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The U.S. Dollar Index is trading $79.80 after bouncing off of the 20-day moving average of $79.55. It's very hard from a fundamental viewpoint to be a dollar bull; however, European contagion fears and rising yields despite QE could be the Grinch that stole the Santa Claus Rally.

Equity futures continue their strong uptrend last evening, hitting $1,235 -- well above the 68.1% Fibonacci retracement from the 2007 S&P highs to the March 2009 S&P lows. In any other market this would be a very bullish development, finally breaking above the April top in a meaningful way. However, many of the economic crosscurrents are at odds with continued strength in equities. 50% of Americans polled said they are worse off this year than last year financially, and unemployment is back around 10% despite a myriad of stimulus programs, EPS gains, and treasury buying from the Fed.

The biggest threats to new highs (I would target $1,310 to the upside if the gains hold above the $1,228.75 68.1% Fib.) are three factors at play: Treasury yields are rising, meaning that homeowners, bond investors, borrowers, and highly leveraged companies will be hurt and economic activity will slow because of lower borrowing and deleveraging; deleveraging will cause the dollar to rise against other currencies to the extent that rising yields will attract new capital to the greenback; and savers who presumably would like to make investments but lack income will benefit from a rising yield trend -- but the risk off trade via a rising dollar could resume and hurt stocks.

The key levels to watch on the dollar index are the 20-day MA at around $79.5 and the breakout in bond yields. If the real-estate market has to absorb higher mortgage rates, the highly leveraged financial system could face the risk of another downturn from falling real estate values.

Conversely, the forces of QE are weakening the dollar, putting a bid under stocks, and fueling a rush to the commodity and PM markets.

To create a less volatile stream of returns, I am hedged in stocks until a confirmation of the uptrend is made (that or I find more bargains): Long TBT calls, RJI, SLV as of today, DBA, COW, etc. By investing in the TBT I have a potential winning investment if rates rise; if they fall instead, stocks will likely sell off and I will be able to buy cheap names. If the dollar rises, stocks will also get cheaper and I can buy back in at better prices. If the dollar falls, TBT will likely rise, DBA and RJI will rise, and the hedged stocks will not dampen the returns too much, if at all. I am also long some puts on VNQ, the Vanguard REIT index in case of downturn in real estate or a realization by investors that REITs aren't that cheap here.

Stocks I like for value reasons are Duckwall-ALCO Stores (DUCK), Freeport-McMoRan Copper & Gold (NYSE:FCX), Vale (NYSE:VALE), Chesapeake Energey Corp, (NYSE:CHK), Kansas City Life Insurance (NASDAQ:KCLI), Total S.A. (NYSE:TOT), Chevron (NYSE:CVX), Pepsico (NYSE:PEP), McDonalds (NYSE:MCD), A.C. Moore Arts & Crafts (NASDAQ:ACMR), Hastings Entertainment (NASDAQ:HAST), Audiovox Corp. (NASDAQ:VOXX), etc..

Some of these names I own with covered calls, but as the futures are very green at the moment, I do regret not front-running some pomo money like everyone else is here.

Whatever happens, it will be interesting to see if the dollar can hold the 20-day, if TBT can close over $38.28 (the previous four-month high), and if the S&P can break $1,250 or so. New five-year highs in the Nasdaq would hasten me to rethink some asset allocation on the short side, as well as buying some additional Cisco (NASDAQ:CSCO) and Intel (NASDAQ:INTC) along with Apple (NASDAQ:AAPL).

All in all, pretty much the same thesis I have had since early October. Some of the momo plays are appetizing potential shorts, but put options are the only way to play them here, and the insurance should be considered only for protection against existing long positions. The move higher here seems to be a bit exuberant, but the market is the market and Mr. Market will trade this at whatever prices he sees fit.

Disclosure: I am Long DUCK, FCX, VALE, CHK, KCLI, TOT, CVX, PEP, MCD, ACMR, HAST, VOXX.

Additional disclosure: I own all stocks mentioned and often trade around core positions. I am hedged in stocks and long commodities and land.

Source: Stocks Look to Break Out, But if Dollar Strength and Rising Yields Continue - Look Out