Stock Selloffs Ignite Dollar Rallies

By: Adam Hamilton | Fri, Feb 18, 2011
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The inevitable periodic selloffs in the general stock markets indiscriminately hammer all stocks lower. But they pose a special magnified risk to commodities stocks. In addition to weighing on this sector directly, stock selloffs ignite fast US dollar rallies. This rapidly drives dollar-denominated commodities prices lower, amplifying the selling pressure faced by commodities stocks.

The threat of a stock-market selloff is particularly relevant today. The flagship S&P 500 stock index (SPX) is extremely overbought technically, and sentiment is wildly complacent and bullish. Key indicators reflecting traders' collective psychology are pegged near dangerous levels from where past major SPX selloffs started. Right now the stock markets are as ripe for a major correction as they've ever been.

Meanwhile the Continuous Commodity Index (CCI) continues to achieve new all-time record highs, reflecting similar exuberance in the commodities realm. And the benchmark US Dollar Index (USDX, the best proxy for this currency) is relatively low with lots of room to soar. I can't imagine a more-perfect scenario for an SPX selloff igniting a USDX rally that temporarily crushes commodities prices!

This effective double jeopardy that SPX selloffs exert on commodities stocks offers great opportunity to speculators and investors who understand it. When the risks of an SPX selloff wax high, speculators can realize profits and raise cash to ride out the coming carnage. Then once the SPX selloff passes, both speculators and investors can snatch up the resulting commodities-stock bargains.

The inverse relationship between the US stock markets and US dollar, at least at its present potency, flared up during 2008's once-in-a-century stock panic. That epic event, far more than anything else in our lifetimes, galvanized traders' sentiment during stock-market selloffs. Its echoes have been strongly felt in the last couple years, and will continue to reverberate for years to come (with decreasing intensity).

In order to understand how SPX selloffs ignite USDX rallies today, we have to start during that crazy panic episode. This first chart superimposes the USDX (blue) over the SPX (red) for comparison. The inverse correlation between these two datasets is visually-astounding. Major SPX selling episodes are highlighted in red so we can easily see what the US dollar did over these particular spans.

SPX and USDX

Before the panic, the US Dollar Index hit an all-time closing low back in April 2008. It had fallen a mind-blowing 41% since its secular bear started in July 2001! It is crucial to realize that the dollar started off a very low base before that autumn's stock panic erupted. By mid-July 2008, the USDX was scraping along just 0.5% above its all-time low. You could hardly even give US dollars away, global investors rightfully spurned them after their long bear.

That month though, a bond panic started brewing. After their stocks plummeted 72% and 78% in a single month, US mortgage giants Fannie Mae and Freddie Mac teetered on the edge of bankruptcy. Large investors around the world who owned trillions of dollars worth of these GSEs' bonds watched nervously. Would they get their principal back if the GSEs failed? Rather than holding and hoping, they rushed to sell GSE bonds. Some of this capital flooded into US dollars (cash), and some parked in US Treasuries.

As these fears accelerated into a full-blown bond panic, the USDX shot up rapidly. Then just when the dollar peaked and started to roll over in August, the stock panic ignited. This is shaded in red above. Between late August and late November 2008, just 3 months, the flagship S&P 500 stock index plummeted 42.2%! It was an utter bloodbath, unlike anything seen since the Panic of 1907.

As terrified traders worldwide rushed to dump their stocks, they moved their capital into cash. There is nothing better to own in a rapidly-falling market, it preserves purchasing power to buy the resulting bargains after the intense selling burns itself out. Countless foreign traders, seeing their local currencies plunging with stocks, sold their own money to buy US dollars. Thus the US dollar skyrocketed, as you can see above.

The USDX itself, a measure of the US dollar versus six other major currencies (mostly the euro at 57.6% of its weight), blasted 22.6% higher in just 4 months! Realize that currencies usually move with all the sound and fury of a glacier, so this was a breathtaking extreme for the world's reserve currency. This particular USDX rally was actually its biggest and fastest ever witnessed over such a short span!

The SPX and USDX inverse correlation over that red panic span is readily evident visually in this chart. This relationship holds up statistically too, sporting a very high 81.7% r-square. Nearly 82% of the daily USDX price action over that stock-panic span was directly explainable mathematically by the SPX's own. The USDX even hit new highs on the same days the SPX hit new lows, both at the original October panic low and the secondary deeper November one. The dollar was slaved to the stock markets' fortunes.

And then when the SPX finally started stabilizing in December, the USDX plummeted. There was no need for the safe-haven refuge of US-dollar-denominated cash with the stock markets clawing higher again. But then in January 2009, the stock markets inexorably started sliding lower again. This trend accelerated in February as the new Obama Administration haughtily asserted that American investors were undertaxed and the federal government was too small. The SPX spiraled lower in despair.

Once again the USDX soared as the SPX plunged, even exceeding its earlier panic highs. But as soon as the stock markets finally managed to bottom in March 2009 (I called this in real-time), the USDX started selling off again. The Fed's announcement that it was starting to monetize US debt, its original gigantic quantitative easing, accelerated this plunge. Once again rallying stock markets negated the need for a safe-haven refuge in the US dollar, capital left to return to stocks.

Note that during that wildly-crazy stock-panic span, the only time the USDX rallied materially was when the stock markets were selling off. Then as soon as the SPX started rallying again, the dollar sold off. At the time, Wall Street argued that this USDX strength was due to the fundamental superiority of the dollar to other fiat currencies. Nonsense! The dollar only rallied when stocks sold off, it was a pure safe-haven play. There was nowhere else to go so traders nervously parked capital in zero-yielding cash.

Even though holding cash is very wise when stock markets are falling, that doesn't mean the US dollar is either fundamentally-sound or a worthy long-term investment. It was a convenient shelter in an epic storm, nothing more. This surging dollar behavior during the panic conditioned traders to flee into the USDX whenever the SPX started selling off in the couple of years since.

A month ago I wrote an essay examining the extreme complacency and apathy in the stock markets today that guarantees a major SPX correction looms. In it I highlighted the pullbacks and corrections the SPX has weathered so far in its cyclical bull to date. These same seven SPX selloffs are highlighted below in red. Note what the US dollar did during each one. The panic-spawned phenomenon of rushing into this currency whenever stocks are weak is very much alive and well.

SPX and USDX

The initial several pullbacks in this stock bull were fairly small and short, and they happened early in the post-panic recovery when the stock markets were rebounding rapidly. So their resulting impact on the US dollar was minor. Yet note that this currency still rallied sharply in each of those initial SPX pullbacks. Then this SPX-driven dollar-rally model appeared to break in December 2009 when the dollar surged on its own accord.

Even though the dollar has been heavily influenced by the stock markets in recent years, it still has its own inherent technicals and sentiment. Occasionally they get extreme enough to overpower the stock markets' dominating influence. And in late November 2009, the dollar was simply getting too oversold. Traders were too bearish on it and one of its periodic bear-market rallies was due. So one indeed erupted, but it soon petered out. Again the stock markets surged in early January 2010 and pushed dollar demand lower.

But then in mid-January last year, what would eventually grow into the largest pullback (less than 10% selloff) in this entire cyclical bull emerged. The USDX shot up sharply, topping the exact day the SPX bottomed just like we had seen during the stock panic. Traders were once again flooding into this currency for a safe-haven refuge during fast stock-market selloffs. Due to the irrational euro panic the dollar kept grinding higher in the subsequent months despite a stronger SPX, but its rally was very anemic.

Then late last April, the SPX started on what would prove to be its only full-blown correction (greater than 10% selloff) of this bull. What did the dollar do as capital fled overbought and complacent stock markets? It rocketed higher so vigorously that it actually neared its old panic highs despite a vastly higher SPX! And then literally the very day the SPX initially bounced in early June, the USDX topped. It started plunging until the next SPX pullback in August, when it again surged sharply.

Beginning in early September when the stock markets recommenced rallying, global traders again pulled their capital out of this safe-haven-currency parking spot and the USDX collapsed. It couldn't manage another rally until the most recent SPX pullback erupted in November. Then of course right on cue, the US Dollar Index rocketed higher until the stock markets stabilized again. See the crystal-clear pattern here?

Nearly without exception, the only times the US dollar has rallied materially in the past few years was exactly during stock-market selloffs. With the Fed relentlessly creating new fiat dollars out of thin air like there is no tomorrow, and interest rates at zero, and Washington spending like drunken sailors, there is literally no fundamental reason to own the US dollar today. Traders only want it in one specific situation, when stock markets are falling fast so cash temporarily becomes king.

The entire dollar gains during the stock panic, which sparked its biggest and fastest rally ever, happened only when the SPX was plunging. At all other times, the USDX was generally sold off. And over the couple of years since that panic ended, the only times we've seen large and sharp USDX rallies (with the single exception of that dollar-oversold episode) was when the SPX was pulling back or correcting.

There is no reason why this behavior shouldn't continue. Since stock-market selloffs drag all sectors lower, none escape, the best trade to own during these events is cash. It preserves your capital while your effective stock purchasing power grows as share prices decline. Demand for cash will always surge during a major stock-market selloff, and this will continue to drive major dollar rallies. I have no doubt that the US Dollar Index will again surge when this next overdue SPX correction finally arrives.

Now if you own stocks in most sectors, the dollar's action is largely irrelevant. Apple is going to keep selling iPhones and iPads like hotcakes regardless of which way the dollar meanders. But if you own commodities stocks, these SPX-driven dollar surges are huge deals. Your commodities producers' profits are driven by the prices of their underlying commodities, and these prices take a hit whenever the dollar rallies. When traders bid the USDX higher, it takes fewer dollars to buy any given unit of commodities.

So commodities stocks are hammered from multiple fronts during stock-market selloffs. Like all sectors, they are sold off simply because the general stock markets are falling. And since professional traders still consider commodities stocks riskier than many other sectors, they tend to leverage the declines in the stock markets. Larger commodities stocks often double whatever the SPX decline happens to be.

And a stock-market selloff's parallel impact on the dollar compounds this selling pressure on commodities stocks. As traders see the commodities prices critical to producers' profits drifting lower, they start to fear for this sector's core fundamentals. So they accelerate their selling even beyond what the stock markets would suggest is reasonable. A rising dollar alone weighs on commodities prices and hence commodities stocks, but coupled with an SPX selloff the resulting impact is freight-train hard.

The natural reaction of traders to any stock-market selloff is to assume the economy must be deteriorating if stocks are down. Usually this is incorrect, as periodic selloffs within ongoing bulls are usually simply driven by technicals (prices rallied too far too fast) and sentiment (consensus is too bullish). They have nothing to do with fundamentals at all. But when a fast dollar rally drives falling commodities prices in concert with an SPX selloff, this bearish economic psychology metastasizes into fundamental concerns.

So when the stock markets are falling, the dollar is surging, and commodities prices are weakening, Wall Street endlessly declares that commodities stocks are falling for fundamental reasons. With lower commodities prices, their profits will deteriorate. Provocatively, you usually hear bold declarations that the secular commodities bulls (or "bubbles") are finished during these SPX-selloff events. This naturally leads to a really-negative environment for commodities stocks. They are often beaten to a pulp.

This probably sounds depressing at this point, but it really isn't at all. Our goal as speculators and investors is simple, to buy low and sell high. In order to buy low, we need selloffs periodically to drive commodities-stock prices low enough to be relatively-cheap bargains. SPX selloffs, which are inevitable, healthy, and necessary to keep sentiment balanced, drive the best buying opportunities ever seen in this entire commodities-stock bull. These selling events should be gleefully anticipated!

They certainly are here at Zeal. As lifelong speculators ourselves, we zealously study the markets to uncover high-probability-for-success trading opportunities for our own capital. By selling commodities-stock trading positions just before stock-market corrections and buying back in just after they've run their courses, we've amassed an amazing record of success over this past decade. Our subscribers have made fortunes by heeding our famous contrarian research and mirroring our trades.

All 235 stock trades made in our flagship Zeal Intelligence monthly newsletter since 2001 have averaged annualized realized gains of +52.4%! Lately with the stock markets so overbought, we've been realizing our many large gains from the autumn rally and amassing cash. Then once this overdue stock-market correction arrives and hammers commodities stocks, we'll be ready to buy the resulting oversold bargains which will subsequently multiply our capital again. Subscribe today to our acclaimed monthly or weekly newsletters and be ready to seize the fantastic buying opportunities that are approaching!

The bottom line is stock-market selloffs ignite major US dollar rallies. And these are almost the only times the dollar surges, as the vast majority of its rallies in the last few years coincided perfectly with stock selloffs. Cash is the natural and prudent refuge in times of falling stocks, as it preserves capital while its purchasing power increases. But the resulting dollar surges weigh heavily on commodities prices.

This is a problem for commodities stocks, especially if they produce commodities with prices particularly sensitive to dollar action. These weaker commodities prices combine with the general bearishness of falling stocks to lead to outsized losses in this sector. While tough on traders not expecting this behavior, it is a huge boon for those who do. It leads to the best commodities-stock buying opportunities ever seen in their ongoing bull markets.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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