Sunday, January 7, 2024

Stocks Won’t Rally as Long as This Does

Stocks Won't Rally as Long as This Does

The stock market has closed in the red three days in a row since the start of the year.

This is highly unusual. Going back to 1990, it's only happened four other times:

1991 — 6 days
2005 — 3 days
2014 — 3 days
2015 — 3 days

Normally, stocks start the year on a high note — with optimism carrying over from the "Santa Claus Rally."

But not only are we not getting that… Santa Claus hardly came to town at all this year.

After the S&P 500's breakout in mid-December, the index gained merely 1% more before the year closed out.

What's going on? And more importantly, what can we do to know when the bleeding might stop?

It lies in the chart of the very greenbacks we use to buy stocks… which we can track in the U.S. Dollar Index.

Let me explain…

Stocks and the Dollar Aren't Getting Along

For the past several years, the charts of the U.S. Dollar Index and the S&P 500 have had an inverse correlation (meaning, they move opposite each other.)

Take a look at this chart of the S&P 500 (orange line) with the U.S. Dollar Index — a measurement of the dollar's performance against a basket of world currencies — in blue.

I've marked vertical white lines at times when stocks and the dollar begin to trend away from each other, or otherwise show major divergences. With the exception of 2021, when the dollar meandered higher as stocks took off (starting at the yellow line), the effect is clear.

Note how the dollar treaded water before beginning a downtrend in the aftermath of the pandemic shutdowns, while stocks quickly recovered and reached new highs.

Also, look at how the dollar really picked up steam at the beginning of 2022 — when stocks began to crater.

Then, just the same, notice how the dollar began to weaken at the outset of 2023 before bottoming out in… late July, just before stocks began a massive and volatile correction.

And now, sure enough, the dollar has been rallying since late December, and stocks are faltering.

So now that we know a strong dollar is bad for stocks, the question becomes simple.

How long will the current dollar rally last?

Things to Watch in the DXY Chart

Let's zoom in on a daily candlestick chart of DXY and add a few key indicators:

With just a quick glance at this chart, my take is we should prepare for at least a few more days of rough weather in the stock market.

The dollar has been in a downtrend channel since early November, just before stocks began their miraculous year-end recovery.

Friday's price action initially looked to break DXY out of the channel, potentially beginning a new uptrend. However, at time of writing, prices have backed off and thus far failed to escape the channel. That's one point for dollar bears.

Either way, should the dollar follow-through and break out, it could indicate another long period of volatility that may last through the first quarter.

Next, look at the colored moving-average lines around the candlesticks — which plot the average price level of DXY over a period of time.

We have the 200-day moving average (in blue), the 50-day moving average (yellow) and the 9-day exponential moving average (orange) — a more short-term-oriented indicator. The 50-day MA is currently above the 200-day MA, and with enough positive price action in the coming days, could bounce off of it and start trending higher. The 9-day EMA, too, is working its way higher.

Should the 9-day EMA rise well above the 50-day MA, and the 50-day MA gain some ground above the 200-day MA, that's a strong bullish trend for the dollar.

And the evidence continues to pile up for that trend change. Both the moving average convergence/divergence (MACD) and relative strength index (RSI) indicators at the bottom of the chart are on a buy signal, with neither of them showing overextended conditions.

All this leads me to think we'll see quite a bit more volatility as we proceed through the first quarter. Traders should tread carefully — holding any new short-term bullish positions with tight stops. Long-term investors, naturally should look to add to their favorite stocks at better prices.

No matter how you invest, keep a close eye on the chart of the dollar. It's shown already to play its hand a bit earlier than the stock market — like when it began falling in early October well before stocks bottomed out. If we see the chart of DXY begin to slide and stocks haven't yet recovered, that'd be a strong sign to prepare for a proper recovery.

To your health and wealth,

Michael Salvatore
Editor, TradeSmith Daily

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Sunday, January 7, 2024