The U.S. Dollar

The U.S. dollar hit some new and exciting lows this week. The Fed has told the world they will cut interest rates until the cows come home. The currency traders have listened. Over the last couple of weeks the U.S. Dollar Index is down almost 4% to close at just under 74. From a technical standpoint, this is scary. While the size of the move is disturbing, more important is the fact that this is completely uncharted territory.

The currency market moves primarily on technical analysis. When there are no obvious points of resistance (previous lows in this case) aggressive traders can try to find resistance. Unfortunately, nice round numbers tend to be psychologically important. Will the traders push the dollar to 70? I don't know and neither does anybody else. However, there is a strong probability that there will be volatile trading while everybody tries to find the next bottom.

Gold

Gold has taken its cue from the falling dollar and closed at $975 on Friday. A similar dynamic is happening in the gold market as gold hits new highs. There is one fundamental difference between the two markets. Gold is a relatively small market and is much more volatile. While the dollar has fallen about 4%, gold has risen about 8% over the last couple of weeks. I would not be surprised to see some short term selling in the next couple of days as traders take some money off the table.

Oil

West Texas Intermediate Crude had its first weekly close above $100/bbl this week. That is up about 80% in nominal terms from its lows of around $55/bbl in January, 2007. The oil market is also in uncharted territory, which creates uncertainty and fear.


Conclusions / Questions

The recent rise in oil and gold is screaming inflation without even looking into the recent agricultural inflation. What does this mean for the U.S. stock market? At some point U.S stocks will become very cheap in other currencies and buyers will start to step in. I don't think that day is anytime soon. What will it take foreign buyers to step in? Personally, I would like to see:

1. Stabilization of the dollar. Let other people try to grab this falling knife!
   
2. Some indication that the official government policy is not to destroy the dollar. A responsible fiscal and monetary policy would go a long way here.
   
3. An indication that the U.S financial system will weather the debt crisis. Right now it seems that everybody is still in denial. Although about $150 billion has been written off, there is still an additional $450 billion to be written off (according to S&P). The mark to model fantasy has to end and the true amount off losses disclosed.
   
4. An attractive dividend yield on the S&P 500. A 50% drop in price would do this.

Over the last two weeks I've heard (insert stock here) is cheap now because its price is down from last year. Well, there is no reason it can't get cheaper. Of course, nobody wants to hear this. Hope springs eternal and most people can justify anything. Right now, analysts are predicting a very large earnings recovery in the second half of 2008. Is their crystal ball better than mine?

There is also a lot of banter about how the Sovereign Wealth Funds are sitting on boatloads of cash and very large investments in the United States are imminent. Of course, anything is possible, but I can't imagine responsible investment professionals assessing the current situation and deciding this is the optimal time to buy into the U.S. market. Then again, I've been wrong before.

The path of least resistance seems to be down for U.S. stocks for the next little while unless there is some catalyst to change this dynamic. If anybody has some insight as to what that catalyst might be, I'd love to hear it.

SunTzu