The Inter Market Report

Trading the World’s Markets

May 18, 2007                      

Matthew Caruso, CMT                                  

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Gold & the U.S. Dollar

Further down: S&P 500 & Russell 2000

Last week we studied the relationship between the rise in commodities and the stock market rally. This week we will look the relationship between Gold & the U.S. Dollar and the current situation they are presently in.

    The U.S. dollar and the price of Gold typically trade inversely to each other; rallies in the dollar lead to a fall in Gold and vice versa. An example of this intermarket relationship can be seen in Figure 1. It is clear from Figure 1 that the bear market in gold ended when the Bull market in the U.S. dollar finally reversed in 2001. This top in the U.S. dollar index led to a bear market that has lasted until the end of 2004. Similarly, the bottom in Gold in 2001 has led to a Bull market in Gold that has continued until 2006. What is important to note is that the U.S. dollar has not made a new low since its 2004 bottom, but gold has continued to climb to new highs until 2006. Therefore the U.S. dollar has not been confirming the rise and Gold and this may have some very bearish implications for Gold. If the U.S. dollar could stage a rally at current levels, it may be turning its trend from sideways to up. As well, if Gold were to fall from these levels it will be forming a lower high and would be beginning the start of a bearish pattern of lower high and lower low on its monthly chart.



    The preceding analysis presents the possibility for a change in fortune for two very important commodities. What is more important is to be able to forecast the probability of such events occurring. One method for doing this is to study the current position of commercial traders. The commercial traders are the smart money, and they historically hold large positions before up moves, and hold much smaller or even short positions prior to down moves in the prices of commodities. Figure 2 displays the index of commercial traders for the U.S. dollar index. When the commercials are bearish, which is represented by the green line being near the 0 level, the U.S. dollar typically falls and Gold rallies. When the commercial traders are bullish and the green line is near 100, the U.S. dollar rallies and Gold falls. Where does this leave us now? Well as you can see commercial traders are currently bullish with a reading at 92.31 for the U.S. Dollar. It is important to see if a dollar rally materializes because it will certainly have a bearish effect on Gold and other commodities as well. This will have a bearish affect on stock prices as well. A full explanation on its effect on stock prices is covered in last weeks report.

Russell 2000 & the S&P 500

    For avid watchers of CNBC it would seem that the current uptrend in the stock market couldn’t be better. However, after a close analysis it is clear that the underlying strength in the stock market rally is weakening. It is important to understand that there are 3 classes of stock, Large, medium and small capitalization (cap). The Dow Jones Industrial average is comprised of 30 large cap stocks and the Russell 2000 is an index of 2000 small cap stocks. How investors invest in these stocks can give clues to the future direction of stocks in general. Figure 3 shows the Russell 2000 in the upper panel and the Dow in the lower. It is important to notice that as the Dow has continually been making new highs, the Russell has stalled and is 8 days off its 52 week high. What does this mean? When investors are bullish on the future of stocks they will buy small cap stocks which are typically growth stocks with higher volatility and have the potential for quicker appreciation. When investors have a less optimistic or bearish outlook on stocks they will choose to invest in more stable large cap stocks which the Dow is comprised of. These stocks appreciate less quickly and have lower volatility and are viewed as the safer choice. Therefore the current new high in the Dow and lack of new highs in the Russell is showing that investors are less optimistic about the outlook for stocks and are now buying safer investments.


    

Another way to view this relationship is took look at the Russell relative to the consumer staple sector. The Staples are viewed as a sector to buy when the market is risky, this due to their stability and ability to generate income in good and bad economic situations. Figure 4 shows this relationship with the blue line in the bottom panel. When the blue line rises, the Russell 2000 is outperforming the staples and vice versa. As you can see, all new highs in the Russell since its 2002 bottom except the 2007 highs have occurred with small caps outperforming the large cap consumer staples. This means that for the first time in this entire bull market, small caps are not a leading group, in fact even the staples have outperformed the small cap stocks in 2007. This clearly shows that investors are no longer as optimistic as they were at other times in this bull market, and that they are preparing for a downturn in stocks.