Top Advisors Corner

FinGraphs: Let's wish for continued Dollar strength

Jean-Francois Owczarczak

Jean-Francois Owczarczak


We last contributed before spring-break, to be precise on the 27th of March.  We were arguing that this time was different, that markets differed from the 2000 and 2007 tops. Cyclicals stocks (e.g. the SPDR XLY Consumer Discretionary ETF) had indeed been leading the way up (unlike in 2000 and 2007) and a combination of a very strong Dollar and subdued oil prices were “fueling” a positive wealth effect for consumers or for 70% of the US economy (not the case in the aftermaths of the Internet Bubble or the Subprime Crisis).  The current FinGraphs’ Daily Mosaic below still reflects this situation (Daily charts usually deliver an investment perspective over the next few months):


In the first chart above, although it has had to brush off two consolidation periods since early December, SPY (or the SPDR S&P500 ETF) is back near its consolidation highs.  Our trend analysis still shows a potential “Bull” and price targets do extend further. Our second chart is the relative performance of XLY (the SPDR Consumer Discretionary ETF) vs SPY. It has led the market up, has reached our Impulsive targets up (“I up done”), but is still showing a “Bull” (possibly pointing to an intermediate consolidation before moving higher).  Our third chart is the Dollar Index, it has reached extended Impulsive 2 targets up (“I2 Up done”). We argued in our contribution mid March that this situation was exceptional and that although this trend seemed overextended, given its speed and strength, it could continue up following several weeks of correction into early April.  There is a lot of talk about the US Dollar being the main culprit for US markets underperformance vs other international markets. We, on the contrary, believe that it is the other markets which are on steroids and that the Dollar strength actually has a net positive effect on the US economy. It cheapens imports and keeps a negative pressure on the price of commodities.  Sure it’s disinflationary, sure it impacts earnings generated abroad, but the net wealth effect to US consumers remains positive.  This leads us to our fourth chart above or the Daily chart of Brent Oil.  The drastic fall in Oil price in the 2nd half of last year is equivalent to a huge tax break for US consumers.  The correction up, although significant, is well within what could be expected (our grey oval corrective up targets “C up” are between circa $62 and $72).  We believe the longer term downtrend remains intact for now as we will see when we consider the Weekly chart of Brent Oil later on in this paper.

So three weeks ago, we were quite positive.  We believed that the March correction presented an interesting “buy the dips” opportunity and that the uptrend on SPY although climbing a wall of “Dollar strength worry” was still in place. Indeed, over the last couple of weeks, SPY did move back up to flirt with its consolidation highs.  Yet, last week, the upside breakout was rejected and SPY corrected down strongly on Friday.  We feel that the market internals over the last week offer interesting insight into the dynamics at play. No trend is linear and such set-backs, as long as they do not turn into outright reversals, often provide valuable guidance as to what to watch out for in the future.  For this purpose, let’s consider the FinGraphs Hourly Mosaic below featuring the same set of instruments (Hourly charts usually deliver an investment perspective over the next few weeks):

Last week, as you can see from the first Hourly chart above, SPY did attempt to continue its advance towards previous highs.  Yet on Friday, the idea of a possible breakout was rejected as US markets corrected circa 1.5% to close down for the week (followed by a decent snapback today).  One can notice that market internals were indeed quite different last week from the ones in the previous two weeks.  In the second chart above, Consumer Discretionary (the XLY SPDR ETF) corrected quite significantly vs the general market (SPY).  Was it due to a new correction down on the USD (third chart featuring the Dollar index DXY) or an upside breakup on Oil (fourth chart featuring Brent Oil)? Both are probably related anyway.  Our conclusion looking at last week’s events, is that investors really need to understand what they are wishing for. Indeed, a weaker Dollar would probably help the Oil countertrend rally to continue.  More generally, the price of imports would also be adjusted up. Such events would have an immediate impact on consumers and as we have seen above on our Daily charts, it is precisely the more cyclical Consumer Discretionary sector (XLY) which has been one of the key forces behind this year’s positive US market performance.    

Follow me through, the USD started to rally from mid last year. It was reacting to the termination of Quantitative Easing 3 in the US and to prospects for an acceleration in US economic growth (and a related pick-up in inflation and possible US rate rises from mid this year).  Abenomics and Europe’s own quantitative easing program provided an additional push. Yet, interestingly enough, the USD rise is actually having a disinflationary effect in the US.  It probably exacerbated the drop in oil prices and it is keeping the cost of imports as well as the price of commodities under pressure. The benefits for US consumers are significant and we believe they outweigh the competitive disadvantage the strong USD imposes on US corporations.  Last week’s price action may highlight the new dynamic.  Unlike in February, when US markets and XLY vs SPY rallied on the back of a consolidating USD (almost a relief rally), the recent price action saw the Dollar, the general market and XLY vs SPY correcting down.  If these corrections were to accelerate, oil and other commodities would probably continue/start to rally on the back of a weakening USD.  The positive wealth effect for US consumers could gradually disappear. Domestic Consumption and economic growth could slow, resulting in further Dollar declines (a negative feedback loop). To sum it up, in a predominantly domestic and import focused economy, which is trying to get going, such as the US right now, a strong currency with decent growth and low inflation is probably the best one can hope for.  Sure, at some point, as economic expansion matures, commodity prices will rally on the back of increased demand, inflation will start ticking up, rates will rises, bonds will correct.  However, it feels widely premature to wish for such events today, especially given that we are still working through a large government and private debt overhang.

It is also interesting to consider last week price action in other international markets.  Indeed, as we have argued in previous contributions, the US cannot be the only motor of growth in the world’s economy.  With China slowing structurally, an economic upturn would definitely need growth in Europe and Japan to continue their recovery.  The Hourly Mosaic below highlights what we would not want to see happen:

On the back of a renewed EUR/USD correction up (first chart) and some concern about GREXIT, the Dow Jones EuroSTOXX 600 dives (second chart).  Similarly, as the correction down on USD/JPY resumes (third chart), the Nikkei 225 Index starts to consolidate (fourth chart).

To sum it up again:

Continued Dollar strength is essential to keep the momentum in European and Japanese equity markets going.  Yet, it is also a net positive for US markets and this despite concerns about the translation of foreign earnings and the competitive disadvantage of US corporates abroad.  Indeed, it keeps commodity prices under pressure (oil especially) and by doing so generates the equivalent of an instantaneous tax break for US consumers.  On the contrary, we believe that if the USD started to correct down, it could trigger a very negative string of events: the oil correction up would gain further momentum putting pressure on the US consumer and more generally on the cyclical market sectors.  The general market would correct and non-US markets would only make it worse.  Commodity led inflation would tick up, discussions about rate hikes would take centre stage, the bond market would start correcting and more generally volatility would accelerate up.  In turn, these events would put a brake on US growth prospects resulting in a negative feedback loop as further Dollar declines take their toll.

We will look to the following Investor’s Views on the Dollar Index, Brent Oil, XLY vs SPY, SPY and the EuroSTOXX 600 to weigh up the current correction. For reference, a FinGraphs’s Investor’s View is a combination of a Weekly, Daily and Hourly chart.  It is meant to give the perspective over the next few quarters (Weekly left hand chart), over the next few months (Daily middle chart) and over the next few weeks (Hourly right hand chart). 

DXY (Dollar Index) – Investor’s View (Weekly, Daily, Hourly chart combination)

As we wrote mid March, the move up on US Dollar has been exceptionally strong and rapid.  It has now fulfilled our Weekly (left hand chart) Impulsive targets (“I up Done”) and our Daily (middle chart) extended Impulsive 2 targets (“I2 up done”).  In that report, we had gone back over the last 100 years to find similar situations on market key drivers (market indexes, commodities, FX pairs) and concluded that such very extended situations usually trigger intermediate tops, not major reversals. Focusing back on the Weekly chart above, we notice that the Risk Index has only just entered the OverBought zone.  Both envelopes are touching each other, which is a sign of Market Stress (of exaggeration).  Yet, the wider envelope (the dark yellow one) is still heading up quite aggressively pointing to the intermediate nature of any correction. The Daily chart is in a similar situation, the Risk Index is just reaching the OverBought zone and although our envelopes have been in contact for more than a month, the larger envelope is still heading up quite nicely. It is hence premature for now to call an important reversal and although our extended Impulsive 2 targets have been met, we would consider the current countertrend on our Daily chart as a mere consolidation. So, over both the long and medium term, we continue to follow the trends up.  We are focused on the two “Bulls” which for now are still in place.  Finally, the Hourly chart (right hand chart) highlights the current consolidation phase.  Although both envelopes are touching each other to the downside, which may justify initial levels of support, the Risk Index is still mid range and our targets are pointing lower (although limited time is left in this move).  We hence cannot exclude further weakness during the rest of this week.

Brent Oil - Investor’s View 

The Weekly (left hand chart) on Brent is in an impulsive move down.  It has reached the initial boundaries of its targets range.  Yet, the move could extend further both from a time and price perspective (i.e. downtrend still in place with possibly more downside potential).  The Risk Index is Oversold, but hasn’t reversed yet.  The Larger envelope is still pointing aggressively down. In this context, the Daily (middle chart) is correcting up. The price move for now is just a correction (grey oval target range labelled “C up”).  It would need to make above this target range to actually endanger the longer term Weekly trend.  This would be the case if it were to move above U$ 72.39. We are still quite far away from these levels (Brent is currently flirting with the lower end of these corrective targets around U$ 63-64) and hence we will consider the current Daily price move as a mere correction for now.  Finally, on our Hourly (right hand chart), the acceleration up last week is clearly visible. Yet, we have now reached Impulsive targets up (“I up”).  In the context of a Weekly downtrend and a mere Daily correction up, such countertrend exhaustion may provide strong resistance. That said, we cannot confirm that this shorter term uptrend is quite over yet, as the large envelope is still pointing strongly up and the Risk Index is only entering its OverBought zone.  Brent may have a few more Dollars to climb.

XLY (Consumer Discretionary SPDR ETF) vs SPY (S&P500 SPDR ETF) – Investor’s View

Our Weekly and Daily (left hand and middle charts) are still heading up although they have reached their initial Impulsive up targets.  Yet again, on both charts, the Risk Indexes are still shy from the OverBought zone. Hence, although the reward may be limited, the risk is not yet in exaggeration.  We will give these uptrends the benefit of the doubt for now.  The Hourly correction (right hand chart) last week is nevertheless quite impressive.  Although, this countertrend may be showing early signs of exhaustion (Risk Index nearing the OverSold zone with both envelopes touching each other), it will probably be another week before it finds support in its impulsive target zone down.

SPY (S&P500 SPDR ETF) – Investor’s View

So SPY has climbed a wall of worry, yet it is till heading up both on our Weekly and Daily charts (left hand and middle charts). On our Weekly, extended Impulsive 2 targets are still some ways out, both in terms of time and price.  The Risk Index is not yet Overbought.  The Daily is in a similar situation: its Risk Index is still mid range and Impulsive targets are also pointing higher over the next month or so.   The Hourly (right hand chart) is showing strong resilience. Following Friday’s sell-off, it snapped back rapidly on what was really a very limited Dollar upward reaction today.  Our trend indicator is in a Bear, yet corrective targets down were achieved some time ago.  We believe there is no need to be too alarmist at this stage.

SXXE (EuroSTOXX 600 Index) – Investor’s View

EuroZone markets have had a tremendous run since the beginning of the year.  They have pretty much achieved their Impulsive targets up both on a Weekly and Daily basis (left hand and middle chart). Yet, their Risk Indexes are just starting to be OverBought.  Hence, although the correction down last week on our Hourly (right hand chart) is compelling and doesn’t seem quite over yet, we will continue to favour a continuation of the medium and long term trends for now.

Some may consider our analysis of these Investor’s Views above as positively biased. Yet, all we are doing is following our Weekly and Daily trends on DXY, XLY vs SPY, SPY and SXXE.  Some of these may be nearing exhaustion.  Yet, all of them, are still showing potential Bulls on a medium to long term basis (Daily and Weekly).  In the case of Brent Oil, we remain negative on a Weekly basis as it would be farfetched to consider the current Daily countertrend move up as anything but a correction for now. 

In this context and although they may extend a few more days, we would consider the current negative Hourly dynamics as transitory for now.  What they do seem to reveal, however, is that the market as a whole is vulnerable to US Dollar weakness. This could serve as valuable information in future corrections to come.

Previous articles mentioned in this paper:

This Time is different (27th March 2015):
http://stockcharts.com/articles/tac/2015/03/fingraphs-this-time-is-different-.html

Triangulating possible targets on EUR/USD using its cross rates (16th March 2015)
http://stockcharts.com/articles/tac/2015/03/phonographs-triangulating-possible-targets-on-eurusd-using-its-cross-rates.html

For more information on our methodology click here (http://www.fingraphs.com/#couponid-STKCHARTS14) and then view the Introduction slide-show and visit the ‘User Guide’ section on our website.  Clicking that link also qualifies you for a 7 day demo and a 10% discount on our services if you choose to subscribe.

We wish you all the best with your trading week, J-F Owczarczak (@fingraphs)