The stock market has been on a tear over the past few weeks, being the beneficiary of renewed optimism surrounding the economy and the relentless hopes for more stimulus. While there is reason for more optimism, the market has overcompensated and it is almost certain that a pullback is in the cards within the next month. That said, investors should be looking to hedge while taking on little risk as it is also possible for the market to maintain its optimism or receive the stimulus it desires abroad. The usual hedges, such as shorting the SPY or buying gold (NYSEARCA:GLD) may not be the best options due to the market's willingness and eagerness to move upward, which opens the door for the U.S. dollar (NYSEARCA:UUP). The U.S. dollar is not only a great investment because of its superiority against international currencies, it is also a relatively low-risk hedge against slowing or immobile domestic inflation.
It is necessary to cover the current domestic economic conditions and their effects on the U.S. dollar. It was the economic performance in July that helped to spark the ongoing extended rally. The U.S. economy added 163,000 jobs, far above the 95,000 projected by economists. Worries of slowing domestic growth have a basis in fact as industrial output held flat at low levels, but it seems as if many of those fears were amplified by hysteria. The Consumer Confidence Index rose to 65.9 from 62.7 in June, which marks the first increase in five months and the highest level since April. Unemployment remains above 8%, which signals that the economy is not where most would want it to be, but overall last month showed slow but sturdy and substantial progress.
The better-than-expected U.S. performance minimizes the risk of more Federal Reserve Board action, particularly in the form of quantitative easing. The enactment of QE3 has been the strongest bear case against the dollar, and speculation continues as to whether or not Ben Bernanke will utilize it. The market craves QE for a quick pop, but it appears less and less likely that Bernanke will throw the market a bone. Bernanke realizes that he has done all that he could, but also that more monetary stimulus is not the answer or solution to the current economic predicament. At this point the market requires action on the fiscal policy front, and Bernanke made that very clear in his testimony in front of the Senate Banking Committee weeks ago. It was unfounded speculation at best that QE3 may happen prior to the release of economic data from July, but with unexpectedly good results it is increasingly apparent that more action is not only unnecessary and excessive, but unlikely.
On the other side of the coin, the market has overreacted to the positive surprise from July and a correction is looming. As mentioned above, there is rationality in the current optimism, but the fact of the matter is that the economy is far from out of the woods. It is entirely possible that July is just a platform effectively setting up similar performances in upcoming months, which makes traditional hedges an unnecessary risk. There is no reason to get caught in a short squeeze as the S&P rallies from hopes of stimulus, more positive news, or economic data beats. Similarly, there is no need to get burned owning gold if the Fed, or other international central banks, fail to take more action. Gold acts inversely with the dollar and, of course, relies heavily on stimulus from the Fed to allow it to rise. The Federal Reserve is the key to each pattern, and while the chances of more action are being depleted, the dollar comes out on top of gold.
With too much risk in the S&P 500 and in gold, the U.S. dollar becomes relevant as a hedge in conjunction with being an investment. The dollar hedges against slowing growth and, in turn, slowing inflation. Bill Gross stated that he believes returns on equities will be minimal due to too much inflation in developed countries, and he may be right -- but not in the United States. The height of Federal Reserve Board intervention is in the past, and global inflation would help to weaken international currencies, concurrently strengthening the dollar. As the risk mounts for traditional hedges, brightening prospects for the U.S. dollar make it the most attractive hedge for a coming correction, and for global inflation.
Strengthening U.S. purchasing power will be aided by continuation of more moves courtesy of both the European Central Bank and the People's Bank of China. The euro has continuously declined from highs of 1.45 (against the dollar) in September 2011, and shows no signs of halting this trend. Mario Draghi has yet to act drastically, but it is widely anticipated that he will do so and in turn further depreciate the value of the euro. Italian and Spanish bond yields are out of control, and the recession is deepening, giving Draghi the cue for stimulus that has disappeared for Bernanke. Although the U.S. economy is progressing, there has been little to cause optimism out of Europe. The economic climate in the eurozone is depressed and is in dire need of help and reform, both fiscally and monetarily. As conditions continue to decline and Draghi is given more incentive to act, the euro will deteriorate, boosting the value of the dollar.
Growth is slowing in China and advancement of central bank stimulus has just begun to come to fruition. China has been giving a boost to its economy by manufacturing growth centrally in an effort to maintain its GDP numbers. The depth at which growth in China has slowed is just now being fully exhumed. Chinese consumer inflation fell to a 30-month low in July, and Chinese Industrial Output rose 9.2% in the month vs. economists' estimates of 9.7%. Of course, the situation is nowhere close to as bad as it is in Europe, but it is worrisome and China will have no qualms about using its central bank to provide easing. The official growth target for 2012 is 7.5%, and it is appearing more and more difficult for China to hit this number, confirming the likelihood of central intervention. More stimulus will weaken the Chinese yuan, and in a similar case to the euro, it will enhance the U.S. dollar.
The contagion of global central bank intervention is evident and depletion of the value of foreign currencies is a clear-cut side effect. The United States economy is progressing, maybe not at a lightning-fast pace, but this is all the better for the U.S. dollar as inflation stays at low levels. U.S. economic performance has improved the dollar in and of itself, but more importantly it has drastically lowered the chances of a third round of quantitative easing. As an investment and as a hedge against foreign inflation as well as against less domestic stimulus, owning the dollar fulfills a multitude of services. You can bet on American prosperity and go long on the U.S. dollar by purchasing the PowerShares DB US Dollar Index Bullish Trust.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.