A Closer Look at the Dollar, Correlation, And Causation, Part I

Correlation does not imply causation.

This is true. Just because there is a relationship between two items does not mean that the effect on one is due to the other.

In the case of the dollar, we do know that there is a relationship between the dollar going down and asset prices going up. Can it be used to predict? Is the relationship always there? This is where we need to look at charts to help us make determinations.

Please take a look at the chart of the S&P 500 over the last 3 full years, from August 2006 to August 2009. Click on the image for a closer view.


What do we see here? First, in the foreground, we have the S&P from August 2006 to present, which generally rose, peaked in October 2007, crashed into March of 2009, and has been rising since. The S&P 500 is, in our opinion, the best measure of US corporate health.

The blue, green, and red lines are the 50, 150, and 200 day moving averages for the S&P, respectively.

The dark gray-black line is the USDX in the same period. You can see that the stock market has generally moved against the USDX.

The red vertical lines are draw where the USDX and the S&P 500 have crossed on the chart. The red lines divide the chart into four sections. We've labeled the periods as follows:

1. Pre Crash [Until end of October 2006]
   
2. Stock Market Crash Period 1 [Late October 2006-Early October 2008]
   
3. Credit Crisis Deleveraging [Early October 2008-Late July 2009]
   
4. Where Do We Go From Here? [Late July 2009-Present]
   

Note that in the Pre Crash Period, the USDX and the stock market were NOT correlated. Both were rising.

The first cross occurred in late October 2006. Note that this period is also considered the peak of the housing market.

We first heard about possible problems with Bear Stearns hedge funds in March of 2007. That's about the time that the dollar really started falling fast.

By October of 2008, the stock market started falling, but the dollar was falling faster. You can see the gap between the dollar and the S&P widen.

The dollar started bottoming in March of 2008. It set up a consolidation pattern where it traded between the lows of just under 72 to about 74 from March to mid-July, 2008 (shown in the red box).

It was at this point that the dollar broke out of its trading range and went parabolic to the upside.

We cross into the "Credit Crisis Deleveraging" period in October of 2008, although it could be argued that the real deleveraging started with either the bottoming of the dollar in March of 2008 or with the breakout from the bottoming in August of 2008.

November 2008 and March 2009 may prove to be a "double top" in the dollar (circled in red). Since the dollar peak in March, it has declined as the stock market has "recovered."

The USDX and S&P crossed again in late July. The question we want to answer is "where do we go from here?"

We believe that the USDX may be the best determinant of asset direction because of the correlation in the dollar to assets, notably commodities. It is true that correlation does not imply causation--that the dollar alone does not determine asset prices. However, we KNOW that the price of anything depends on the supply and demand characteristics of the thing itself and the supply and demand characteristics of the currency it is measured in.

Let's look at the same chart, but with different mark-ups. Please make sure you're comfortable with the relationship of events in the prior chart before looking at this one. It's busy, and without studying the first one, you can get lost.


The red vertical lines still mark the same period locations where the USDX and the S&P cross.

The blue circles and lines correspond to dips in the dollar and intermittent peaks in the stock market.

The green circles and lines correspond to peaks in the dollar and intermittent dips in the stock market.

Note that in the Pre-Crash period before late October 2006, the market correlation we're observing did not exist.

In the Stock Market Crash Period 1, from late October 2006 (peak of the housing market) to early October 2008, we see that the dollar makes a move, and then there is a corresponding move in the stock market. The first dip in the dollar, circles in blue in December 2006, has a corresponding rise in late February 2007 (approximately 2.5 months). As time moves on, every dip in the dollar is met with a peak in the stock market, but the lead time between dollar moves and market moves decreases, ultimately being almost simultaneous by mid-September 2008.

At that point, we enter the Credit Crisis Deleveraging period of early October 2008-late July 2009. The dollar "lead time" now appears to be getting longer and longer.

Let's look at the dollar vs. the Reuters commodity index. Since the dollar is the reserve currency of the world, we would expect that commodities, which have to be priced in dollars (since it's the reserve currency), would rise in price as the dollar falls. Let's see.


Holy Correlation, Batman. This chart needs NO explanation. All it shows is a perfect correlation between prices of commodities and the value of the dollar. The credit crisis made commodity prices crash because it sparked a demand for dollars. It really is that straightforward.

Thus far, this analysis appears to be telling us that the supply and demand of dollars is taking precedence over the supply and demand of assets since at least October 2006 (and longer in the case of commodities), which was the peak of the housing market. Before we dig into that specifically, let's take a look at the dollar vs. gold:


As one would expect, most of the time gold moves opposite the dollar, and the move has almost no lag time at all. The exception was between late December 2008 and March 2009 (bottom of the stock market). During this period of panic, gold and the dollar were both considered "safe havens" while the stock market was massacred Since March of 2008, the dollar has resumed its downtrend and gold has been in a trading range. We believe that if the dollar continues its downtrend, gold will break out of its trading range by surpassing the 990 mark and will move on to much higher highs.

So let's look at the S&P again, but compared this time to gold instead of the dollar.


Note that gold tends to lead the stock market as well. It's as if the first decision is "do I hold dollars?" The next decision is "do I hold gold?" Then some money flows to stocks accordingly.

From January 2008 until August of 2008 was a period where gold and stocks were essentially in chaos. There was no discernible relationship. This period overlaps with the rise of the dollar out of its trading range and ended during the period of "flight to safety," which benefited both dollars and gold.

Finally, a look at commodities vs. gold. After all, gold is a commodity, right?


Maybe no. Gold is a commodity in this chart until October of 2008--the beginning of the Credit Crisis Deleveraging period from the first chart. Since then, although commodities move with gold (and opposite the dollar), gold took leadership over when during the "flight to safety period" it held up along with the dollar. Since then the dollar has fallen, but gold has held on.

What does this all mean? Fundamentally, this crisis has been about the dollar. We have two separate but related issues going on. The first is that the dollar is under pressure to decline. It has been trashed by politicians and inflation now for years. The other crisis is the crisis of credit. When the credit crisis rears its ugly head, it forces a rise in the value of the dollar. The more it does this, the more politicians weaken the dollar with inflation. Gold has now taken the leadership role and is the only asset out there which has maintained its value.

The stock market has a whole lot less to do with the economy than it does with the value of the dollar, and conversely, the value of gold.

The key is to determine when the dollar may rise, which would be a reaction to the credit crisis. After a period of time, the crisis will abate, but the dollar will fall again while gold will maintain its value relative to everything else.

Remember "store of value?"

One more, before we go....

This is the USDX in the last few months. We redrew the symmetrical triangle that we spoke about near when we first started the blog back in June. Note that we predicted a breakdown through the bottom of the triangle, which happened around July 20. Note also that this diagram comes from Friday. Since then, we've broken down through the support level (red horizontal line below the triangle) of 78.33. This is major. Commodities today are reacting accordingly.

Note the RSI failed to rise above 50 on the top of the chart (bearish signal) and the slow stochastic is turning negative (bottom of chart).

Interestingly, gold has not reacted as much. We think we know why, but we'll cover that more later. Right now, the trend stands--assets rise and the dollar sinks. Expect prices at the grocery store to start moving again. We have to keep any eye out for the credit crisis return, but if it does not, or until it does, this market moves one way--crashing dollar, rising asset prices.

Get used to reading charts. It takes some practice, but without them, you're flying blind.