By Martin Pring
One of my favorite techniques for identifying important upcoming moves in financial markets is to combine a trendline violation by price itself with one generated by a momentum indicator. It's a pretty simplistic approach, of course, but usually highly effective, and that's what counts. The dollar did just this recently, and the impact on investors could be significant.
Chart 1 shows that on Sept. 30, the Dollar Index violated a two-year up trendline, and this was confirmed by a momentum indicator, the 18-month RSI, penetrating an even longer line going all the way back to 2008. Additional evidence of a weakening dollar comes from the fact that the Index also crossed below its 12-month moving average last month. These crossovers do not have a perfect record, but with just two false signals or whipsaws in 17-years that's not bad odds.
These price/momentum multi-year trendline penetrations signal that a fairly important down move is likely. You can see that from previous double-break combinations that have taken place in the last few years. Remember, this is a very long-term chart, so those apparently "small" rallies, signaled in 2006 and 2008, actually lasted for six months or more. The remaining signal was far more powerful.
The ultimate magnitude of the indicated dollar drop is unknowable, because technical analysis does not deal effectively with magnitude and duration. One useful technique, though, is to measure the maximum distance between the price and the up trendline, subsequently projecting it down from the breakout point. This exercise has been flagged by the two dashed brown arrows in Chart 1.
Remember, though, the measured move offers a probable, certainly not a guaranteed target. That seems a reasonable expectation in this case because there is major support just below the target area in the form of the dashed brown trendline which flags the lower area of the 2005-2013 trading range.
One thing bothers me about becoming overly pessimistic is the currency's muted reaction, at least so far, to the government shutdown and potential rancor concerning the debt ceiling. With a background like that, I would have expected the dollar to have fallen much further than it has.
Often a market that can shrug off bad news is one to be bought rather than sold. That's why I drew in the trendline marking the upper part of the 2008-2013 trading range. If the Index were to experience a monthly close a bit above the previous high at 83.5, it would completely reverse the technical situation, by resolving the trading range on the upside. That may be a possibility, but right now we have to go with the actual evidence and that's clearly bearish.
If the dollar does decline, the implications for financial markets will be threefold. First, it will place upward pressure on industrial commodity prices. In this respect, Chart 2 compares the Dollar Index (plotted inversely) to the CRB Spot Raw Industrials. The shaded areas indicate that all of the really strong commodity rallies in the last 40 years have been associated with a falling dollar. (Since the dollar has been plotted inversely that means a rising green line.) There are times when the dollar and commodities move in the same direction, so even if the Index does decline, that does not guarantee commodities will go up. However, if you are looking for a reason why commodity prices may advance a falling dollar is certainly a strong candidate.
The second implication is a rotational swing in the equity market towards inflation-sensitive sectors, such as resource-based entities and away from early cycle leaders such as homebuilders and other interest sensitive areas.
Finally, trends in the relative performance of U.S. equities against the rest of the world are very much tied in with swings in the dollar itself. In this respect, Chart 3 compares the Dollar Index to the relative action of U.S. equities against the rest of the world. That relative-strength line is calculated by dividing the S&P ETF, the /zigman2/quotes/209901640/composite SPY +2.48% , to the MSCI Europe, Australia and Far East ETF, the /zigman2/quotes/207663730/composite EFA +0.34% . You can certainly appreciate how both series move closely together and each has just violated an important trendline. Since a falling ratio favors the rest of the world the breaks indicate that the U.S. will underperform in period ahead.
There are no guarantees in this business, but if the recent dollar breakdown turns out to be valid going forward, we are likely to see higher commodity prices and resource-based equities and superior relative performance by non-U.S. equities. One caveat, superior performance means just that, it says nothing about the direction of absolute prices.