Will the bull return? Look for cues in US$ and S&P500

The US Dollar index has hit resistance and the Nifty bounced off support last Friday, raising the possibility of a short-term rally in the Indian index.

In the week before, we had mentioned the support level of the Nifty and the index bounced from a little above the zone. Support levels are areas where the demand for stocks far exceeds supply, leading to a rise in price. Resistance levels, on the other hand, are zones were the supply of stocks far exceeds demand, leading to a drop in price.

A look at the combined chart of the Nifty and the US Dollar index will show the inverse relationship between the two. (Click here for Dollar-Nifty chart ). Notice that the Nifty usually falls when the dollar rises and vice-versa.

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Right now the Dollar index is at a resistance zone, as shown by the two horizontal red lines, and the Nifty just bounced off support, as shown by the green lines on the Nifty chart. If we see a selloff in the Dollar index it could propel the Nifty higher. The inter-market relationship between the dollar and equities has played well for the past few years. Whenever the risk appetite in the market increases, investors rush to equities. On the other hand, if the risk appetite falls, investors prefer the safety of the US dollar or Japanese yen.

So with the Nifty bouncing from the support level one can assume that appetite for risk is coming back to the market. Also since the Dollar is at resistance, it should fall, given what the greenback has done traditionally.

However, are these normal times? It might not be, given how US equities have reacted to the dollar. Usually, just like the Nifty, US equities have fallen when the Dollar index rises. But, of late, both the greenback and US equities have rallied with the Dow breaking to new highs and the S&P 500 flirting with its all-time highs.

So what could happen to the dollar now? If one looks at the dollar chart, notice that price has hit the resistance levels a few times. The more times a resistance level is hit, the greater is the chance of a breakout higher. In fact the Dollar index did go briefly above the resistance zone in July 2012, which increases the probability of a break out higher. This can be bad news for the Nifty.

The reason for both the US Dollar and US equity indices rallying is increased confidence in the American economy. This means more money is being put into the stock market and more global investors are buying the US dollar to invest in American equities. These two factors are bullish for equities and the dollar. But as the US dollar gets sucked out of countries such as India to be invested in US equities, the Indian stock markets face weakness. Hence we see a rally in both the US Dollar and US equities, but a fall in the Nifty.

What could make things better for the Nifty? Well, for one, a fall in the greenback. The other scenario is a continued rise in US equities that could increase global confidence in the equity market. But for that to happen, the S&P 500 has to make new highs. The three other major US indices - Dow, Nasdaq 100 and Russell 2000 - have gone higher than their 2007 highs. Unless the S&P 500 breaks to new highs, this whole rally is not confirmed.

Remember what happened in 2007. The Dow and the Russell 2000 were above their 2000 highs, but the S&P 500 was not. The S&P 500 was not able to clear its 2002 highs and fell, pulling the whole markets down. So we’d wait for the S&P 500 to confirm the bull with a new high.

George Albert is Editor, www.capturetrends.com