The weak performance on Friday in the face of the best employment news we've had since the first quarter concerns me. I'll be addressing what I believe are the causes in my analysis.
Here's the Nasdaq 100 Index comprised of the top 100 tech stocks in the Nasdaq Composite:
Rather than address every asset class in this commentary I'm going to speak to the driver that will impact equity prices in the coming week. And that driver is simply the US Dollar. It is particularly important that we consider its direction in relation to the Euro, which comprises about 57% on the Dollar Index:
I've stated many times over the years that if you want to know where risk assets are going, watch the Dollar. As a "risk off" or "safe haven" trade, its strength or weakness tells us where stocks and commodities are going. Simply, a stronger Dollar has to equate to lower commodity and stock prices while a weaker Dollar is predictive of the opposite. And while the inverse correlation may not be 100% on a daily basis it certainly is valid on a weekly basis. The Dollar broke down under an ascending channel support line this week (white arrow on chart).
Here's a weekly chart of the Dollar going back to October, 2009:
We're currently snagged on Fibonacci support at the 61.8% retracement level.
Here's the Euro which up to this point is the world's risk on currency:
Just two take aways from this chart. The Euro, while exhibiting strength, is fast closing in on Fibonacci resistance at around 131.80 - 132.00, a level it failed to penetrate last month. Secondly the bottom panel which shows the price relative to the US Dollar is flattening.
Taking all extraneous factors into consideration, while the break down on the Dollar chart may be speaking to continuous strength in stocks and commodities, the Euro rally since Draghi's "whatever it takes" speech is getting long in the tooth. And the probable failure of the Euro to penetrate Fibonacci resistance on the chart above will equate to a strengthening Dollar with a commensurate weakening of risk assets.
I could identify a number of fundamental reasons why this Euro rally has over extended itself but we'll just watch the charts instead. In this way I'll save my readers the boredom of wading through the reasons why these comatose currencies move the way they do :-)
In many ways, there hasn't been a lot of change in the financial outlook since last week. In spite of Governor Romney's outstanding performance in the debate on Wednesday, the popular consensus is that he still has an uphill battle in gaining the presidency next month. A narrowing of Obama's lead in Ohio which is critical to Romney's chances would be a positive and the market would certainly react well to a Romney presidency but this is not the ultimate driver for our markets going forward.
The Fed and the ECB have largely taken "tail risk" out of the market and volatility has largely dissipated since the FOMC announcement of QE3 in early September. This is not a welcome development for those of us who either supplement or make our living trading these markets but it is an excellent environment for longer term investors (as long as it lasts).
There are two issues looming over our markets which will have profound effects upon it over the next three months:
1. Yes, the fiscal cliff. This is a big one folks. If the automatic spending cuts and particularly tax increases go into effect next January 1st, there will be a recession in 2013. I've already expressed my amazement with the pundits who contend that we will get a bi partisan agreement to avoid the cliff. My question: where is the precedent given the past four years of gridlock in Washington?
Granted, anything can happen. And we better hope that saner minds prevail inside the beltway. I'm looking for a lame duck congress to somehow postpone the issue until the first quarter of 2013. The market would initially like such a development and rally into year end but inevitably an issue like this hanging over our market will be a continued weight around the neck of equities and commodities going forward. If we did have a break through in Washington and an agreement to avoid the cliff, stocks would rocket higher in spite of the second issue below ...
2. Coming into earnings season, a high number of companies have lowered expectations for the quarter. In terms of guidance, 80 companies in the S&P 500 have issued negative Earnings Per Share pre-announcements to date while just 23 companies have issued positive EPS pre-announcements. While many analysts on the Street have lowered expectations this season, companies still have to meet or preferably beat expectations to keep stocks levitated at their present level. There's no way to know how this earnings season will turn out, We'll just have to monitor the response of Mr. Market to the announcements.
Lastly, even if the ECB has taken much of the "tail risk" out of the European debt crisis, it is still very much alive and well. I've addressed the separatist movement in the Spanish region of Catalonia and while the financial press has given perfunctory attention to this, in my mind it is a big issue. Similar movements are popping up all over Europe as more economically viable areas in the Euro zone are tiring of supporting weaker areas in the region. Italy is the latest news item in this category with 70% of Venetians in favor of breaking away from the Italian state. The reverberations from any region breaking away from it's country to pursue its own financial and political destiny would be severe. Maybe we can all start using fourteenth century European maps again ... :-)