The Strong Correlation Between Stocks and the U.S. Dollar

“Profit Confidential” Column, by Michael Lombard, CFP, MBA

In the last two weeks, the market has been so weak that even the contentious January indicator has turned bearish for 2010. The indicator turns bearish if the end of January closing price is lower than the preceding December year-end close. This January, the S&P 500 was down by 3.7%.

Thanks to the Internet, simple market patterns and indicators, such as the “January Effect,” are now so widely known that they fall into the category “what everyone knows is not worth knowing.” What has been getting more of my attention than the January Effect is the change in how the market reacts to financial news and data. From a technical point of view, it is more important how the market, a stock or a commodity reacts to pertinent numbers than the numbers

My impression is that, in recent weeks, investors are no longer buying into the slick Wall Street hype that otherwise abysmal data are “better than expected” and therefore bullish. Instead, the headlines signaling improving economy — such as the large and better than expected annualized quarterly gain in the U.S. GDP of 5.7%, the best since 1980 — have been greeted by market declines.

This lack of bullish responses to “good news” was also evident in how individual stocks have been responding to releases of surprisingly strong quarterly earnings. The current issue of “Barron’s” lists a dozen companies that reported quarterly earnings last week between 70% and 500% higher than their Street estimates.

Five of those stocks closed the week up from the day of reporting. The big gainer was Eastman Kodak (NYSE/EK), with earnings of $1.08 per share versus the estimated $0.18 a share. Among the seven stocks that lost ground, in spite of unexpectedly large gains in earnings, were Apple (NASDAQ/AAPL), Oshkosh (NYSE/OSK) and SanDisk (NASDAQ/SNDK). All things being equal, a market responding negatively to bullish news is hardly a strong market.

Another significant shift in market response to news has taken place in the currency markets. In the course of the rebound of the stock market from the March 2009 lows, the U.S dollar was mercilessly bashed, losing ground against most free trading currencies. Though news of the growing U.S. debt, budget deficit and job losses has remained as dismal as ever, the U.S. Dollar Index bottomed out at the major support of $73.00-$74.00, and over the last nine weeks has retraced 30% of its preceding loss.

The plot of the S&P 500 against the U.S. Index shows that, since early 2008, a close inverse correlation has developed between the two indices. While this correlation holds, the resurgent U.S. dollar is bearish for stocks, and more so for gold and other commodities.

My guess is that, beyond a rebound from the current oversold condition, further market weakness will take the market to new 2010 lows. In terms of the S&P 500, a 38.2% retracement of the March 2009-January 2010 rally would bring the index close to the first support of 950-960.