As we go through the first significant pullback in the market for 2012, the dollar seems to be at a turning point that should influence market trends for the next few months. Going all the way back to 2002, there has been a strong inverse correlation between stocks and commodities, and the U.S. dollar. For the most part, the dollar has been falling during this period, which has helped drive cyclical bull markets in stocks and commodities. More recently, the stock market panic of 2008 and the first Euro crisis of 2010 drove significant countertrend rallies in the dollar, and corrections in stocks and commodities.
Almost one year ago in April of last year the dollar put in another significant bottom and has been rallying ever since. The stock market and commodities suffered while the dollar moved higher in 2011, until the stock market put in a bottom in October. Since October, the dollar and stocks have been rallying together, and commodities finally put in a bottom in December 2011. And so far in 2012, we’ve seen a marginally lower dollar, and moves higher in stocks and commodities.
Now that we are at this pullback point in the market, the dollar clearly has a couple choices: 1) either go on to make new highs and most likely drive a deeper correction in stocks and commodities, or 2) fail to make new highs, and stoke a continued rally in stocks and commodities. Looking at a weekly chart of the dollar, from a Stage Analysis perspective the dollar is still rising above a rising 30-week moving average, which is bullish for the dollar. But momentum is clearly slowing to the upside, and both previous major rallies in the dollar failed when the TRIX momentum indicator rolled over to the downside on the weekly chart. Notice too that if the dollar rally were to fail here or close to here, each successive dollar rally since the panic in 2008 has carried less momentum to the upside.
Another upcoming test for the dollar is whether it can get back into “bull mode” according to the 14-day RSI. The 14-day RSI is used by some technicians as a bullish or bearish indicator depending on whether it oscillates in a 80-40 range (bullish) or 60-20 range (bearish). This essentially is a representation of the strength of the trend. In a market strongly trending higher overbought readings above 70 occur more frequently and oversold readings rarely get below 40. Conversely in a bearish trend the market typically can’t get above 60 on a rally and spends more time oversold on the 14-day RSI with readings in the 20s or lower. On the current daily chart of the dollar you can see that the dollar was in bull mode up until the end of last year. But since then it hasn’t been able to get back above 60 on the 14-day RSI. A failure to retake that level on the RSI would be another signal of a weakening dollar.
Going back multiple decades the 80 level on the dollar index has been a key level from a technical standpoint. Obviously the makeup of the dollar index has changed during this time period, but it would be pretty interesting if 80 held as resistance for the dollar here since support tends to turn into resistance once it is penetrated. There is also a confluence of resistance around the 85 level that repelled both the 2008 and 2010 dollar rallies.
Switching gears a little, it’s often constructive to look at other markets to see if they provide corroborating evidence when formulating an opinion. Both of the charts of brent and west texas intermediate crude oil still look bullish, with recent breakouts on high volume. They both have also consolidated into tight flag patterns on the recent pullback.
Finally certain currencies such as the Australian dollar are trying to stay in “bull mode” with an upcoming test of the 40 level on the 14-day RSI. The Aussie is also poised to breakout to new highs if it can get back above 108 and stay above it.
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The views and opinions expressed are for informational purposes only, and should not be considered as investment advice. Please see the disclaimer.
The market has had an impressive run since the start of the year, but one sector that has lagged is the commodities sector. Unlike general stocks, commodities are still quite a ways away from their 2011 highs. Recession fears and a surging dollar contributed to the weakness in commodities last year. But a number of factors are starting to show the tide potentially turning for the commodities sector going forward in 2012.
In the first leg of the secular bull market in commodities that started in 2002, commodities more or less enjoyed a steady grind higher. They were helped along by a bear market in the dollar. Countertrend rallies in the dollar had little effect on commodities during this period, most notably in 2005 where the dollar rallied for most of the year. In 2007 commodities started to accelerate higher as more individual commodities started joining the overall commodities rally. This included the grains sector which until 2007 hadn’t enjoyed the gains other commodities such as gold and oil had achieved. All of this culminated in a peak in the CCI commodities index in 2008 as it accelerated into a parabolic move in March, underwent a correction, then made a final top in the summer of 2008.
Then came the stock market panic in mid to late 2008. From the onset of the panic and ever since, commodities have acted much differently than they did during the previous 6 years leading up to the panic. They have had two major swings to the downside, along with a mini correction in 2010. All three corrections were in large part caused by three major dollar rallies that have occurred since 2008, shown on the chart below.
The primary driver of the last two dollar rallies has been a collapsing Euro. The first Euro crisis, which seems like forever ago, actually caused a much more severe correction in the Euro than this latest Euro crisis. But what is interesting is a similar setup to the end of the first Euro crisis is occurring again. This of course would be bullish for commodities since it would imply a near term end to the rallying dollar.
The next few charts show how the Euro is positioned in a similar manner now to what is was doing back in 2010 when it bottomed. First, taking a look at Euro futures positions, back in May 2010 large speculators finally stopped adding to their short positions in the Euro after a 6-month downward move. Open interest also leveled off, which indicated a possible trend reversal.
On the chart below you can see how this leveling off in speculative activity helped confirm the final bottom in the Euro. Note the divergence in price and momentum in May and early June.
Now moving to the current situation for the Euro, you can see a similar leveling off in the addition of positions in the futures market. Open interest also topped way back in December. It’s interesting to note that there was more speculative activity in Euro futures during this latest move in the Euro, but the overall move wasn’t as significant as the first Euro crisis.
Again, a similar divergence in momentum and price led to a change of trend for the Euro in January. So far this change in trend has held up.
Money flows into the bullish dollar ETF UUP also were dramatically lower than they were during the last major dollar rally as shown in the next chart. And selling pressure has started to accelerate over the last month.
Finally, from a Stage Analysis perspective commodities are starting to line up into a potential Stage 2 breakout. On the weekly charts of individual commodities many of them are starting to move back above their 30-week moving average. Some of the money flows are moving back from negative to positive such as the grains sector while other commodities like oil and precious metals are showing increased positive money flow. For comparison purposes, it will be important to monitor how this move compares to 2010 which proved to be a significant breakout to the upside for commodities. Continue to watch the trend in price action along with increased volume for confirmation.
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The original article and much more can be found at: http://www.nextbigtrade.com
The views and opinions expressed are for informational purposes only, and should not be considered as investment advice. Please see the disclaimer.
Sector rotation has been the name of the game to start 2012 for the stock market. The lagging sectors from 2011, including the financials, homebuilders, industrials, and materials, have been the leading sectors to start the year. This is exactly what the market needed to start establishing a more healthy structure. The market did not have a chance of making a legitimate move to the upside in 2012 without seeing money rotate out of defensive sectors that led during 2011. The following are some of the bullish signs the market has been displaying since putting in an important low in early October last year:
Rotation Out of Defensive Sectors
The rotation out of utilities, consumer staples, and health care and into more growth oriented sectors can be seen on the next two charts. In 2011 double-digit returns were achieved in the three defensive sectors while other sectors struggled.
Since the early October bottom money has piled into more offensive sectors at a faster pace than the defensive sectors. This can be seen on the next chart showing performance since early October of 2011.
Part of the performance of the offensive sectors out of the October low was due to them being oversold and ripe for a bounce. But they’ve continued to outperform the defensive sectors to start 2012. The next chart shows just the performance since the start of the year. Utilities and consumer staples are actually down, while homebuilders, materials, and financials are leading the way.
Fewer Downtrends in World Markets
The early October low continues to be a major low across world markets. The longer this low holds in place, the more likely the Stage 4 downtrend that attempted to start last year will have terminated at that low. The next table shows a list of world markets and their relationship to their October low. As can be seen from the table the majority of world markets are still holding strong above their October lows.
Some world markets are a lot closer to their October lows than others. Due to the fact that U.S. markets have performed so well against world markets over the last year, I think that if the bear market were to resume, it would more than likely originate from foreign markets. Some foreign markets that are reaching inflection points on their charts include Australia, Brazil, India, Japan and China. The direction that these markets move should provide clues as to the future direction of other markets across the world, including U.S. markets.
The chart of the Australian market is tracing a symmetric triangle with momentum still to the upside since October.
Brazil seems to have formed a significant double bottom in August and October of last year, and is now in an ascending triangle with momentum to the upside.
India looked like it was starting to breakdown further at the end of last year, but has rallied during the first two weeks of the year. The chart now looks like a falling wedge with a positive divergence in momentum. This is typically a bullish chart pattern.
The Japanese Nikkei is coiled into a triangle with momentum ever so slightly trying to cross to the upside.
The Chinese market has been one of the worst performers over the last year, and ended 2011 with an astonishing 9 down weeks in a row. Momentum is still clearly to the downside but a significant new low in price hasn’t been seen for almost a month now.
Renewed Speculation in Small Cap Stocks
Another bullish sign is more speculation in small cap stocks. When money piles into large cap and defensive names it tends to flow away from higher risk small cap stocks, and it also means money is more adverse to speculation in general. This creates more of a “market of stocks”, and not a stock market, where it is imperative to pick the right stocks in order to be successful. This is exactly what happened in 2011. But when speculation returns, there’s more opportunities to find rising stocks since more money is entering the market.
The next chart shows the ratio of the Russell 2000 to the Dow Jones Industrial Average. Notice that from 2009 until early 2011 small cap stocks outperformed large cap Dow stocks. Then the ratio made no further progress to the upside in early 2011 and started trending lower. This was a warning sign of money getting more defensive. Since the October bottom the ratio has slowly moved higher with positive momentum, and has traced a symmetric triangle on the chart.
Fluctuations in volume on the small cap Canadian Venture exchange is another sign as to the amount of speculation going on in the market. On the next chart you can see that in 2009 and 2010 there was heavy speculation and upside volume in the Canadian Venture exchange leading to the market trending strongly higher. In 2011 that buying pressure dried up, and the poor performance of the small caps in Canada mirrored the poor performance of small caps in the U.S. Recently there has finally been some higher than average weekly volume on the upside though which is what the bulls want to see for the trend to change direction back higher.
There are other signs bulls would like to see for this market to continue acting healthy. Leading stocks need to continuing moving higher, an expansion in new highs and contraction in new lows, and formation of leadership sectors that help drive the market higher. This could also turn out to be another phony rally if the conditions laid out above don’t work out. A quote from the great book How To Make Money In Stocks by William J. O’Neil kind of sums up the current situation:
“The key to staying on top of the stock market is not predicting or knowing what the market is going to do. It’s knowing and understanding what the market has actually done in the past few weeks and what it is currently doing now.”
With the headline threats of the European financial mess, calls for a recession in different parts of the world and political turmoil, it’s hard to believe the market could continue to act well. But underneath the covers that’s what some of the signs are so far in 2012.
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Of the legions of investors who are welcoming a fresh start to the year after the choppy and directionless market of 2011, perhaps gold stock investors are the most eager. Gold stocks had a volatile year last year with no progress made on the upside. The HUI Gold Bugs Index was rangebound between 500 and 600 for the whole year, with 3 failed breakouts above 600. As if to put a cherry on top of a depressing year for gold stock investors, the HUI closed down -14.7% for the month of December, which was the worst December for the HUI since the beginning of this gold bull market.
Taking a look at the performance of the HUI this past year compared to previous years, it’s interesting to note that gold stocks had only their second negative performance for the last 6 months of the year going all the way back to 2003. The only other time since 2003 gold stocks didn’t produce positive returns during the second half of the year was during the stock market panic in 2008. 2011 was also the first year since 2003 where gold stocks had negative returns for both the first half and second half of the year.
Gold meanwhile produced positive returns during both the first half and second half of 2011. But gold had it’s 3rd weakest performance for the second half of the year since 2003. Gold has tended to perform better in the second half of the year than the first half of the year, but 2011 was an exception.
Looking at the relative performance of the HUI vs. gold, the HUI performed almost as poorly against gold last year as it did in 2008! As a result of this poor perfomance gold stocks are almost as cheap relative to gold as they were during the panic in 2008.
Now why did gold stocks struggle so much in 2011? Since gold stocks are still stocks, they are greatly affected by the action in the stock market. Negative action in the stock market can cause gold stocks to perform poorly against gold. When gold is rising and the stock market is falling, the stock market can act like a lead weight on gold stocks and hold them down. And when gold and the stock market are falling simultaneously gold stocks can get crushed. On the bright side, when gold and the stock market are both rising you can get huge upside moves in gold stocks.
The two main moments that contributed to the rangebound nature of gold stocks for 2011 was the stock market top in May 2011 and the top in gold in September 2011. The top in gold in September was particularly nasty since it coincided with a falling stock market. This caused a violent move lower in the HUI over a two week period at the end of September where the HUI plummeted from 630 to almost 480. After that plunge, gold and the stock market both recovered in October which drove gold stocks higher, but then gold sold off starting in November and continuing into the end of the year. This drove gold stocks to close at the low end of the range in December.
For 2012 obviously the two main threats to gold stocks continue to be: 1) a falling gold price and 2) a falling stock market. A falling gold price looks to be a lesser threat to start 2012, as gold is overdue for a bounce after having a dismal December. Sentiment levels on gold are extremely bearish. The Commitment of Traders report is showing a reduced commercial net short position against gold, which typically occurs when gold gets close to a bottom. It is also showing the lowest level in open interest in more than a year, which indicates a lack of speculative activity and also coincides with a bottoming in price.
There is also a bullish falling wedge on the gold chart with a positive divergence in momentum. This is another sign gold is due for a potential short term bounce.
Moving further into 2012, the threat of a continued bear market in stocks could keep a lid on gold stocks, even if the gold price firms. The stock market made a low volume push from the last week of November until the end of December. In order for it to fight through the overhead resistance that was established in the first half of 2011, there needs to be more conviction on the buy side.
There also needs to be a rotation back out of defensive sectors and into growth stocks. Consumer staples for instance continued to outperform the tech sector during the last two months of the year, and that trend has been going on since February. That was one of the earlier signs of the risk off trade that occurred during 2011 along with the early 2011 top in financials.
So the bottoming process in gold stocks could continue for an extended period of time if the overall stock market moves lower during the first half of 2012. One other thing to look for is a majority of gold stocks moving higher once a bottom is established. During 2011 the gold stock sector was fragmented during the breakout attempts, with many gold stocks continuing to move lower while other gold stocks attempted to breakout. Contrast that with what happened in the second half of 2010 where the entire gold sector was lined up for a powerful breakout at the same time. When most gold stocks move higher together it adds legitimacy and sustainability to their move.
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With a couple weeks left to go for the year, many stock market analysts are still hoping for a Santa Claus rally. They were emboldened by the huge October rally in the stock market, and then a big bounce out of the worst Thanksgiving week since the Great Depression. But after selling off again last week, the S&P 500 has still failed to trade above the 30-week moving average for an entire week since July! If you look at the chart below you can see that for the last 9 weeks the S&P 500 has failed to retake the 30-week moving average.
This type of bearish action occurred during the last two bear markets. During the 2008 bear market, once the S&P 500 dipped below the 30-week moving average during the last week of 2007, it never again traded completely above the 30-week moving average until the bear market was over. It tried to re-take the 30-week moving average in May of 2008, but failed.
During the 2000-2002 bear market, which was much more drawn out than the 2008 bear market, the S&P 500 made more attempts to re-take the 30-week moving average. But it failed every time except for a single week in March 2002. Only when the end of the bear market was reached in April 2003 was the S&P 500 able to trade above the 30-week moving average for more than a week.
Besides the bearish implications above, there’s more bear tracks showing up in other markets. Some markets are looking like they could breakdown below their October lows. Canadian banks are one, which is interesting because they were supposed to be relatively healthy, due to the fact they didn’t use as much crazy leverage as U.S. or European banks. Bank of Montreal made a new closing low for the year last week, and is clearly in a Stage 4 downtrend.
Bank of Nova Scotia is also threatening it’s October lows, and like Bank of Montreal is in a Stage 4 downtrend. I’m not showing them below, but Stage 4 downtrends are also occurring in the Royal Bank of Canada and Toronto Dominion Bank.
India made a new closing low for the year last week and looks set to continue moving lower. This is obviously bearish since India is supposed to be a source of global growth.
Now you might say why should I care about Canadian banks or India, if I’m only concerned with U.S. markets? If these markets weren’t heavily intertwined with the rest of the world I would agree. But since they are important parts of the world economy, the signals they are giving can’t be ignored.
Finally, for the October rally to be something other than a simple mean reversion rally, the tech sector needs to re-establish its leadership position. If the Nasdaq 100 was to break below the November lows it would start a pattern of lower highs and lower lows, which would add to the bear case.
The market will continue to remain unhealthy if these bearish trends proceed. Watch those October lows and whether other markets are able to hold those lows or fall below them.
One of the beauties of trend following is ignoring the constant swirl of noise that surrounds the market. Charts don’t lie, and they don’t have opinions. By pouring through a wide variety of charts, from the major market indexes, to commodities, bonds, and foreign markets, you can develop an overall feel for what is going on in the markets. This objective method of looking at the market can dramatically improve your confidence and understanding.
To get a simple view of the trend I like to use weekly charts with a 30-week moving average and a TRIX indicator. The relationship of the weekly price action to the 30-week moving average determines what stage the market is in, according to Stage Analysis. Stage Analysis is one of my preferred trend following methods since it is easy to visualize but still very effective in understanding the current trend.
The TRIX indicator is used to confirm the trend, and also determine whether the market is trending or pulling back within a trend. My interpretation of the TRIX is as follows: when the TRIX is above zero, the long term trend is up, and when the TRIX is below zero, the long term trend is down. Along with that rule, if the TRIX is above zero but has crossed back below it’s signal line and is traveling back down, then the market is pulling back within a longer term uptrend. Conversely, when the TRIX is below zero, but has crossed back up above its signal line and is moving higher, then the market is bouncing within a longer term downtrend.
The weekly chart of the S&P 500 below shows the stage transitions through the bull and bear markets of the last 10+ years. Notice how the TRIX helped confirm the trend, it stays below zero during bear markets and above zero during bull markets.
Looking closer at the S&P 500, it started losing momentum back in March of this year, as evidenced by the TRIX crossing over and moving to the downside. Then the S&P 500 topped in May, and the TRIX continued to move lower and cross below zero. The cross below zero is key, since it signals a long term trend change to a downtrend. This is a clear warning sign to long term investors. Since October the TRIX has crossed over to the upside, but is still below the zero line. So according to the rules laid out above the bounce from October is still a bounce within a downtrend.
It’s important to follow the major indexes since they form the foundation for where the market is headed. But smaller components of the market, such as sectors, commodities, currencies, and even individual stocks or collections of stocks can give clues as to when the overall market could slowly be undergoing a trend change. One thing I like to focus on is where the strength in the market is, and where the weakness is.
The financial sector was the primary cause of the bear market in 2008 and topped well ahead of the rest of the stock market. The same thing has happened again with the financials topping in February of this year ahead of the market. Notice how the financials have shown some strength with their recent bounce, but it still hasn’t developed into a definitive trend change.
The commodities sector is one of the weakest components of the market currently. The CCI Commodities index broke to new lows this week, and the TRIX hasn’t even crossed over to the upside yet, and is still below zero.
Looking at commodity sub-sectors, the agricultural sector is especially weak compared to other commodities like gold and oil.
Gold finally broke below it’s 30-week moving average this week. The fact that silver, platinum, and palladium had broken down previously into a Stage 4 downtrend was a warning sign that gold could be vulnerable. Usually the precious metals move in more or less the same direction, so it’s important to note when there are divergences within the sector. This time around the weakness that the other three metals were showing finally caught up to gold.
The charts presented above represent a portion of the overall market, but if one were to delve further into charts across other sectors, commodities, and foreign indexes there is a predominance of Stage 4 downtrends currently in the market. The key question now is how long will it take for these downtrends to play out? If you set aside attempts to forecast a bottom, all you can do is wait for it to come. Think of a bear market like a horrific accident, it’s much better to experience it as an innocent bystander passing by it, than a participant right in the middle of it. You want to be in a safe place and let the bear market run its course.
The most positive end to the current bear market would be if the early October bottom held up for portions of the market that haven’t broken below it yet. Commodities have already broken below this bottom, but if other sectors diverged and didn’t break below their October lows that would setup the basis for a much healthier market. So the October lows will provide an important area to monitor as this bear market plays out.
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Kyle Bass of Hayman Capital Management is known for successfully betting against the housing bubble, and was featured in the book Boomerang by Michael Lewis. He also has done substantial, thought-provoking work on the sovereign debt crisis facing Europe. In this video Bass covers the potential timing, order, and magnitude of sovereign debt defaults in Europe. He also discusses his view on the housing market, Japan sovereign debt problems, and the U.S. dollar among other topics.
AC2011 Session 1.2 Come Undone: Kyle Bass redux
Some noteworthy quotes and points from the interview:
“Debt has grown in the last 9 years at a 12% annual growth rate. GDP has grown at 4% (annually). So what do you expect when you have a pillar of the world community, the European Union, entering a prolonged stage of deleveraging. The rest of the world in the absence of private credit demand isn’t going to grow.”
“The bottom line is the bill is due today. The bill is due in Europe today, in Japan tomorrow, it’s due in the U.S. the next day. And those days are separated by years of course. And no one wants to admit it.”
“For those of you that think a 50 cent default on the private sector is going to fix Greece, you’ve lost your mind. It is a full writedown of what the Troika doesn’t own….if you just do that math you’ll realize it is a full wipeout.”
Bass thinks December 19th is a critical date for the Greeks since they require another tranche of money to finance their debts on that date.
“There’s a divide between reality and belief in Europe that is going to sink Europe before we sink.”
“We haven’t had a developed western sovereign restructure (it’s debt) since WWII….as soon as they do, you have to think about the qualitative analysis of the participants changing. If it just changes on the margin, for countries like Japan or Italy, then the dominoes start falling….I’ve never seen an orderly default process, I think it’s going to be a forest fire….it’s not the end of the world, it just means a lot of people are going to lose a lot of money.”
“What this means is a very difficult time for the world. This is not a cyclical rebound from a crisis we had two years ago and you should be buying stocks because a P/E ratio is low comparatively speaking with the rest of the S&P years. Because the E is wrong. And we’re going to see declines, and people don’t know how to position themselves for declines.”
“If you’re an individual you need to be much more conservative then you even think you need to be. Return of capital is much more important in the next few years than return on capital.”
“In the environment we’re talking about here, the U.S. dollar should be fine in the short to medium term, if we’re right about Europe and Japan….I think you should be more in cash, and hanging onto productive assets and less invested in financial assets.”
Bass says productive assets could still experience losses but they should provide a better inflation hedge.
Bass discusses why he took physical delivery of gold, and it had to do with the fractional reserve nature of the COMEX. He alluded to the idea that the COMEX wouldn’t be able to handle a large request for gold delivery because they only actually hold a small percentage of the gold traded on the exchange in physical form.
“What’s going to happen in Europe is going to happen very soon.”
Bass thinks the 30-year bond rate in the U.S. could go lower than 2% if money starts running to the U.S. during the upcoming European sovereign crisis.
Bass doesn’t believe collective participants in the market fully appreciate how negatively the debt crisis will affect the markets.
“I don’t get paid to be an optimist or a pessimist, I get paid to be a realist. Being a realist in this scenario is pretty negative.”
“Don’t believe these governments, when they tell you that everything is going to be fine….think about Mexico in 1994….if you remember the crisis, the day before the government devalued 60% they said they wouldn’t devalue. The government can never tell you what they are about to do….the key takeaway is develop your own opinion.”
More Kyle Bass interviews:
Debt Sustainability: Which Countries Are Beyond The Point Of Return And Why
Kyle Bass Explains Impending Greek Default
Kyle Bass On European Banking Crisis
Kyle Bass @ AmeriCatalyst 2010 | ‘Confessions of a Dangerous Mind’
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