Get ready for the resource rally

As a matter of practice, when an instrument gets either overbought or oversold, I like to wait for a mean reversion signal into a neutral before taking action. Overbought stocks can get even more overbought and oversold stocks can get even more oversold.

When I wrote that the US Dollar, which is inversely correlated to commodity prices, was overbought on September 17, 2014 (see Overbought USD = Commodities poised to rally), I never dreamed that it would take this long to work off the overbought condition in the USD Index. As the chart below shows, the 14 week RSI of the USD Index reached 70.16 at the close on Tuesday, which is just above the 70 overbought threshold condition for taking action to sell the USD and tactically buy the commodity complex.

In addition, I marked past instances when the RSI reading rolled over from an overbought reading and every case saw a relatively substantial decline in the USD. Indeed, the chart of the CRB Index below shows that it is testing support and starting to move off an oversold reading. These conditions are classic setups for a commodity rally.

As well, the price of gold is also showing a similar pattern of a successful test of support and an upturn in the 14-week RSI.

Stock market implications
While the resource sectors are poised for rallies for the next few weeks, figuring out the wider directional market implications for the equities is more difficult. On one hand, the market leadership will change to the long suffering Energy and Material sectors under such a scenario. The market may interpret that as a bullish reflationary environment.

On the other hand, recent comments from the Fed may spook the markets to give such a development a bearish spin. Consider that the latest FOMC minutes indicated that the Fed was concerned about how the high level of the US Dollar is impeding growth (emphasis added):

In the economic forecast prepared by the staff for the September FOMC meeting, the projection for growth in real gross domestic product (GDP) in the second half of this year was revised down slightly from the one prepared for the previous meeting, primarily because of a somewhat weaker near-term outlook for consumer spending. The staff's medium-term forecast for real GDP was also revised down a little, reflecting a higher projected path for the foreign exchange value of the dollar along with slightly smaller projected gains for home prices.

The WSJ also highlighted comments from Bill Dudley of the New York Fed voicing similar concerns as the reasoning for the current dovish tilt at the Fed (emphasis added):

First, Mr. Dudley has elevated the strength of the dollar and soft global growth as factors affecting the Fed’s policy thinking. He said the strong dollar puts downward pressure on U.S. inflation and dims U.S. near-term export prospects, factors that keep the Fed patient about raising rates even as the job market improves. It’s unusual for a senior Fed official to speak so directly about the impact of the currency on his thinking, in part because the currency is supposed to be the domain of the U.S. Treasury.

Second, Mr. Dudley affirmed that he still sees “significant underutilization” of labor market resources, even after a surprisingly strong September jobs report showed the jobless rate has fallen below 6% for the first time since July 2008. This phrase “significant underutilization” is an important tripwire in the Fed’s policy statement. When officials take it out, it likely will be a signal they see rate hikes as getting closer. Mr. Dudley’s comments strongly suggest it stays in the October policy statement.

Here is the key question for the market and policy makers. If the greenback were to violently retrace its up move in the next few weeks, will that push the rhetoric to be hawkish?

How will these bullish and bearish developments resolve themselves under a scenario of a falling USD and rising commodity prices? I have no idea. For the time being, it appears to be a recipe for volatility.

In a recent post, I wrote that I wanted to see a deeper correction and more volatile condition for the equity market as a way of stress testing my Trend Model, which had seen excellent returns in the past year (see Trend Model September report: +40.1%). I suppose I should have been careful about what I wished for.