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November 28, 2005

Dollar Revisited

On November 7 this blog made a case for watching the US Dollar Index as the primary indicator of stock market direction. The dollar index seems to be signaling stock market inflection points with about a month of lead. Given that the strength of the dollar has been a point of fretful focus, it is not surprising to see it become a preeminent psychological factor to traders.

An updated chart (below) of the front-month dollar index future shows a possible inflection point occurring two weeks ago. Today's sharp dollar decline increases the probability that an inflection point has, indeed, occurred. Previously, a turning point in the dollar signaled an inflection in stock prices with about 3-5 weeks of lead time. However, if more traders are catching on to this correlation, the effect could be accelerated, meaning we could be witnessing an equity market turning point presently. It will be an interesting and important development to watch.

dollar index chart

Today's action, as expected, was considerably more interesting and meaningful than last week's low-volume brew. That the major indices sold off from the get-go, despite solid overnight gains in the index futures, tells us that the October rally is weakening. I do not expect to see end-of-month tape painting tomorrow or Wednesday. The tape has already been painted bright green over the passed 4 weeks, and the aforementioned dollar weakness will weigh on equities.

Yahoo and Beazer Homes, the two stocks with currently open short signals in my model, both got hammered today, falling 2.5% and 3.5%, respectively. There seemed to be general weakness in the homeys with Centex, Building Materials Holding, Toll Brothers, and KB Homes all down at least 3%. IBM and Apple, two stocks that have shown tremendous strength this month, both managed gains in the face of today's sharp declines. I am itching to form short positions around these two stocks, but have not seen whatever it is I want to see to pull the trigger.

Speaking of assets correlated with the dollar, the shinies put on a superb show today. Silver knocked off a cool 20-cent gain while gold gain over a percent to come within a whisper of $500. But the prize goes to platinum which cracked a spot price of $1,000 per ounce for the first time ever. It was only 6 years ago that gold and platinum were both trading within $100 of each other. With the rapid growth of platinum's industrial uses, it has left gold in the dust. I believe that silver's industrial uses also give it an edge over gold, and so I have weighted my metals positions more toward silver.

And finally, oil. Last Wednesday I mocked financial journalists for their reckless habit of drawing fatuous correlations between the stock market and other asset prices, namely oil. Today, oil fell nearly 3%, but the markets nevertheless sold off sharply. Doubtless, this fact will be dim in their minds, and the next time we see oil down on a day the market rallies, we will hear more proclamations of a direct correlation. In the meantime, I am keeping an eye on a couple of oil-related stocks, Chevron and Encore Acquisition, as my targets for playing energy the next time a rally seems to be upon us. I will write more of those two companies in the near future.

Disclosure: Short BZH, BMHC; Long YHOO Puts


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