Relativity Of The Dollar Index To Markets

| About: PowerShares DB (UUP)

Summary

To express the real or true value of an item is to multiply the dollar index, DXY, with the item.

Stock market was on a downtrend by multiplying with DXY.

DXY affects markets inversely and with different amplifying factors within a time period.

Replace cash with cash equivalents that include dollar index, gold, and currencies.

By Paul Wong

Introduction

"Natural law as expressed in mathematics is simply an observation in discovering and describing about the world."

"Distant galaxies can be seen clearer with the Hubble Telescope."

"Einstein's Relativity Theory is inspiring to compare movements of objects."

This article is about observing and describing the markets with the US Dollar Index.

The US Dollar Index, DXY, or the PowerShares DB USD Bull ETF (NYSEARCA:UUP), is an index (or measure) of the value of the US dollar relative to a basket of foreign currencies. As a measure of value, the index relates to the purchasing power or the worth as opposed to the US dollar, which is a constant unit of 1.

DXY can be treated as the real or true value of the US dollar, which is DXY multiplied by 1. A good way to express the real or true value of an item is to multiply DXY with the item. The dollar is good and appears to be constant within the US. Internationally, all trades are done according to the dollar index, which changes constantly.

Since the inception in 1973, the dollar index, DXY, started at 100.0. It traded as high as 164.7 in 1985 and as low as 70.7 in 2008 during the financial crisis. The variations about the worth of the dollar can be very large and affect international trades. Since 2008 to 2014, DXY has recovered from the low point and fluctuated around 80, which was still fairly low. At the end of the quantitative easing (QE) in 2014, DXY moved up strongly to 101 in December 2015, due to the Fed's tightening, with only one interest rate increase of 0.25 percent. Since then, DXY was drifting down to 92 in May and bounced up to around 95 in June 2016. The rise of DXY can be due to the strength of the US economy to some extent, and also the result of the weakening of other currencies due to the continuation and expansion of QE in Europe and Japan.

Generally speaking, having a strong dollar policy, which means a high DXY, is a very good thing. All US assets will become more valuable with higher purchasing power. DXY is a proxy to reflect the strength and health of the US, such as the balance of fiscal budget, low national debt, wealth of the nation and its citizen, good economic GDP growth, high employment and wages, and stable financial and political systems. All these factors that promote high DXY are what a nation strives for.

For the sake of convenience of ETFs for data analysis, I will be using UUP for DXY as the dollar index interchangeably, the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) for SPX as S&P 500, the SPDR Gold Trust ETF (NYSEARCA:GLD) for gold, and the United States Oil ETF (NYSEARCA:USO) for oil (WTI or Brent).

Relativity of DXY to the S&P 500 Index

DXY can be thought of as a yardstick which lengthens and shrinks all the time. And we use this varying yardstick to measure the value of all items. Because the true value of each item does not change much in a short time, the price of the item will inversely increase or decrease with DXY to hold the value.

This is mostly the reason why DXY moves in the opposite direction or inversely to most items such as commodities and stock markets. Each item is affected by the daily movement of DXY differently, depending on how closely the resemblance of the item to DXY as cash equivalents and many other underlying factors.

Basic research can provide interesting results and rewards to aid investment decisions. Accepting the benefits about measuring an item such as the S&P 500 index with DXY or UUP may offer some insights and different viewpoints. I'll try to perform the following analysis; each of the analyses has to be defined with a duration such as the past 24-month analysis as an example to illustrate a longer-term perspective:

  • UUP - Dollar index
  • SPY - S&P 500 with dollar in constant unit of 1.0
  • UUP*SPY - UUP multiplied by SPY
  • UUP/SPY - UUP divided by SPY

The rise of UUP, or DXY, in blue over this 24-month period was really remarkable. Much of the credit had to go to the Fed's policies to achieve a higher UUP outperforming other currencies. The higher dollar index meant an increase of the value of our assets and our purchasing power for internationally traded goods. The rapid rise of DXY or UUP from 80 took seven months for a 20% rise, and held steady for 10 months till the peak at 101 around the first interest rate hike in December 2015. DXY was sliding down to hit 92 in May 2016 and hovering around 95 in June 2016. Despite the slide in the past six months, DXY or UUP still gained about 13% since June 2014.

SPY in orange independently gained about the same amount, but mostly took a lower path and underperformed UUP during this period. But there were two corrections of 13% each in early September 2015 and February 2016 before SPY recovered strongly to the recent high.

A good way to measure the true value or the performance of the US stock market is by multiplying UUP with SPY; UUP*SPY in gray. The result is the product of the value of the dollar and the market index. This is a good measure of the true value of the market aside from SPY and will offer us another way to gauge the market, looking for trends and flags. Tracking the performance of the product of UUP*SPY revealed that the gains were 30% by March 2015 and held steady until September 2015. After the fall, UUP*SPY bounced back and hit a peak mostly due to the strength of UUP in December 2015. This UUP*SPY peak may be very significant because even with the recent rise of SPY, the recent UUP*SPY peak is well below the December peak due to the weakness of UUP. Potentially, the recent lower peak in June 2016 may signal the beginning of a downtrend, which may confirm itself in the next month.

Relative or compared to SPY/UUP, in yellow, the market barely recovered to the starting point in 24 months after languishing below 1.0 for a majority of the 24-month period. The result means that comparing to UUP, SPY was weaker during most of the time period until five months ago when SPY was much stronger than UUP.

For trading purposes, a shorter time frame like 12 months with a similar analysis is beneficial, because it offers a more focused look. The chart looks different because the values for comparison at the starting point are not the same as the 24-month period.

Actually, starting in June 2015, UUP, in blue, was strengthening until December 2015 and becoming weaker since then. The reversal was marking a drastic change of trends, from up to down. At 95 in June 2016, DXY was about 5% less than 12 months ago. Factors that influenced DXY can be many and complex. Partly, it was becoming apparent that the Fed would not be able to raise interest rates any time soon. It mentioned four hikes for 2016 and none has happened yet. Most likely there will be no more hike this year especially when the presidential election is approaching, for the sake of avoiding political favor. And of course, the overall economic indexes and corporate profits are heading down too. Fiscal budgets and trade deficits are becoming more negative also. It will be hard press for the Fed to gather enough reasons for any rate hike. The best the Fed can do was what it did back in May to talk DXY up with possible tightening moves after hitting a low of 92. It was quite successful in pushing DXY up to 95, but going forward, it will not be as easy. To push DXY above this level by economic performance alone will be a big challenge, unless the rest of the other currencies are becoming weaker. DXY will probably be fluctuating between 92 and 98 for the rest of the year, which is 3% each way from 95.

The peaks of the S&P 500 index (SPX or SPY), in orange, are essentially flat within 1% for the past 12 months, with two dips of 13% each in possibly a five-month cycle. Currently, SPY is nearing another peak and struggles to break out on the upside. With another estimated earnings decline for the upcoming quarter, any upside move will be weak and downside move can be more severe. This may be a set up for the next down leg in the market, reflecting the cumulative negative reasons stated above.

UUP*SPY, in gray, looked alarming. This measure of the true value of the market reached a peak back in December 2015 and the recent peak in June 2015 was 6% less while SPY recovered to the previous peak. The significantly lowered recent peak might mean that the December 2015 peak could be the highest point of the true value of the market for the coming years. The recent lower peak in June 2016 was establishing a downtrend. Going forward, we need to be aware of the possibility about this observation.

SPY/UUP appeared especially strong since February 2016. The rise was magnified by the 13% increase in SPY and the 5% drop in UUP. UUP*SPY and SPY/UUP seem to be changing place since five months ago. Looking at all these items made us aware about the changes in both SPY and UUP, so that we have a better description and feel about the direction of the market.

Other interesting and useful observations about rapid market drops in last September and February were characterized by the drops in both UUP and SPY in tandem. Disregarding the many reasons about the fall, the distinct and sharp bottoms of UUP*SPY, green circles, correctly marked the true bounced-up points both times. This observation may be useful to identify a similar UUP*SPY bottom next time.

Another point about the December 2015 peak of DXY was it coincided with the bottom of commodities such as gold. If anyone recognized this fact and converted much of their cash, based on the purchasing power of DXY, into commodities and other overseas assets, the rewards were very high. Going forward, similar tactics of using the high DXY to buy hard assets remain true.

For the past 12 months, the dollar index, UUP, in blue, generally acted weak to SPY, in orange, as illustrated above. This relationship looked more balanced, a similar change of magnitude, by multiplying UUP by 2 to form UUP*2, dark blue. The weak inverse effect was simply the compensation of SPY to the daily changes of UUP. But each index had its own set of factors that caused the movements independently.

My previous article on the possibility of a bear market in the presidential election year 2016 offered a more detail discussion. After a strong rally partly due to Fed's less hawkish action since February 2016, cracks are appearing from the economic issues. The 2000 and 2008 July to November stock markets experienced downturns; this year the set-up is similar.

Overall, more different viewpoints sometimes are helpful to learn about the true value movement of the market. In many ways, the true market value of UUP*SPY, which represents the purchasing power, is more important than the apparent value as expressed in SPY alone. Referring to the recent examples is the currency depreciation of Nigeria and Venezuela. Their stock indexes may remain high, but with a drastic fall of the currencies, the true and net worth of those markets suffer. Therefore, applying the dollar index to all items is an important and worthwhile exercise.

Gold and Dollar Index

Until 1967, similar to DXY, gold was used as a measure of the value of the US dollar, which was set at $35 per ounce. After 1973, DXY was adopted, replacing gold to be used as the measure of the value or worth of the US dollar.

Gold can be viewed as a barometer of constant value against inflation. Now, at $1,300 per ounce, there is a 36-fold increase in the price of gold since 1966, which equates to roughly an 8% compound rate of inflation over the past 50 years. The unofficial inflation rate by ShadowStats, which uses pre-1980 methodology for tracking, is also about 8%. These independent calculations about real inflation rate are far different than the official rate of 2%. We can judge on our own. Another note about preserving the value of our assets, investment gains will be taxed, the before tax return on investment needs to be at least 10% just to keep up with real inflation. Preservation of capital becomes even more vital because only capital provides returns.

Gold also holds a strong position as a cash equivalent being accepted globally with the same value and very liquid. Holding gold can be in the form of physical ownership to certificates or ETFs such as GLD. All precious metals, including silver and platinum, should have a bigger percentage as cash equivalents or replacing cash for the next few years in guarding against inflation. Currently, both silver and platinum are better in value for potential appreciation than gold.

There is a difference between investing in gold vs. gold miners. For gold, we only concern about the outlook on price. For gold miners, we have to look at the profitability of the business, which means the realized gold price minus all-in cost on a per ounce basis. Due to the extended fall of gold prices for four years until last December, the all-in cost for many miners is below $1,200 per ounce. In other words, rising from the low of $1,050 to $1,300, the profitability of the miners reversed from negative to positive. If the price goes up further from now, the profitability or earnings will be much higher in percentage than just the increase in price of gold, which explains the outperformance of gold miners vs. gold this year.

Gold is also a safeguard of value in times of turmoil such as market drops. It is one of the few investments that can hold or gain in value through financial storms. In this unprecedented time of high total debts and zero to negative interest rates, preserving and building our wealth with gold and gold equivalents such as silver and platinum make a lot of sense comparing to a world that is losing common sense and value by promoting inflation.

Years ago, central banks were net sellers of gold. But, in the past year, central banks of many large emerging countries are net aggressive buyers of gold. A good evidence is a vote against the increasing rate of fiat currency creation and trust. Demand is becoming stronger to drive the price of gold up since December 2015, and the year-end high demand season is just ahead now.

All the above explanations fit well with the recent announcement of George Soros's large investment in gold and gold miners. He is the admired one who is very hard to bet against in times of financial unbalance.

Oil and Dollar Index

My earlier article, Long Run Of Oil Price In 2016, depicts that the price of oil hit the bottom in February 2016 and will rise at least till the end of the year. Going against most Wall Street recommendations then, my opinion on oil has been correct so far with six more months to go.

Oil is another commodity that is affected by the dollar index. Oil, or USO, in use as a consumable is very different from gold. Once each barrel is consumed, a new barrel must be produced for use. Aside from the inverse effect of UUP, other factors such as supply and demand, political policies and debt of the exporting and importing countries all contribute to a very complex movement of the price of oil. The drastic decrease of oil price from $110 to $26 for a 75% fall since 2014 coincided with the rise of the dollar index. Although oil price has recovered from $26 to $51 in June 2016, the fall of oil price hurt many exporting countries financially, especially the ones with a large amount of debt denominated in US dollars.

For the reasons above, the change in UUP has an even bigger amplifying factor on USO. For the past nine months, to balance the magnitude of change in showing the inverse relationship, the amplifying factor is estimated to be 4. For any 1% change in UUP, there is a 4% change in USO or the oil price as an inverse. This observation about the amplified sensitivity can be very useful in trading USO. Although USO may not be a good way to trade oil due to the high frictional or forward option costs.

The rise in oil price will definitely help the profitability of oil companies. In general, with per unit analysis, profitability is the difference between realized price and all-in breakeven cost. Once the realized price surpasses the cost, then investing in an oil company is becoming rewarding. Of course, the stock market will always anticipate the future movement of oil in advance in driving up the stock prices of oil companies. At the price of $50, profitability varies greatly among companies. For most of the shale oil companies, losses continue until oil price reaches at least $60. For some of the large integrated international oil companies with small asset write-downs, the earnings are positive, but much less than last year. With the dramatic rise of oil price since February, earnings in the upcoming quarter will be much better than the last quarter, benefiting from higher oil price.

Even after a 90% upward movement since the February low of $26, the outlook of oil price appears to be quite positive. Largely due to the strong demand in the past two years and from slowing to negative growth of supplies, finally, supply surplus will be gone within six months. A large reduction of capital investment by all producers around the world during the period of low oil price ensures that supply for the coming years will be lowered. Unless there is a slowdown in world economy, oil is a good bet as an investment for the rest of 2016, similar to the 150% increase in 1999, but to a lesser degree.

Conclusion

The US Dollar Index is indeed essential in measuring the true value of all assets. Tracking the movement and performing analysis on UUP with other items can be rewarding for investment purposes. Many uses of the dollar index analysis are confirming the stock market trend, amplifying factors and picking stock bottoms. Like other analysis, interpretation of the results about the effects of UUP on markets can vary among individuals. At the very least, the above analysis can offer a different viewpoint, so that we can extract some important information in helping with the decision making of our investments.

In an extremely unbalance ballooning debt world, which is based on faith and credit, the unending erosion of the ability and willingness to pay is becoming more acute. It is about time to plan mainly for the preservation of capital. Since countries of the world overplay the cards in normal times by borrowing above their ability to pay, abnormal times will follow in vengeance when defaults abound and many of the usual old investment ways will be ineffective. We need to go back to the basics, about history and the construct of the financial systems, and evaluate investment options before the placement of capital to asset classes. The principles to go by are:

  • In gold (or black gold - oil) we trust (2016).
  • Shorten trading cycle to three months or less and stay conservative.
  • Neither a lender nor borrower be.

Implications and Applications

Rethink and redefine cash by increasing cash equivalents near term, and further rotate for profits among dollar, dollar index and gold, the last one for long-term (five years) accumulation.

Gold and oil (companies too) are the twin vehicles with four engines for stock gains for the rest of 2016.

Stock market will be rocked by the news of the election till November, initiate a short bias now on stocks especially for financials; with a target at or below the last two lows.

Revolt and strike of the bond buyers within a couple of years will happen when they refuse to add any more bonds and start selling, yields will shoot up that spell the end of bond bull market.

Disclosure: I am/we are long GLD, XLE.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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