Last week I outlined how market psychology in October set the stage for the current rally. Let's take a bigger-picture look at psychology and try to determine what may signal the next turning point for the markets. During the course of the last year, there has been a growing concern that the US Dollar is done for: that we as a nation have over-consumed and that our over-consumption, which has been fueled by the Federal Reserve's printing presses, will eventually result in a severe consumer recession along with high inflation. Concern for the ultimate outcome is reflected in gold's recent surge. Stock traders, however, are a little more difficult to convince. They want proof by way of market action, and the dollar rally of 2005 is their signal that everything is okay... for now.
Let's take a look at a couple of charts. On top is a weekly chart of the US Dollar Index. Below, the same chart for the S&P 500:
Note how the US Dollar Index has lead the S&P 500 during 2005. Each inflection in the dollar index has lead a shift in equity prices by about a month. The dollar was falling into the end of 2004, preceding the January decline in equities. By the end of January, the dollar index had spiked, giving temporary reprieve to stocks. However, the sell-off in the dollar during February scared traders and precipitated a sharper equity sell-off starting in March. By the time equities bottomed in April, the dollar was pushing new highs for the year, helping stocks shift direction. Bears were surprised by the strength of the summer rally, but look how sharply the dollar rallied! The dollar turned south again in early July, and behold! Another equity swoon beginning exactly a month later. The fact that stocks didn't crash like the Hindenburg in October is, without a doubt, related to a new dollar rally, once again with about a month's lead time to the current equity rally. Now that the dollar is now setting new highs for the year, stocks should have impetus to extend the current rally.
Certainly, the fate of the US Dollar is forefront on traders' minds these days. The irony here is that higher interest rates are supporting stocks rather than hurting them by way of support for the dollar. In my opinion, bears should watch the dollar closely for signs of when to go aggressively short again. So, when will the dollar tank? If we can accredit gold traders with any amount of foresight, the time may be as early as January. Gold, which is in a bull market thanks to the Fed's monetary folly, started a sharp run to new highs in July. These types of anticipitory runs usually entail 6-8 month lead times to the underlying fundamental. Therefore, we could the dollar diving again early next year, followed by stock later in the first quarter.