Dow To Suffer 10% Decline

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Includes: DIA, DUG
by: Michael Markowski

The US stock market or the Dow Jones 30 Industrial Composite Index (NYSEARCA:DIA) is in danger of declining by 10% to 15% from its closing level of 12,414.79 on June 6th to between 10,300 and 10,906. My predicted decline is based on the spread between the Euro and the Dow, which has been widening since November 30, 2011. The Dow could also decline by more than 15% should the Euro fall to new 24 month lows against the Dollar.

For most of the period since 2000 in which the Euro has been a reserve currency, its movement has predicted the direction of the major US stock indices. Since 2000, long, steady downtrends for the Euro's exchange rate versus the US Dollar have resulted in long, steady downtrends or bear markets for US stocks and vice versa. For example, the Euro declined steadily by 18% from its 2000 high in the first week of January to a new all time low ten months later in October of 2000. During the same ten months the Dow fell by 7.5%.

The Euro also predicted the bottom for the Dow in October of 2002. After bottoming in 2001, it began a long steady climb in January of 2002 and gained 10% versus the Dollar in the first half of 2002. Three months later in October of 2002, the Dow made its bear market bottom. The Dow advanced by more than 25% during the Euro's steady climb from the summer of 2002 to its new all time high versus the Dollar in November of 2004. From January 2006 both the Euro and the Dow steadily climbed towards all time highs which they achieved in late 2007. Both racked up gains in excess of 20% over the two year period.

In the summer of 2008, the Euro hit its all time high against the US Dollar and began a steep descent. During the week of September 29th, it effectively crashed, when it fell by 5.5% as compared to its previous week's level. For the week of October 6th which was one week later the Dow declined by over 6%. When the Euro had skidded to its two year lows against the Dollar in mid November of 2008, it had fallen by an additional 9.4% as compared to its level in the last week of September 2008. During the same period the Dow declined by 23.7% to 8,497.

Click to enlarge.

EURUSD 5 yr chartClick to enlarge

For the past 24 months the relationship between the Euro and the Dow has been erratic. During the first half of the two year period or for the twelve months ended June 2, 2011, the Euro and the Dow had been tracking each other. Two years ago on June 2, 2010 the Euro's exchange rate was 1.22. One year later on June 2nd of 2011 the Euro's exchange rate climbed to 1.44, an increase of 18.0% versus the Dollar. During the same period the Dow went from 10,249.54 to 12,248.55, an increase of 19.5%.

Over the last 12 months the Euro's and the Dow's trends have diverged. The Euro declined by 13.8% to 1.24 and is now less than two percent above its two year June 2010, low of 1.22. The Dow over the same period went from 12,249.54 to 12,414.79, which was an increase of approximately one percent. However, the Dow most recently was 1,869 points or 19.2% higher than 10,249.54, which is where it was trading on June 1, 2010.

As displayed in the chart below the divergence between the Euro and the Dow became more pronounced and the spread began to widen on November 29, 2011 when the Dow bottomed at 11,231.78 and the Euro was at 1.32. Since then the Euro fell to 1.24, which is a decline of 6.0%. The Dow has increased by 8.3% to 12,414.79, which was its June 6, 2012 close. With the 6.0% decline in the Euro and the increase in the Dow by 8.3% the spread between the two has widened to a combined 14.3%.

EURUSD 2 yr chartClick to enlarge

Since the Euro's inception as a currency, there have been only two other times in which the spreads between the Euro and the Dow were as wide as the current one. Both resulted in declines of more than 10% for the Dow and also for the larger S&P 500 index. The first occurred in November of 2000, when the Dow was approximately 10,600. By October 1, 2001, one year later the Dow was at 8,847, a decline of 16.5%. The second occurred in August of 2007 with the Dow at 13,239. One year later in the August of 2008, it had fallen to 11,734 for a decline of 11.4%.

EURUSD 12 yr chartClick to enlarge

Long term trend divergences between the Euro and the Dow always result in a widening economic spread. The spread between the two has no choice but to eventually narrow and close. Its because its economically or mathematically impossible for any large economy such as the USA's which represents 23% of the global economy to steadily grow while its currency is also steadily appreciating against the currency of an economy which is even larger than it's such as the European Union which represents 25% of the world's economy.

The European Union and US are by far the world's two largest economies. Together they represent 48% of the total global gross domestic product (GDP). The third largest economy is China and it accounts for 10% of global GDP. Since the two biggest economies are almost equal in size any "significant change" in the exchange rates between their two currencies will have "significant impact" on both of their economies. For example, a 20% decline in the Euro versus the Dollar lowers the price of Airbus' airliners in Euros by 20% or raises the price of Boeing's (NYSE:BA) jets in Dollars by the same percentage. The same would be true for European and US automobile manufacturers.

The only possible outcomes from the widening spreads are severe corrections for stock market indices such as the Dow and the S&P 500. Its for two reasons. The first is that the indices are much less liquid than the currency markets. The second is that 43% of all of the revenue of the 30 companies who are members of the Dow are generated from outside the US borders. The percentage includes both Verizon (NYSE:VZ) and AT&T (NYSE:T), who generate 100% of their revenues within the United States.

When the Dollar appreciates against the Euro, products produced in the USA and sold to Europeans become more expensive. Procter & Gamble (NYSE:PG) is a good example of what can happen to a US company when the US Dollar appreciates significantly against the Euro. After its revenue and profits hit all time highs for its Fiscal Year ended June of 2008, which was its 7th consecutive year since 2002, its revenue and profits fell by 3% and 5% respectively for its 2009 and 2010 Fiscal Years. The declines were attributed to the strength of the Dollar versus the Euro.

The Euro's 20% decline from its July 2008 peak to its November 2008 low was a direct cause of the 2008 stock market crash and the ensuing 2009 recession. Shrewd investors who are very aware that sudden and significant changes in currency exchange rates can have a significant impact on an economy hit the bids in late September of 2008. While many may believe that Lehman's bankruptcy caused the stock market crash of 2008, I disagree. The Euro did not fall by 3.9% in one week and skid to its new 52 week low until two weeks after Lehman declared bankruptcy. During the same week the Dow fell by 2.4% to 11,143. Three weeks later or the week of October 20th the Euro had fallen by an additional 8.7% and the Dow had fallen by an additional 20.6% to 8,852 over the same three weeks.

The industry with the most risk due to the significant changes due to the Euro's exchange rate versus the Dollar is the Oil industry. Oil is among the few global commodities that are priced only in US Dollars. Therefore, the 13.8% decline in the Euro versus the US Dollar over the last 12 months effectively raises the price of oil in Euros by 13.8%.

Since oil is an elastic commodity the demand for it in Europe will continue to decline as the price of oil in Euros increases. As demand decreases from the world's largest economy the price of oil in Dollars must adjust downward. Otherwise, the oil producing countries who have oil surpluses will not be able to liquidate. Another reason why the price of oil could go significantly lower is because the chances are increasing that both the European Union and the US could enter into recessions. Should that happen the demand for oil will decline and so will its price.

The share prices of oil companies could decline by more than 15% and if the Euro continues to make new lows against the Dollar the price of oil could continue lower as well. One of the trading vehicles that can be utilized to participate in potentially lower oil prices and the share prices of oil companies is the Pro Shares Ultra Short Oil & Gas ETF (DUG).

The industries that will benefit from lower oil prices are the airline and shipping industries. The consumer retail store industry in the US will also benefit from lower gasoline prices.

Disclosure:

I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.