Dollar Must Stop Making Higher Lows For Market To Decisively Rally

| About: SPDR S&P (SPY)

While the market has broken the downward trend it began at the end of April and rallied over 4% from its June low to the July 4th holiday, a very important long signal in the U.S. Dollar (NYSEARCA:UUP) has recently appeared--the 6th higher low in the price of the Dollar since late August of 2011--undermining hope for a decisive S&P 500 (NYSEARCA:SPY) summer rebound.

Higher lows are just as important a signal as higher highs that Dollar accumulation is not subsiding, and that buyers are coming into the market faster than they are leaving it. A higher low in the Dollar, while an excellent entry point for those wishing to long UUP (a useful investment vehicle for profiting from gaining strength in the Greenback) has recently been, as we shall see below, a very reliable exit signal for those long equities--especially broad indices such as the S&P 500 .

In the chart below we can see the U.S. Dollar (dashed green line) plotted against the S&P 500 (solid blue line). The green arrows indicate intermediate-term lows on the U.S. Dollar; the red arrows indicate multi-week tops on the S&P 500. The solid green lines indicate the slopes of the increasingly higher lows in the Dollar.

Click to enlarge

On June 20th we saw another decisive higher low in the U.S. Dollar, and on July 5th, we registered the sixth intermediate-term higher low on the U.S. Dollar since last August. While this fact alone cannot stop a rally in the short term (and did not stop the rally from October 2011 to late April 2012), higher lows on the U.S. Dollar have, in 5 of the last 6 cases since August 2011, been associated with immediate multi-week and even multi-month tops in the S&P 500 (red arrows).

The relationship between U.S. Dollar strength and Equity Market weakness is well documented; as I noted in Bloomberg, "Perhaps no other asset in recent years has traded as precisely in (inverse) tandem with the market as the U.S. Dollar." Research we conducted at Harvard found that simply looking for an intermediate high in the U.S. Dollar could have successfully predicted every S&P 500 market bottom since 2008 (see chart from our study in Bloomberg).

Much of this relationship arises from the Dollar's save-haven status relative to the Euro, the fate of which has recently become an important proxy for the global market outlook. Since the start of 2012, the EURUSD currency pair has traded at around a .90 correlation with the S&P 500, meaning that the Euro and the S&P 500 rise and fall in tandem about 9 out of 10 times. It is hardly surprising then that if money largely moves out Euros and into U.S. Dollars during times of Eurozone anxiety, we would in turn see strength in the U.S. Dollar being highly associated with weakness in U.S. Equity Markets.

As the Eurozone area stabilizes this correlation may weaken, but that does not seem likely to happen any time soon, and for the time being, as the relationship between a strong dollar and stock-market losses is likely to persist, investors must heed important intermediate term signals of strength in the U.S. Dollar, such as the higher low registered around July 5th.

Conclusion: Long Dollar, Exit Equities

In recent days we registered an important intermediate term signal of strength in the U.S. Dollar: A 6th higher low in the price of the Dollar since late August of 2011. This suggests an inviting entry point for those wishing to go long on the Dollar through investment vehicles such as UUP. Those presently invested in equities, especially the S&P 500, might want to consider an intermediate term exit to cash until the largely political factors that drive the EUR-USD-Equities relationship are resolved with more clarity.

In terms of the ticker tape itself, we will want to look out for a termination of the higher-low U.S. Dollar trend--i.e. a lower low in the U.S. Dollar--before feeling comfortable with a decisive long-term bullish position on the S&P 500.

In the series of articles that will follow, I will look out for a change in this trend, and discuss in greater depth how the state of the U.S. Dollar-U.S. Equity relationship should be applied to all stock market investing decisions.

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