by Kevin Klombies, Senior Analyst,

We start off today with a chart-based premise. An arguable one, no doubt, but a premise all the same. The chart below shows the U.S. Dollar Index (DXY) from 1987 into 2008. The aforementioned premise is that the long-term trend for the dollar is both flat and bound at the extremes by the horizontal lines on the chart. In other words anything between roughly 81 and 105 for the U.S. Dollar Index is ‘on trend’ while anything above or below represents a destabilizing extreme.

Below we show the U.S. Dollar Index futures and the S&P 500 Index (SPX) from late 1999 into mid-2003.

In early 2000 the dollar pushed above the channel top and it remained in ‘too high’ territory through into the second half of 2002.

The argument would be that the entire 2000- 2002 equitybear market took place while the dollar was tradingabove the top of the channel. When the DXY pushed above 105 in early 2000 the SPX began to ‘top’ and it wasn’t until the dollar had returned back to the 105 level that the equity markets finally began to work through a bottom.

The inspiration for this particular argument comes in large part from a series of chart-based views that we have shown in the past based on the ratios between Phelps Dodge and SPX, Phelps Dodge and JPMorgan Chase, FreePort McMoRan and the SPX, as well as FreePort McMoRan and Johnson and Johnson.

The ongoing argument was that the financials
, consumers, and pharma themes or, perhaps, U.S. ‘large cap’ had been elevated to levels that required a catch-up rally by the commoditycyclicals. Put another way the 1995- 2000 trend had created a distortion or imbalance between relative prices which then led to a prolonged period of weakness for the non-commodity sectors while the commodity cyclicals, commodity prices, and the currenciesof those countries tied to the commodity cycle flourished. Fair enough.

What intrigues us about the chart below is the way the ‘bubble’ in the dollar captures the entire equity bear market. In a sense the idea is that when the dollar outside of its normal trading range… bad things happen. They continue to happen until the dollar is forced back into the broad channel. Given that the dollar moved through the bottom of its channel last year we will continue with the argument on the next page.



Equity/Bond Markets

At right we feature a chart comparison of the U.S. Dollar Index (DXY) futures and the S&P 500 Index (SPX) from late 2006 to the present day.

On page 1 we showed that when the dollar got ‘too high’ in 2000 the SPX effectively crumbled only to make bottom in 2002 when the dollar had returned to the channel top.

The premise is that any time the dollar trades above 105 or below around 81 the SPX something negative is going to happen to the SPX. The chart at right certainly supports that assertion.

When the dollar declined to around 81 in the spring of 2007 the SPX began to work into a ‘top’ that extended into October. By simply drawing a trend line under the series of lows that the SPX has made since 2007 we can ‘date’ the start of the negative trend back to April of 2007 which, of course, is exactly the point in time when the dollar first hit its channel bottom.

Many will argue that the dollar has no where to go but down and that might well be true- for now- but the chart argues that as long as the DXY remains below 81 the farther the SPX will fall. Our view, of course, is that the dollar is on the road to recovery and that as it pushes back above 80- 81 the SPX will start the process of making a bottom.

The charts below compare the DXY futures with the CRB Index with chart at right covering the time frame from 2001 into 2003 and the chart below running from the summer of 2007 to the current time period.

Into 2002 the dollar was ‘too high’ and was being forced lower. The offset to the weaker dollar was stronger commodity prices. In 2008 the dollar remains ‘too low’ so the offset to this is downward pressure on commodity prices. The issue, we suppose, is how long it takes for the DXY to rise back above 80- 81. Ideally this occurs during October as the CRB Index is forced back towards 300 but with the post-hurricane oil markets still tight and the grains crops needing a couple more weeks without frost this is hardly a given.