
  • There was plenty of spin on the housing data, but I emphasize a leading housing indicator -- building permits. This is a good series, since the permit requires a real commitment and it is a true leading indicator. Since building permits fell 5.6%, this is a negative despite the increase in housing starts.
  • The Beige Book was mostly irrelevant, but the anecdotal evidence indicated only a slight economic improvement.

It is difficult to label "good" and "bad" when the market is responding in a contrary fashion. For most of the last two weeks the focus has remained on the propects for aggressive quantitative easing by the Fed. For several weeks I have suggested that this is the topic to understand. Last week I showed you what to read. If you understand the QE2 arguments you will be ahead of most of the traders.

The Mysterious

Understanding recent market action has a bit of mystery. In one sense, the explanation is obvious. The stock market is moving inversely with the dollar.

They mystery is why. In the long run a strong dollar is good for US equities. In the short run, the correlation has been very negative. The same can be said for bonds.

I am working on an update to my article from last year, a favorite piece that showed both of these relationships. For the moment, let us just say that my daily observations suggest that nothing has changed.

The Week Ahead

The market has continued to improve in tone, but the reasons are troublesome. Daily gains still relate to a weaker dollar rather than economic strength. Economic weakness is excused as more evidence that the Fed will act aggressively.

Next week we will see updated sentiment data and the Chicago PMI. These will provide an idea about the October employment report.

We also will see an increased focus on the mid-term elections with plenty of polling data. I expect a tightening of the races. The outcome will still be a form of gridlock, but with a less Republican emphasis. It is a modest change in expectations.

Our Own Forecast

As we have been for most of the recent rally, we remain bullish. With few sectors in the penalty box, there are more attractive ETF choices in addition to many low P/E stocks with good yields. We continue our multi-week bullish posture in the weekly Ticker Sense Blogger Sentiment Poll. Here is what we see:

  • 87% of our 55 ETF's have a positive rating, down from 91% last week.
  • 16% of our 55 sectors are in our "penalty box," down from 35% last week. This means that there are many attractive sector and stock opportunities, and a reduced level of risk.
  • Our universe has a median strength of +28, down slightly from +43 last week.

For trading accounts, we had full exposure during the past week, continuing to catch the recent rally.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]

Thinking Ahead

The relationship bewteen the dollar and equity prices is an interesting challenge. Your causal model could take many different forms, but here are the three principal choices:

  1. A weak dollar increases corporate earnings and therefore stock prices;
  2. Increasing stock prices drive the dollar lower; or
  3. An unspecified factor is the real cause, pushing the dollar lower and stocks higher.

Answering the causation question correctly can help in making a solid investment decision.

Meanwhile, I see the inverse relationship as important for short-term trading, but not for long-term investing.

Source: Weighing the Week Ahead: It's All About the Dollar