Posted by Joseph Y. Calhoun, III

Is the stock market rallying because the economy is getting better? Well, maybe, but if the US economy is really improving, why is the dollar falling? I tend to see national currencies as barometers of the health of the economy. If economic statistics and stock prices are getting better and the dollar is stable or rising, that means, at least to me, that the underlying economic growth is desirable and of high quality. If, on the other hand, the economic statistics and stock prices are getting better but the dollar is falling, that means, again at least to me, that the underlying economic growth is really just inflation in disguise. Which brings me to the charts of the day:

S&P 500

US Dollar Index

There is a lot of confusion about the cause and effect when it comes to the dollar and stocks. I’ve heard a lot of people say that the reason the dollar is dropping is because risk apetite is returning. That seems at least partially true but if it is, it isn’t because the people with a rising risk tolerance are willing to take that risk in the US. So why do stocks rise when the dollar falls? Personally, I think the causation is the other way; people are buying stocks to try and protect themselves from the falling value of the dollar.

Whatever the reasons and the source of the inverse correlation, the trend is well established. The dollar just broke down through support and there is little on the chart in the way of support before the lows of last summer. The S&P 500 is at a critical resistance level of 1005. That’s the level where the initial rebound attempts failed last fall:

There is little in the way of resistance up to 1100-1200 which is my optimistic target for the S&P. I suspect that if we find ourselves at that level, the dollar index will be moving in the opposite direction and approaching its old lows.