(click on chart for larger image)
(click on chart for larger image)
The take away from these two charts is that it's very apparent that any correction in stocks will appear to be very short lived if we even get one. As a matter of fact, there's an equal chance that stocks are presently working off any overbought condition in the churning we've been experiencing in the past week. Here's a daily chart of the Dow Jones Industrials and I've circled the past ten days price action:
(click on chart for larger image)
There's a pretty firm short term ceiling at 14000 (dashed red line) but the Dow can't seem to trade below 13850 either.
We've blown thru "Fibonacci Queen" Carol Boroden's 1511 S&P500 price target on Friday. My next target on the S&P is the 1523 - 1528 area.
However, I want to point to a significant divergence that is developing and is starting to concern many technicians on the street. The following is a daily chart of the SPDR Barclays High Yield Bond ETF (JNK) going back one year with the S&P500 superimposed behind it (black line). The top panel is the correlation of the Junk Bond ETF to the S&P500 on a 20 day basis:
(click on chart for larger image)
As can be seen from the chart itself as well as the top panel there is an extremely high price correlation between stocks and junk bonds. They move in tandem with each other and the correlation between both has always been very strong, except for the last two weeks (red circle). I ran the same chart going back to 2007 and the last time we saw a divergence like this was shortly before the Lehman Brother meltdown in 2008 which was the catalyst to the cataclysmic events of that autumn:
(click on chart for larger image)
But if this divergence is signalling a major downturn this time what's precipitating it? In mid 2008 we already had Bear Stearns shut down and we were in the throes of the sub prime mortgage crisis. I'll discuss this divergence in my analysis.
Treasuries had a crazy week and actually finished modestly higher. However,as can be seen on the chart below of the iShares Barclays 20+ Year Treasury Bond ETF, the treasury market is in a pronounced downtrend, making a series of lower highs and lower lows:
(click on chart for larger image)
I'll be tying my analysis of the Treasury market with Junk bonds below.
I wish I had something good to say about Gold because I know a fair amount of my readers are enamored with the yellow metal. But it's literally all over the board on an intra day basis which tells me that everyone is confused about its prospects. And in the market, where confusion reigns, prices usually continue to decline:
(click on chart for larger image)
The black arrow points to Friday's close and as can be seen, gold has not been even to get near resistance at the 1690 level and is sitting on a support line (blue dashed). If it breaks this line we'll be starting the next leg lower. Will we?
As someone who uses inter market analysis in my trading I'm disturbed by gold's price action. In the recent past (up to last October's high) gold and equities correlated well and strong gold prices served to reinforce that stock prices were moving higher. That is no longer the case and there is almost no correlation between the yellow metal and any other market. Once in awhile we get a whiff of geopolitical risk and gold makes a move higher only to fall back to previous levels. I continue to watch gold and will update my readers when I think I've discerned its message for the markets.
The big driver this week in our market, regardless of any rhetoric to the contrary, was the FOREX (Foreign Exchange market). If you read my commentary last week you know I had concerns about the ECB meeting on Thursday and any comments Mr. Draghi might make about recent Euro strength. Well, he made his remarks and if you were short the market on Thursday morning you did well as long as you were out by 10:30AM CST!
The Euro, if you remember from the last two commentaries, had broken out of a massive multi month inverse head and shoulders formation that projected Euro145 to 150. Draghi's remarks sent it reeling and below the neckline of the inverse head and shoulders formation. This is an update of the same chart I've posted in my last two commentaries and I've circled Thursday's and Friday's price action in black:
(click on chart for larger image)
A couple of take aways pertaining to the Euro:
- the violation of the neckline does not necessarily negate the message of the bullish pattern. As I stated in my past commentaries, once there's a break out a financial instrument will often return to the break out area and "kiss" prior resistance turned support goodbye before moving higher. And just because there's a strictly delineated neckline doesn't mean the Euro had to stop right at the neckline. In other words, there is some wiggle room. But we better see a resumption of the upside next week. Any further downside movement over the next five to ten business days WILL negate the pattern.
- As long as the ECB does not lower interest rates there will be a floor under the Euro at present levels. But Draghi did hint at the possibility that additional stimulus might be needed to pull the uneven and depressed Euro zone economy out of the pit it finds itself.
- recent tensions in Spain (kickback scandal with accusations Rajoy is involved) and an upcoming Italian election this month where it seems former Prime Minister Silvio Berlusconi has a chance to upset the political "apple cart" with anti German rhetoric will probably pressure the Euro.
- It's getting more difficult for EU officials to ignore the "race to the bottom" presently going on among all global currencies. With the Japanese government now competing with the Federal Reserve in printing money, a strong Euro is pressuring Europe's export economy at a time they can least afford a higher valued currency.
Why should we care about the Euro? It's the premier "risk on" currency and is strongly correlated to global equities as can be seen on the chart below:
(click on chart for larger image)
This is a daily line chart of the Vanguard Total World Stock ETF (VT) and the top panel shows the correlation of the ETF with the Euro. Any reading over the zero line means there is a positive correlation between the currency and the ETF. As you can see, except for very brief periods there is a strong positive correlation. So, a strong Euro means a strong stock market and conversely, a weak Euro means a weak stock market.
Analysis
More and more our equity markets are coming under the influence of the FOREX market. My analysis of the issues surrounding the Euro's price movement this week are indicative of this fact.
The Japanese government's determination to end two decades of virulent deflation has turned the currency world upside down! the mounds of liquidity coming out of the Fed and BoJ (Bank of Japan) is forcing all countries to devalue their currencies.
What's really scary is that Gold is not moving under the unprecedented avalanche of fiat money printing. This speaks to the deflationary juggernaut the global financial world faces.
Obviously, anyone sane cannot look at this situation and think its anything but dangerous to the world's economic well being. But I don't write these commentaries to prognosticate on what the possible dire implications of these monetary policies might be. I write these commentaries first and foremost to step back and "see the forest for the trees" after a busy week trading these markets at a micro level. I'm looking for intermediate to long term trends but most importantly, I'm looking to discern what the market will be doing next week. To the extent anyone who reads these commentaries can glean something from them I'm happy.
Regardless of fiat money devaluation, excess liquidity and stocks go together! They're like "two peas in a pod". They compliment each other and because of that, central bank liquidity has put a floor under equity markets. And we can see that floor on the first few charts I posted in this commentary.
I identified the junk bond/equity divergence above and I also touched on the divergence when I briefly discussed Treasuries. The signal we're getting may be explained by the opinion of almost everyone in the financial world that this will be the year interest rates finally start rising. It must be remembered that junk bonds are the highest yielding bonds and also the most volatile that can be purchased. Because they are normally not the highest rated bonds, purchasers demand a higher rate of interest for the risk they are exposed to.
Still, for the higher risk investors must incur, even junk bonds are yielding on average, only 5.91% at this time. And while this beats the paltry returns on Treasuries, it is way too low and if rates start backing up the capital losses on "junk" versus Treasuries will be substantial. So the divergence could be anticipatory selling in the junk bond market on the expectation that yields will definitely back up.
If this thesis on the divergence is wrong, then we need to press my question above: what could be the catalyst for a significant decline in stocks? Or is it different this time around?
I can make a cogent case that it is different this time around. First of all, the financial world has never returned to normal since the fall of 2008. Massive amounts of liquidity supplied by central banks have skewed many inter market relationships and traditional signals market prognosticators used to determine market direction. So when we see a divergence like I identified above that has not manifested itself since before the GFC (Great Financial Crisis) we must be very careful about drawing the same conclusions.
Secondly, the divergence may be signalling a pull back which everyone is expecting but to say that it might be signalling a major debacle like 2008 does not cohere with present monetary conditions. The world is awash in cash! This is an effective "put" under the market.
The only scenario that could support a cataclysmic decline in stocks is literally something out of "left field" that we have no prior knowledge of and the inability/denial of central banks to address the issue in the classic Keynesian way (which they're not going to do).
In the short term, I, like many others, am looking for a pull back and with the possibility of the Euro weakening further along with Act Two of the "fiscal follies" coming to a theatre near you, we should get our catalysts for a correction. Another short term curve ball would be a surprise Berlusconi victory in the upcoming elections on February 24th and 25th.
Finally, remember February is not traditionally kind to stocks. Given the political and FOREX issues I've identified in this commentary, this February should be no different.
Have a great week!
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