Three Questions to Ask Yourself About the U.S. Dollar

Does the strong U.S. dollar spell disaster for this bull market?

Senior Vice President of Research
Mar 16, 2015 at 8:43 AM
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"Now, the January highs in the $206 area -- which is also home to SPY's 40-day and 80-day moving averages -- become a potential support zone in the days immediately ahead. Also, note that SPY's Dec. 31 close is at $205.54, adding an additional layer of support, from a technical perspective."

"... for those of you with a time frame of six weeks or less, we recommend a decent balance of long and short exposure. Or, if you're trading options, maintain a healthy mix of call and put exposure, given the growing risk to the bullish outlook ..."

-- Monday Morning Outlook, March 9, 2015

Last week was almost a carbon copy of the prior week's price action, if you follow the SPDR S&P 500 ETF Trust (SPY - 205.83). In other words, a Monday rally was quickly wiped out by a mid-week decline, a rally back to the prior week's close, and then Friday ending in a huge disappointment. The one difference is that this past Friday's lows were above the lows in the middle of the week, whereas in the week prior, new weekly lows were carved out on the last trading day of the week.

30-Minute SPY since 2/27

As you might infer from the tweets above, things quickly changed as SPY at first reacted favorably to weak economic data, but then sold off on weak economic data the following day. Volatility, as measured by the CBOE Volatility Index (VIX - 16.00), advanced and declined sharply around the 15.53 area -- half the October peak, and a level that we have been watching closely.

Moreover, during a three-day period, SPY bounced around its year-to-date (YTD) breakeven point at $205.54, with closes below this level on Tuesday and Wednesday followed by a close well above it on the heels of Thursday's surge. By Friday, the put-heavy 205 strike (for options expiring on Friday, March 13) and YTD breakeven zone were again retested as the market plunged on a negative producer price index (PPI) reading, with SPY ending the week around its 2014 close.

With the sharp movements from day to day, it was certainly a week in which having a healthy mix of long and short exposure proved to be worthwhile, as we suggested last week. We continue to recommend such exposure in the days and weeks ahead, amid a mixed short-term technical backdrop and a potentially volatile expiration week upcoming, with the featured event a two-day Federal Open Market Committee (FOMC) meeting.

On the technical front, bulls might be encouraged by the fact that a few major indexes continue to trade above their respective 2014 year-end closes, such as the Russell 2000 Index (RUT - 1,232.14), Nasdaq Composite (COMP - 4,871.76), and S&P MidCap 400 Index (MID - 1,491.12).

Furthermore, the RUT remains above the round 1,200 level, which was a resistance area during much of last year. But the COMP has been unable to retake 5,000 after a brief move above this level earlier in the month, and the same can be said for 1,500 on the MID. And if that isn't enough, the Dow Jones Industrial Average (DJI - 17,749.31) and Dow Jones Transportation Average (DJT - 8,945.13) have not been able to sustain movements above the round numbers 18,000 and 9,000, respectively.

Daily Chart of DJT since September 2014

The FOMC policy statement and Fed Chair Janet Yellen's press briefing could be mid-week drivers. The removal of the word "patient" from the FOMC statement has been anticipated by some Fed watchers. If "patient" is removed, stocks might sell off in response, as our "data dependent" Fed was just presented with weaker-than-expected retail sales and inflation data, and yields on the 10-year Treasury note have risen almost 50 basis points from their early February lows.

SPY comes into this week trading around the biggest put open interest strikes in the March series. In the event of a negative reaction to the Fed, these heavy put strikes could act as magnets, with potential downside to the round-number 200 strike and slightly below. But the upside to this configuration is that a positive reaction to the Fed would unleash short covering related to this expiring put open interest. This is, again, why we recommend that those with a shortened time frame maintain exposure to both sides of the market heading into a potentially volatile expiration week, amid this lingering uncertainty.

SPY March Open Interest Configuration
(click to enlarge)
SPY March Open Interest Configuration

"Hedge fund titans from Stan Druckenmiller to George Soros to David Tepper have been scaling back on their exposure to U.S. stocks and, instead, are putting more money to work overseas. Just last week Mr. Druckenmiller said the majority of his long exposure is in Europe and Japan as both markets are cheaper than the U.S. and should benefit from their own versions of QE."
-- The Wall Street Journal, March 10, 2015
"The strengthening dollar is forecast to contribute to the first back-to-back profit contractions since 2009."
-- Bloomberg, March 5, 2015
"The stronger dollar will continue to weigh on U.S. companies this year. Wall Street analysts are making deeper cuts to their forecasts ... analysts now expect companies in the S&P 500 to report earnings growth of 2.4% for 2015. That's the weakest pace of annual profit growth since 2009 ... analysts had been expecting S&P 500 profits to grow 8% for 2015."
-- The Wall Street Journal, March 6, 2015

Speaking of round numbers, another major index -- the U.S. Dollar Index (DXY - 100.18) -- has run up to the round $100 century mark. The strong dollar has been one of many "fear factors" among market participants, especially as it relates to multi-national companies doing business overseas.

Just as the dollar grabs headlines with its impressive rally and analysts trip all over themselves to reduce earnings estimates based on recent dollar movement, one has to ask whether this round number proves to be a major speed bump in the days and weeks ahead? The century level was a temporary resistance area in 1987 and 1997, but this round number proved meaningless during the early 1980s advance. A rejection at $100 would certainly be a surprise, as long positions in the dollar are at multi-year highs, according to the weekly Commitment of Traders (CoT) data.

Regardless, here are important facts to consider with respect to the dollar and its impact on stocks:

  • On May 6, 2014, DXY closed at 79.09, which means this index has rallied 26.7% over this period.
  • On May 6, 2014, the S&P 500 Index (SPX - 2,053.40) closed at 1,867.72. The SPX is up roughly 10% during this period.

With the above facts in mind, here are three questions to ask yourself, as an investor in U.S. stocks:

  1. Is the dollar rally really impacting U.S. stocks, or is something else at work?

  2. If so, why now? Are hedge fund managers reacting to the reduced earnings estimates and seeing a market perceived to be overvalued, and now seeking what they view as "greener pastures" in Europe and Japan?

  3. What (if any) upside is there to the coverage the U.S. dollar is getting? In other words, might lower earnings expectations work in favor of the bulls, in terms of a lower bar to hurdle when earnings season rolls around again?

Read more:

Indicator of the Week: Does This Bull Market Have Legs?

The Week Ahead: All Eyes on the Fed


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