Watch Dollar Longs And Commodity Shorts.

Watch dollar longs and commodity shorts.

Weeks back we wrote an article suggesting all kinds of actions to take should the dollar index clearly break down under 71.80.  But the dollar never closed below that level, and now it is not only threatening to breakout on the upside over 74.50 to signal a likely new intermediate-term bull move underway, but the dollar is rallying with more breadth against more global currencies than anytime since 2005.  This would be a tectonic shift in the market environment since 2005 if the dollar clearly breaks out, and portfolios would need to react.  The dollar action has many analysts scratching their head and wondering what on earth could make the dollar rally.  Certainly with the US likely in recession that will only be declared after the election upon revision, the Fed is very unlikely to raise rates.   There are therefore likely two main macro economic arguments for a dollar rally.  The first is that expectations for rate hikes abroad are plummeting and set to fall further as evidence mounts that recession or much weaker growth is spreading internationally while sharp declines in growth or recession are being felt by Canada, Spain, Portugal, Italy, Greece, Ireland, the UK, much of the Baltics, New Zealand, and Japan.  The more dire macro economic argument for the dollar is that the US could face a substantial consumption decline which could reduce the trade deficit more sharply than anyone could imagine.  Either or both of these forces, if boosted by increasing evidence, could help propel the substantially undervalued dollar higher in an increasingly deep and broad global slowdown ahead.  A clear breakout up by the dollar index over 74.75 would suggest UUP and other dollar favoring ETF longs with stops under last month's lows.

 
Chart 1:  Watch for clear dollar breakout over 74.75 to signal new bull leg up.  Courtesy Bloomberg
 
Chart 2:  JPY breakout of head & shoulder bottom signals likely continued Yen weakness.  Courtesy Bloomberg

The dollar/Yen or JPY on the forex market (which trades inversely to the FXY Yen ETF on the stock exchange) actually broke out of a huge head & shoulders bottom today with a nice thrust pattern breakout.  Forex investors could buy JPY with a 103.50 ops or stock investors could sell short FXY with an ops above 96.  The breakdown in the Yen increases the likelihood of a dollar breakout.  Japan is groping with recession and with its interest rates very low (1/2% currently) it has little room to cushion the blow of a weakening economy outside of a weaker currency.  Japanese bonds have broken out of a head & shoulder bottom this week as well, to confirm the weakening economy theme.

We talked last week about watching oil and the CRB index for signals of a breakdown in commodities.  Oil indeed has closed under the critical 120 level already, and the CRB is threatening severely to break down under the key 393 level.  The oil decline is a head & shoulders top that likely signals a more prolonged and deep oil correction to the 85-111 support zone off of the weekly charts.  One could short USO, the oil ETF, but we would prefer to short the commodity indexes as a whole on a clear breakdown confirmation of the CRB index below the 393 level, which can easily be done via by buying the short commodity ETF, DDP, with stops over last week's highs basis the CRB.

 
Chart 3:  Crude Oil has now broken under 120 to confirm head & shoulder top.  Courtesy Bloomberg

 
Chart 4:  CRB index will confirm similar major breakdown on close under 393.  Courtesy Bloomberg

In stocks while we have now had two follow-through days on the upside, we have not yet had a 90% up-day - nor are we seeing the type of global plurality, group leadership, or breadth typical of even a catchable bear rally yet.  We will keep an open mind and watch for more volume and breadth on the upside before trying to catch any buy signals in what we still strongly suspect is another bear market rally in stocks.  Note the chart at the bottom of the column which shows Top RS/EPS New Highs versus Bottom RS/EPS New Lows.  TRE New Highs are not yet 40 above BRE New lows, so a decent upside potential environment is not yet close to being signaled.  Normally we would like to see five trading days in a row of a 40+ advantage before believing that a truly decent upside environment is developing.  Group leadership seems to be heavily focused on former laggards like financials and airlines, and new high leadership is heavily focused in bio-tech and health care.  Those wanting to play this rally could focus on ETF's in these groups like IBB and IYH, or in stocks in these groups that are breaking out and close to criteria.

However, investors are encouraged to mostly stand aside from this dangerous market environment.  Short-sellers are being targeted but the fundamentals behind a sustainable economic rebound are absent.  Wait for clear breadth and volume on the upside before trying to play the next bear market rally that may be catchable ala March-May.  Continue to watch the dollar, oil, bonds, payrolls, consumption, and market internals for clues as to when this downward spiral will end.  If it ends soon and before too much more downside action in stocks, a global recession can still be avoided.  If it does not, and the recession grows into a consumption decline then there will be more rounds of write-offs from consumer debt and more broad-based earnings declines that will feed into a deep and more global recession than we've witnessed in many decades - and probably a sharp dollar rally.

The market remains in its most dangerous negative phase.  The Fed remains stuck in a box where it cannot raise rates because that would kill banks that are already on the ropes, but it cannot lower rates because inflation is flaring from higher oil and food prices.   It is helpful economically for oil prices to correct, and further downside in commodities will confirm a helpful trend here, although Iranian saber-rattling could interrupt it in the period before the election when the US and Europe will be pushing as hard as they can on a nuclear deal.

Our long/short strategy remains happily 100% in T-bills awaiting new trades.  Since our last update we got close calls on the buy side from OLN, GTLS, and PCM, and on the short-side from AXP, THQI, and NRG with no valid signals.  Check out www.midasresourcegroup.com for daily listings of Top EPS/RS New Highs and Bottom EPS/RS New Lows to make sure you catch all potential breakouts meeting our criteria.  As the chart at the bottom of the page illustrates, we do not have top RS/EPS new highs or bottom RS/EPS new lows in a clearly dominant position (40 over the other for 5 or more days in a row) to signal a good environment for either long-side or short-side dominated activity. This is often the most dangerous, volatile, and tricky phase of a bear market.

For those not familiar with our long/short strategies, we suggest you
review my book "The Hedge Fund Edge," my course "The Science of Trading," my video seminar, where I discuss many new techniques, and my latest educational product, the interactive training module. Basically, we have rigorous criteria for potential long stocks that we call "upfuel," as well as rigorous criteria for potential short
 stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published
on www.midasresourcegroup.com for breakouts of four-week or longer flags, or of valid cup-and handles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags
 or cup and handles on the downside. In the U.S. market, continue to only buy or short stocks in leading or lagging industries according to our group and sub-group new high and low lists. We continue to buy new long signals and sell short new short signals until our portfolio is
100% long and 100% short (less aggressive investors stop at 50% long
 and 50% short).   We keep capital in T-bill cash while waiting for more trades.

The chart below shows that neither Top RS new highs (available on www.midasresourcegroup.com) or Bottom EPS/RS New Lows are over 40, let alone greater than their opposite series by 40 or more.  Heavy cash and alternative asset class defense should be utilized!