Dollar And Presidential Cycles Lining Up For A Rally
Oct. 11, 2014 7:22 AM ET
Summary
- The U.S. dollar could be headed much higher in 2015.
- The presidential cycle predicts stocks will rally in Q4 and into 2015.
- November and December are two of the strongest months for stocks since 1950.
Conditions are favorable for a strong U.S. stock market performance in the fourth quarter of 2014 and into first half of 2015 once the current corrective selling has abated.
U.S. Dollar
The first factor working in the favor of stocks is the U.S. Dollar Index (DXY). The major rally in the U.S. dollar since July has been historic, the first ever 12-week win streak for the U.S. Dollar Index in its entire history. While a stronger U.S. dollar has been bad for stocks during its rapid ascent, the move appears exhausted and there's a historic parallel with the early 1997 U.S. dollar rally.In fact, the parallels go much further, since the U.S. Dollar Index from 2002 to 2014 has behaved very similarly to the U.S. Dollar Index from 1985 to 1997, including the recent three-month rally.
In addition to the chart signaling a repeat performance by the greenback, there is also a relatively strong U.S. economy compared to a slowing global economy. Europe and Japan are both sliding into recession, China is slowing, and weak commodity prices have battered nations such as Brazil, Russia and Australia.
The U.S. Federal Reserve is tightening monetary policy by exiting round three of quantitative easing, while Europe is stepping up its efforts.
Given the economic conditions, a weaker U.S. dollar over the next few months will likely not be matched by a full rebound in commodities. Further, if DXY breaks above 88 then commodity prices and foreign stocks will underperform well into 2015 and beyond.
Since the dollar appears more likely to advance rather than retreat in the intermediate to long-term, U.S. assets are the better choice for a fourth quarter rebound that runs at least into the first half of 2015. Beyond then, rising U.S. energy production could eventually make the U.S. the largest oil producer in the world, and even if you're skeptical about the ability of the U.S. to maintain shale oil production, production is likely to stay high for the next couple of years (assuming oil prices don't crater so much as to make it unprofitable to drill), long enough to fuel a U.S. dollar rally.
Overall, the U.S. is creating and exporting fewer U.S. dollars to the world due to lower federal deficits (reduced Treasury issuance), Fed tightening and reduced imports, while on the flip side, there is greater demand for U.S. assets, such as equities, real estate and Treasury bonds that yield more than their European and Japanese competition. Additionally, since the global economy is still growing, the demand for the reserve currency is growing as well. Foreign companies are borrowing in dollars at higher rates, including many Chinese companies such as real estate developers who face tight credit conditions at home. The net effect on the global economy will be a growing shortage of U.S. dollars in the near and intermediate term.
Yearly Cycle
Since 1950, November and December have been the third and first best months for stocks. The recent decline in stocks has the markets well positioned to deliver gains in the last two month of the year.
Presidential Cycle
The quarter leading up to a midterm election tends to be a poor one for stocks, but the next three quarters have delivered the best returns of a presidential term, with the second term of an incumbent president the strongest of all. This period from November to April has historically delivered 15 percent gains and the market has moved higher 94 percent of the time. These odds climb to 100 percent for an incumbent president.
Summary
Stocks are poised to rally in Q4 based on a corrective trend reversal. The dollar is overbought and the three-month rally ended this week. Major stock indexes are either oversold or close to being oversold. The current selling has not yet ended though, so a bottom could still be days or weeks away.
Commodities and foreign markets are likely to rally on a weaker U.S. dollar, but longer term the U.S. dollar appears ready to begin a move higher, based on economic fundamentals and a very strong repeating pattern in the chart, which would be unfavorable for most non-U.S. assets heading into 2015 and beyond.
ETFs to Consider
Foreign ETFs, emerging markets and commodity-related funds are out given the expected strength in the U.S. dollar that could unfold in 2015. An aggressive ETF play would be the small caps, as represented by a broad ETF such as iShares Russell 2000 (NYSEARCA:IWM). The index is down for the year and taken the brunt of selling over the past few months, but if stocks rally at the end of the year and into 2015, small caps will play catch up. Small caps are also less exposed to foreign markets than multinationals that dominate many of the large cap ETFs.
For sector plays, financials could do very well if interest rates move higher. U.S. economic growth and Fed policy will work to push rates higher, but overseas troubles could weigh on interest rates if capital flows into the U.S. If rates head lower, income producing sector such as consumer staples, healthcare and utilities will perform well. Since U.S. exposure is desired, sectors with smaller exposure to global markets are preferred, which gives the edge to healthcare and utilities. Utilities of course will suffer if rates end up moving higher, but they will do well if rates stay at the same level or head lower.
Health Care Select Sector SPDR ETF (NYSEARCA:XLV) gets the job done for broad healthcare exposure; investors looking for subsector exposure might consider this breakdown in the available pharmaceutical ETFs.
In financials, iShares U.S. Broker-Dealers (NYSEARCA:IAI) is a compelling choice since the rising global volatility that is likely to accompany a stronger dollar will work in favor of large banks, but any broad financial ETFs such as iShares U.S. Financials (NYSEARCA:IYF) will also benefit from these trends.
For utilities, Utilities Select Sector SPDR ETF (NYSEARCA:XLU) or Vanguard Utilities (NYSEARCA:VPU) are two possibilities.
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