Rally vs. Dollar – Update

Since I last reviewed the market’s rally and the correlation to the dollar, the markets have continued to grind their way slightly higher. This bodes the question of whether or not anything has changed since my last review.

First, I’ve previously made my case that the rise and/or fall of the dollar is the key to the next major move in the market.  There has been a very obvious inverse link between the dollar and the equity markets. To review my take on this link, please go to: http://www.themeshreport.com/tuesday’s-sell-off-or-2-day-rally/ and http://www.themeshreport.com/time-to-look-at-the-dollar/

With the above articles in mind, please take another look at the dollar index, which I have included below:

Even though the markets have ground out slightly higher gains over the past couple of weeks, the dollar is holding its ground above its trend line support. Eventually, the dollar will have to do one of two things:  Either 1) Continue, and most likely accelerate, higher, or 2) Break support and continue much lower.

The reason why I say “accelerate” is because of the extreme bearishness I discussed in my previous articles. If the dollar were to gain any momentum on the upside, I would expect the equivalent of a short squeeze. However, if the dollar were to break lower, that could be the fuel needed for another leg up in the markets.

Ultimately, I believe that the Fed decision on Wednesday could be the piece of data needed to answer the question as to what the dollar’s next move will be. The obvious thought would be that the Fed’s issuance of QE2 would cause the dollar to move lower, but could it instead be a case of “buy on the rumor, sell on the news” for the markets?

The Tale of the Tape: The dollar appears to be the linchpin for the stock market’s next move. Probabilities say the dollar will hold support, in which case a long play on the dollar and/or short position on the market would make sense. However, if the dollar were to break support, shorting the dollar and/or entering new long positions in the stock market would most likely be the best trading opportunity.

No matter what your strategy or when you decide to enter, always remember to use protective stops and you’ll be around for the next trade.  Capital preservation is always key!

Good luck!

Christian Tharp, CMT