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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. Here’s why.
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.
(click to enlarge)
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% gains and the market
- moved higher 94% of the time and
- 100% of the time 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.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
* http://seekingalpha.com/article/2554875-dollar-and-presidential-cycles-lining-up-for-a-rally (© 2014 Seeking Alpha)
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