Dollar Will Foretell S&P's Next Move

By MoneyShow.com | March 28, 2012 AAA

JW Jones of Options Trading Signals believes upcoming price action in the US dollar index will bring about one of two possible scenarios in the S&P 500, and one is the more likely of the two.

The recent rally has been breathtaking, however, the majority of investors have missed out on a large portion of these gains, as significant levels of cash have been either moved to bond funds or taken out of the equity markets consistently during this rally.

That’s just one more reason to be a trader with at least a portion of your portfolio. Let’s face it, financial markets around the world are not what they once were.

US equity markets in particular are manipulated by high-frequency trading, which is wreaking havoc in the marketplace in terms of potential short-term volatility expansions and “flash crashes” that can be isolated to one underlying stock.

See related: How Any Trader Can Beat the Computers

In addition to the high-frequency trading robots, the Federal Reserve is equally involved in the direct manipulation of financial markets through record easing adjustments. The Federal Reserve has unleashed massive amounts of liquidity while keeping interest rates incredibly low, which has produced an environment where the risk-on attitude permeates the landscape.

As a basic example of the failure of recent Federal Reserve policies and their impact generally on the valuation of various underlying assets, I submit for consideration to readers a 20-year price chart of the US dollar index.

20-Year US Dollar Index Chart

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It boggles the mind to consider that Chairman Bernanke routinely denies that the Federal Reserve has failed to maintain what he calls “price stability.” When looking at the chart of the valuation of the US dollar against a basket of foreign currencies, most fifth graders, if given the context, would proclaim that the Federal Reserve has failed in their objective to maintain price stability.

As time passes and the financial crisis moves further into the rear-view mirror, average Americans have varied views about the economy, the stock market, and trust in their government. For most Americans, the stock market does not make sense because they view the stock market and the economy as the same thing. Sophisticated investors understand that stocks and the economy are two totally separate issues, particularly with the amount of manipulation that has taken place since 2007.

This manipulation has not gone unnoticed by the average American. Now more than ever, regular people are not only distrustful of domestic financial markets, but also of Wall Street in general...and for good reason.

In light of this, data compiled during the recent uptrend suggests that retail investors have been pulling money out of equities for weeks even though prices continue to move higher. The chart shown below courtesy of ZeroHedge.com illustrates the recent trend.

US Domestic Mutual Fund Flows

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The chart above shows the price of the Sypder Trust (SPY) represented as the black line and equity fund inflows/outflows as the red area. As can be seen above, retail investors have been pulling massive amounts of capital out of equity-based mutual funds over the past few months as equity prices have rallied. The retail crowd, commonly referred to as “sheep”—or courtesy of Goldman Sachs, “muppets”—are selling into the rally.

So why is the retail crowd selling? They do not believe that this rally will last because the real world around them is arguing in the face of everything this rally stands for. Gasoline prices are crippling the lower and middle classes, further reducing their disposable income. Higher food and energy prices paired with job scarcity and serious concerns have begun to mount.

See related: Doomsday Speculators in Lousy Company

The average retail investor believes the game is rigged at this point and thinks they are only helping Wall Street bankers fund their lavish lifestyles. Ultimately, the retail crowd likely believes that the only way to win the game is to simply not play.

Will time prove the supposed sheep wrong? Statistically, one would think so, but in this case, the retail folks may just be right. Headwinds surround the global macroeconomic landscape. Europe is moving into a recession which is being exacerbated by austerity measures. Data came out Thursday (March 22) that the PMI in several European countries and China contracted. Ireland missed growth targets, and central banks around the world continue to print unprecedented levels of fiat currency, as if printing money and creating more debt will solve a debt problem.

NEXT: The Bullish and Bearish Cases for S&P 500

All of these issues are concerns, but ultimately, price is the final arbiter in the world of flickering ticks. From these eyes, there are two possible outcomes for the price action in the S&P 500. The first outcome—which I believe is more likely—is a test of the 2011 highs, which results in a snap-back rally that takes us deeper into the 1,420-1,440 resistance zone. The chart below demonstrates the bullish potential outcome.

SPX Bullish Outcome

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Price action at some point will backtest the 2011 highs, and the reaction at that point will be critical. Generally speaking, price action does not break a key support or resistance level on the first attempt. Usually, the second or third attempt will result in a break of a key support/resistance level.

In this case, a test in the coming days would likely result in a bounce and reversion to the previous trend. A possible, albeit unlikely outcome, would be a break below the 2011 support zone, which would then come close to triggering a trend change. The daily chart below demonstrates the bearish potential outcome.

SPX Bearish Outcome

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I do firmly believe that the US dollar index will hold clues about the future for the price action of equities. According to cycle analysis, the dollar should come into its daily cycle low sometime in the next few weeks, if not sooner.

From that low, we should see another move higher for the dollar index, which I anticipate will test the recent highs near 81. The daily chart of the US dollar index futures is shown below.

US Dollar Index Futures Daily Chart

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If my expectations are somewhat accurate, the short-term weakness in the dollar will assist stocks and risk assets in a move above recent highs. In the case of the S&P 500, a move to key resistance at 1,420-1,450 could occur.

Readers should keep in mind that weakness could be disguised as just a consolidation near the 20-period moving average, which has occurred in the past when analyzing the dollar index. However, I would not rule out one more leg lower before the dollar finds a bottom.

See related: “Blast-off” Level for US Dollar Index

NEXT: What's Ahead for Gold, Silver, and Gold Mining Stocks

Gold, silver, and the miners have been under selling pressure for some time and are likely due for a bounce to the upside. The weakness in the dollar discussed above would allow precious metals and miners to work off some of the short-term oversold conditions that we are seeing presently.

The daily chart of gold futures is shown below.

Gold Futures Daily Chart

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After a move higher into or around the $1,700/ounce price level for gold, I believe that another leg lower will be quite likely.

Conclusion

Readers should be mindful that the first quarter in the financial markets will end on March 30. Window dressing and portfolio painting are likely to occur this week. I would not be at all surprised to see the tape painted to the upside during the final week of March after the brief pullback that we witnessed on Thursday and Friday morning.

Money managers want to show off their returns while demonstrating ownership of key names that drove performance during the quarter such as Apple (AAPL). I expect the price action for the rest of this week to have relatively light volume and a bias to the upside.

Barring any major financial news or geopolitical events, I do not expect to see price action work below the 2011 highs in the near term. The possibility cannot be totally ruled out, but it would seemingly be a rare occurrence to see a major support level break down on the first backtest attempt. We may see lower prices early this week, but if the 2011 highs hold, the bulls remain in control in the short term.

The real question readers should ask themselves is if prices do extend higher and we reach my target resistance zone for the S&P 500, will the retail crowd jump in and push prices higher, or will the banks be trading with each other as a major top forms? In coming days and weeks, we should find out once and for all just who the real “muppets” truly are.

By JW Jones of Options Trading Signals

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