Proof That Cash Is A Position Too

Those who check out our work often, know that we are advocates of patience, risk management, and high probability asymmetric risk/reward scenarios. This is a fancy way of saying we like to minimize loss while maximizing gain. Isn’t that what every investor wants? Related to our approach, we have been known to tell our readers that “cash is a position too.” In this article, we’ll show you just how valuable cash is as a position. At this point, it needs to be made clear that there are many opinions about the functionality and validity of fiat currency. That is not what this article is about. We are not here to debate whether the U.S. dollar is worth the paper it’s printed on. We are writing to show you that holding U.S. dollars is a valid investment position and one that can protect your capital.

To show you this, we’re going to use ratio analysis, a valuable instrument in our tool box. This approach of comparing the price of two securities against each other as a ratio is valuable in identifying opportunities. Today, we’re using a ratio of the U.S. Dollar Index (USDX) versus the S&P 500 (SPX). The U.S. Dollar Index is our proxy for the value of (you guessed it) the U.S. dollar. This index uses a weighted mean of the dollar’s value relative to other select currencies. When USDX rises, it indicates U.S. dollar strength and when it falls, U.S. dollar weakness.

In the weekly chart below, we’ve divided the USDX by SPX (the S&P 500). Our ratio (dollar/S&P 500) is in the upper panel and the S&P 500 is by itself in the lower panel.

When this ratio moves upward, the dollar is outperforming the S&P 500. When the ratio moves downward, the S&P 500 is outperforming the dollar. For the majority of the time, as you would expect, the ratio travels downward because the S&P 500 is outperforming the dollar. But when the ratio turns upward, investors should take notice. Based on this simple ratio, we know when holding the dollar is more valuable than owning U.S. stocks. Take a look at the chart (click it to enlarge). What do we see? We see that this ratio moves in relatively predictable trends. Notice the price trends identified within green channels (1995-2000) and descending triangles (see 2002-2005, 2002-2007, 2009-2011, and again during 2012-2014). These downward patterns are highlighted in green and when the downward trend has been broken, and the ratio moves up, we’ve annotated the chart with vertical black and orange dashed lines. The orange dashed lines indicate times when this ratio broke upward and the S&P saw a major correction or bear market. The black dashed line indicates a minor correction within the market when the ratio broke upwards. As you can see, starting back in October 2014, the ratio broke its upper trendline. From that point forward, investors have been better off holding U.S. dollars than owning the S&P 500. This is significant. With the dollar outperforming the S&P 500, it tells us that major money managers are seeking safety. Now is a time to pay close attention to U.S. stock markets. Will the dollar continue to outperform the S&P 500? Could this be the start of a minor correction or a major trend change for the S&P 500? No one knows for sure, but the warning signs are abundant [1]. In the end, we’ll let price guide us.

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[1] You can read more about the warning signs we’ve identified via our seven part series:

Weight of Evidence: Part 1 | Part 2 | Part 3 | Part 4 | Part 5 | Part 6 | Part 7

[the following chart was added on 02-04-2015 to show USDX next to the S&P 500, no ratio, dashed lines in same exact locations as the chart above]