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Devil's advocate

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In recent months, I've received multiple e-mails from subscribers questioning the rise in gold and the bullish performance of the sector. We've talked about the recent decline in the U.S. dollar and its potentially bullish and bearish impacts on various equities here in the U.S.

In today's market monitor at OptionInvestor.com, my observation of brief selling in the 13-week Treasury Note ($IRX.X) and slight divergence from the very short-end that is more sensitive to near-term interest rates that could be influenced by the Fed potentially raising rates, triggered some interesting e-mails from equity bears.

Here's a re-print of a readers e-mail that does a pretty good job of stating a bears case. I'll play "devils advocate" with it later on, only to stimulate the trader's/investor's mind and give us some scenarios to build on and monitor going forward.

Jeff: The Fed will have to raise rates to save Uncle Buck (the U.S. $). But doing so will pop the credit bubble and nuke consumers, home (whole) mortgages, and worst of all, corporate debtors. With consumer and corporate spending at 5-year highs (so I've heard somewhere), it seems that Easy Al (Mr. Greenspan) is in a very tight corner. Thus, buy gold, sell U.S. equities. This is borne out by the relative strength of most foreign stock markets as compared with U.S. Market.

Now for the "devil's advocate" portion.

Firs, the Fed doesn't "have" to raise rates to save Uncle Buck. It's not the Fed's policy to change interest rates in order to "save the dollar." The Fed's policy is to try and maintain a stable and growth biased economy. Inflation is and has been the Fed's major concern as to the threat of a healthy economy.

Now, "inflation" can be experienced from a weakening U.S. dollar. As the dollar weakens, the U.S. consumer experiences less buying power for goods that are imported into the country. This lack of purchasing power is or can be inflationary.

5-year YIELD Chart - Weekly Interval

The shorter-term 5-year YIELD ($FVX.X) is showing some buying today as YIELD declines to 4.43%. In March, we noted the NASDAQ- 100 Bullish % was "overbought" and that now correlates with the recent relative highs found in the 5-year YIELD where money may indeed have rotated out of some "riskier" technology stocks and back into the 5-year YIELD.

At the same time, the U.S. dollar had started to exhibit some weakness against the major foreign currencies. But is a weaker U.S. Dollar going to drive Fed action? When a trader looks at the US Dollar Index on a weekly chart interval it becomes rather apparent at just how strong the greenback has been and the recent declines are still rather "miniscule" compared to past levels.

US Dollar Index Chart - Weekly Interval

The U.S. Dollar has shown rather sharp drops on the weekly chart in recent history. As discussed, this can have an inflationary effect on consumers. But when back-tested against Fed policy, the fluctuations in the U.S. Dollar has not impacted Fed decisions on interest rates. What has impacted Fed policy is the growth of the economy weighed against inflationary pricing pressures.

Gold and action there

Later today, we'll tie in the price action of gold and what could possibly be taking place there. It is becoming more apparent that the recent run in gold has probably been U.S. Dollar related.

However, an equity bear that simply begins shorting stocks on the thought that there's doom and gloom on the horizon for U.S. equities may need to rethink things a bit.

The "devils advocate" to such thought would be the positive impact the weakening U.S. dollar may have on the U.S. Industrial base here in the United States. Many corporations have complained for years that their business has suffered from the impact of a stronger U.S. Dollar.

In recent months, dating clear back to October of 2000 at the OptionInvestor.com fall seminar, I pointed out that equity bulls should be looking to the deeper cyclicals for bullishness.

Those observations were made simply for some of the charts and bullishness found in the Transports and some forest/paper stocks like International Paper (NYSE:IP) $38.80 +0.62%.

It could well be, that a weaker U.S. dollar is just what the doctor ordered in order to boost industrial activity here in the United States. Then perhaps they can become more competitive in overseas markets, see increased demand for their products, hire back some workers, and see further renewed confidence from the consumer.

Again, I will reiterate my past position that there will be weak spots in the U.S. equity market. I still think that some technology stocks are a long ways away from the proverbial "money pot" that would eventually be filled under the scenario that a weaker U.S. dollar, could stimulate industrial activity here in the U.S., thus eventually create some bottom line earnings for the larger industrial sector and get some IT spending created.

Thanks to the subscribers for all the e-mail. I hope my "devil's advocate" is not taken as criticism, it shouldn't be! We'll discuss this further. We're just getting started.

Some things on my mind that need looking into. The U.S. steel industry was perhaps hardest hit by the strong U.S. dollar as our steel exports dropped off the face of the earth and some of the oldest U.S. companies dried up and blew away. Recently we've seen some bullishness in this sector. Could it be this group of stocks is about to embark on a multi-year bullish cycle?

Let's get to work and draw up some scenarios! Things are just starting to get interesting!

Jeff Bailey
Senior Market Technician
Option Investor

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