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NOTE: Please look for the interview with Jay Kaeppel in the November 2009 issue of "Technical Analysis of Stocks and Commodities" magazine on newsstands now.

As I have mentioned several times in the past, one of the problems in the financial markets today is that we literally have a generation of investors who only know one approach to investing - put your money in the stock market. And of course, this method has some basis in historical fact, for in the long run, yes, the stock market tends to go up. Except of course for when it doesn't. Ah, there's the rub. In 2008, millions of investors watched in stunned disbelief as 50% or more of their investment dollars vanished into the abyss. Even now, many of them remain fully invested in stocks in the hope that the market rally since the March lows is only the beginning stage of a new bull market. But is it? There appear to be two basic (opposing) viewpoints.

OPPOSING VIEWPOINTS

There seem to be two primary ways of characterizing the March into November 2009 stock market rally:

Viewpoint #1: This viewpoint can be captured in one word and that word is "capitulation." In other words, the belief here is that collapse in late 2008 and the subsequent plunge to the March 2009 low cleared the way for a new bull market as many investors finally "puked" (an admittedly vulgar, yet entirely fitting description) and sold their stocks in a panic. This viewpoint avers that the stock market rally since that time is telling us that better things are ahead for the economy.

Viewpoint #2: this viewpoint can also be captured in a word and that word is "nuh-uh." In other words, those holding this viewpoint consider the rally from March until now to be nothing more than a rally in a bear market and that given all of the budget busting, tax raising and job killing ideas emanating from Washington D.C. these days, there is little hope for a sustained economic recovery anytime soon.

So which viewpoint should we believe? Well, as the old saying goes, "opinions are like, er, earlobes - everybody has at least one, and it's usually good to have at least two, just in case one of them doesn't work out." OK, well it was something like that. In any event the salient point is that both Viewpoint 1 and Viewpoint 2 can be argued quite convincingly.

Figure 1 displays both viewpoints in the same chart. Those adhering to Viewpoint #1 argue that the stock market fully discounted the near collapse of the financial system as both stock and (for the first time in generations) home prices plummeted during the 2007-2009 decline. Those holding Viewpoint #2 will point out grimly that while the March to November rally has been "nice," it still represents nothing more than a 50% retracement of the 2007-2009 down leg (See the horizontal percentage retracement lines in Figure 1).

Figure 1 - Dow Industrials: Capitulation and new bull market or 50% retracement rally in a bear market?
click here for larger view

So the obvious question is, "who's right and who's wrong?" Unfortunately, I don't claim to have the answer. I'm more of a "go with the flow" kind of guy. Still, for those seeking some guidance I would like to redisplay something I revealed last week, which I refer to as the "Handy Dandy U.S. Dollar versus Pretty Much Everything Else (or PMEE)" indicator. The "rules" appear in Figure 2.

Figure 2 - U.S. Dollar versus Pretty Much Everything Else Handy Relationship Guide

In layman's terms, if the U.S. Dollar is up, "PMEE" is down and if the U.S. dollar is down, well, you get the idea. Now I don't want anyone to start thinking that they can "forecast the markets with uncanny accuracy" or anything, but please take a look at Figures 3 and 4.

Figure 3 is my eSignal quote screen around 6:40AM on November 16. The December 2009 U.S. dollar futures contract (symbol DX Z9) is listed first followed by PMEE. Green means "UP", red means "DOWN."

Figure 3 - U.S. Dollar down, Pretty Much Everything Else up

Figure 4 displays my quote screen at around 5:16 AM on December 17. Again, the U.S. dollar is listed first followed by PMEE.

Figure 4 - U.S. Dollar up, Pretty Much Everything Else down

In Figure 3, the dollar is down. Note the direction of PMEE. In Figure 4 the dollar is up. Once again note the direction of PMEE. Anyone notice a trend?

So is it time to declare that "the dollar knows all?" or even better, that "you can't lose trading commodities based on the action of the U.S. dollar?" Sadly, no. While these examples are pretty stark, this is not one of those "always and forever" types of relationships. Still, it's presently pretty darn useful for those of us who reside here at "Camp Go With the Flow" (including many fellow alumni from "The School of Whatever Works" - or good old SWW for short).

WHAT NOW FOR THE BUCK?

Ah, human nature. What a wonderful thing. Expect of course when it's not. Many of us are not content to simply "go with the flow" and say "well if the dollar is declining I'll look at playing the long side of everything else." Oh no. The next thought is instead, "gee, if only I could accurately forecast where the dollar is headed next then I could in turn accurately forecast where everything else is headed also. How freaking smart would I look then?" Sigh. We here at "Camp Go With the Flow" frown at this type of thinking. We frown a lot. But of course, like many others, when it's dark and late at night, when there is no one around, we fire up our laptops, we log onto the Internet, we stop frowning, and we - what else - start analyzing charts of the U.S. Dollar (fortunately, "Camp I Need Professional Help" is right next door. But I digress).

Let's skip to the bottom line: the truth is that I cannot "predict" where the dollar is headed next. Still, given that "pretty much everything else" is pretty much inversely correlated to the action of the U.S. dollar right now, the one thing we do need to be concerned about is a reversal to the upside by the dollar. So with the caveat that we cannot "predict" the next move for the dollar, perhaps we can at least "surmise."

Figure 5 displays the dollar versus the euro with both weekly and daily Elliot Wave counts. The top clip shows that on the Weekly chart an A down wave may have been completed. If so, an "up" B wave would be in store next. The bottom clip shows that on the Daily chart a 5 wave down move may be winding up. In theory at least, this should be followed by Wave 1 to the upside. In any event, both chart suggest an up move in the dollar (and thus a likely concurrent decline in PMEE) could be in the offing.

Figure 5 - Dollar versus Euro (weekly chart on top, daily chart on bottom) with Elliott Wave counts

Figure 6 displays the same weekly and daily charts for FXUSEU with the 3-period Relative Strength Index plotted below. In both charts the RSI is moving higher while price is moving lower. This is what we highly advanced technical analysis types refer to as a "Double Upside Divergence" (DUD? OK, perhaps we need to spend a little time upgrading our acronyms).

Figure 6 - U.S. Dollar versus Euro (weekly on top, daily on bottom); RSI diverging to the upside on both weekly and daily charts (possible bullish divergence?)

SUMMARY

The U.S. dollar has been declining steadily since March of 2009. Pretty much everything else has been rallying since March of 2009. Hmmmm. As long as this wants to continue, I'm good with it. But clearly the thing we need to be concerned about and alert to the possibility of, is an upside reversal in the U.S. dollar. As I mentioned, while I can neither predict when this will happen nor the magnitude of such a move when it finally occurs, two things I do know are:

1) At some point the dollar will rally (and some reasonably reliable indicators are suggesting that a possible upside reversal in the dollar may be in the offing);

2) When #1 occurs, the odds are quite high that pretty much everything else (PMEE) will decline;

So should we sell and/or aggressively sell short PMEE? Not necessarily. At a minimum now is the time to think about what, if anything, you want to do if in fact numbers 1 and 2 start to unfold. That could mean selling some stock holdings, hedging a portfolio now using options or inverse ETFs or selling short a bunch of futures contracts. I can't tell you what's best for your own portfolio. In the immortal words of whoever said it to me first (I'm pretty sure it was my Father), "I'm not your Mother."

One last note: if by chance you do decide to aggressively play the downside of PMEE if the dollar rallies, please remember:

Jay's Trading Maxim #1 (Yes, #1): Your number one job today as a trader is to make sure you can come back and be a trader again tomorrow.

So hey, let's be careful out there.

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

NOTES:

Jay's latest book, Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, was ranked among the Top 10 Investment Books for 2009 by the venerable The Stock Trader's Almanac 2010. For more info, please click here.

Please look for the interview with Jay Kaeppel in the November 2009 issue of Technical Analysis of Stocks and Commodities magazine.

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