2000 TOP EVOLVED OVER 9-MONTH PERIOD RSI BREAK DOWN CONFIRMED 2007 TOP -- RSI FORMS BEARISH FAILURE SWING ON SPX WEEKLY CHART -- DOLLAR FAILS TO ATTRACT MONEY AS SAFE-HAVEN -- JUNK BONDS ARE VULNERABLE WITH WEAK STOCK MARKET
2000 TOP EVOLVED OVER 9-MONTH PERIOD ... Link for todays video. While no two tops are the same, we can learn from prior market tops by dissecting the price action and pinpointing the reversal points. With this in mind, I am going to dissect the 2000 and 2007 tops, both of which marked major reversals after extended advances. First, lets look at the 2000 top. Chart 1 shows the S&P 500 in an uptrend in early 2000 as the index recorded 52-week highs in January and March. A large consolidation became apparent when the index failed to exceed its March high in August. Overall, the topping process covered at least nine months and the consolidation range was around 14.50% of the high.
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Chart 1
The definitive trend reversal occurred with a weekly close below the February-April lows. Also note that RSI broke below 40 for the first time since October 1998. RSI held the 40-50 zone throughout the bull run. The trend-reversing decline ultimately extended some 28% from the August high, clearly not your garden-variety decline. RSI became oversold and the index bounced back to broken support with a throwback rally that retraced 50% of the prior decline.
2007 TOP WAS CONFIRMED WITH RSI BREAK DOWN... Chart 2 shows the S&P 500 with a Double Top marking the 2007 reversal. This topping pattern extended for around nine months with a range of 9.5%. I elected to ignore the volatility spike below 1375 in August 2007. After testing the July high in October 2007, the index declined the next three months and closed below support the last week of December.
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Chart 2
RSI confirmed the support break with a move below 40 the first week of January. Also notice that RSI formed a bearish failure swing prior to the break. The support-breaking decline extended around 20% from the October high to the March lows. Again, this decline was clearly more than just a correction. As in 2001, there was an oversold bounce (throwback) to broken support in 2008. This bounce retraced 50-61.80% of the prior decline.
RSI FORMS BEARISH FAILURE SWING ON SPX WEEKLY CHART... Turning to the current S&P 500 chart, we can see a consolidation extending throughout 2011. Support is at 1250 and resistance at 1371 (range = 8.8%). With a sharp decline over the last two weeks, the index is down over 7% and breaking the 2011 lows this week. Even though this pattern is shorter than the prior two, in both time and length, we cannot ignore this topping process or the current support break.
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Chart 3
Turning to RSI, the indicator formed a lower high in April and failed to exceed 70. According to Wells Wilder, creator of RSI, a Bearish Failure Swing occurs when RSI moves above 70, dips below 70 and then fails to exceed 70 on the next bounce. The Bearish Failure Swing is confirmed with a break below the prior low in RSI. There is also a bearish divergence as the indicator formed a lower high while the index forged a higher high. RSI has since moved back into its support zone (40-50). A break below 40 would provide the final piece of the bearish puzzle.
DOLLAR FAILS TO ATTRACT MONEY AS SAFE-HAVEN... Even though stocks fell sharply and bonds rallied, the US Dollar did not attract much buying interest as a safe-haven. Normally, a sharp decline in stocks would spark the risk-off trade, which favors bonds, the Dollar and gold. Bonds and the gold did their part on Tuesday, but the Dollar was relatively weak. Chart 4 shows the US Dollar Index ($USD) with the S&P 500 and the Correlation Coefficient (125), which is about six months. This look-back period smooths the indicator enough to give us a general idea of the correlation between the two assets. The Dollar and S&P 500 were negatively correlated from October 2008 until February 2009 and from June 2010 to the present. They were positively correlated for a brief period between March 2010 and May 2010, which is when the Euro zone was in crisis. Both stocks and the Dollar moved higher during this time period. Overall, the Dollar is more negatively correlated to stocks.
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Chart 4
Given this negative correlation and the sharp decline in stocks on Tuesday, I was quite surprised to see such a small gain in the greenback. As chart 5 shows, the US Dollar Fund (UUP) remains in bear mode after a triangle support break two weeks ago. The index firmed around 21, but failed to make it back above 21.25 to negate the latest support break. In short, the Dollar remains in bear mode and lower prices are expected.
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Chart 5
Chart 6 shows the Euro Currency Trust (FXE) with a virtual mirror image of the Dollar. This is because the Euro accounts for some 57% of the US Dollar Index and UUP. The Euro ETF formed a falling wedge that retraced 50% of the prior advance. Also notice that the Euro held above its 2010 low in January and exceeded its 2010 high in April. Looks like the big trend is up on this chart. The falling wedge represents a correction within this uptrend. A break above wedge resistance would signal a continuation of this uptrend.
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Chart 6
JUNK BONDS ARE VULNERABLE WITH WEAK STOCK MARKET... We have been talking about the surge in bond prices over the last few weeks. John Murphy showed the iShares Aggregate Bond ETF (AGG) hitting fresh 52-week highs on Tuesday. The 20+ year Bond ETF (TLT) and 7-10 year Bond ETF (IEF) both surged to new highs this week. The PIMCO Munibond Strategy Fund (MUNI) is also strong with a 52-week high this week. While high grade corporate bonds, Munis and US Treasuries are performing well, junk bonds came under selling pressure and followed stocks lower. Junk bonds are dependent on a strong economy to attract buyers. A strong economy increases the chances that these higher yielding bonds will be paid back. An economic slow down reduces the chances of payback and prices fall, just like stocks. Chart 7 shows the iShares High-Yield Bond ETF (HYG) hitting resistance near the May highs and taking a hit over the last two weeks. In contrast to the S&P 500, this ETF remains well above its June lows and could be vulnerable to further weakness. The indicator window shows the 20-day Correlation Coefficient trading above .50 most of the last six months. There were some brief dips to the zero line, but it is clear that stocks and junk bonds are positively correlated. Chart 8 shows the High-Yield Bond SPDR (JNK) with similar characteristics.
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Chart 7
