RECENT MARKET TRENDS FOLLOW "NEW NORMAL" INTERMARKET SCRIPT VERY CLOSELY -- BOND YIELDS AND CRUDE OIL PRICES HAVE LED STOCKS LOWER SINCE THE SPRING -- RISING DOLLAR PUSHED STOCKS SHARPLY LOWER THIS WEEK AS EURO PLUNGES
NEW NORMAL IN INTERMARKET RELATIONSHIPS ... Back on April 5, I wrote a Market Message explaining the "new normal" in intermarket relationships. I did that to highlight two changes that had taken place over the past decade owing primarily to deflationary pressures not seen since the Great Depression of the 1930s. The first major change is that bond and stock prices trend in opposite directions (meaning that bond yields and stocks trend in the same direction). The second is that stocks and commodities usually trend together. A third, and more recent, change is the tendency for stocks to trend in the opposite direction of the US. dollar. The "new normal" relationships among the four markets are outlined below:
-- The INVERSE relationship between bonds and stocks
-- The POSITIVE relationship between stocks and commodities
-- The INVERSE relationship between the US Dollar and stocks and commodities
POSITIVE: When one goes up, the other goes up also.
INVERSE: When one goes up, the other goes down.
HOW THOSE RELATIONSHIPS HELPED PREDICT STOCK DIRECTION ... The purpose of today's message is to demonstrate that those intermarket relationships described above are still very much intact and largely explain the recent downward trend in the stock market. In fact, some even warned of a market downturn. That includes bond yields, commodities, and the action of foreign stocks and currencies. Let's start with bond yields. Bond prices rise when stocks fall. Since bond yields also fall when bond prices rise, that means that bond yields and stocks trend in the same direction. Chart 1 overlays the 10-year T-Note Yield (green line) on the S&P 500 since the start of the year. As we've pointed out several times before, bond yields peaked at the start of April and have been leading stocks lower since then. Falling bond yields (rising bond prices) suggest economic weakness which is bad for stocks. The S&P 500 fell below its June low at the start of August which completed a "head and shoulders" topping pattern. The drop in bond yields to a new 2011 low during June and July gave early warning of the eventual downturn in stocks. To the bottom right, the falling green line shows that bond yields failed to confirm the August bounce in stocks before hitting a new 60-year low earlier this week. That drop in bond yields also warned that the short-term bounce in stocks was on weak footing and set the stage for this week's sharp downturn.
(click to view a live version of this chart)
Chart 1
CRUDE OIL LEADS STOCKS LOWER... Chart 2 shows a very close correlation between crude oil (black line) and the S&P 500 since the start of the year. The Correlation Coefficient indicator below the chart shows that link becoming much stronger near the end of April when both markets peaked. Since then, the price of crude has been leading stocks lower. I'm using crude here because it's one of the most economically-sensitive commodities that rises and falls with the stock market. [Agricultural commodities are less effected by the economy, while gold is being treated more like a currency than a commodity]. The breakdown in crude during June also forewarned of the coming drop in stocks during August. Both markets ended the week on the downside.
(click to view a live version of this chart)
Chart 2
RISING DOLLAR CONFIRMS STOCK DROP ... My Tuesday message explained that stocks (and commodities) have been trending in the opposite direction of the U.S. Dollar for several years and that a rising dollar was bad for both markets. Chart 3 shows that the late April peak in the S&P 500 (down arrow) coincided exactly with a bottom in the U.S. Dollar Index (green up arrow). Both traded sideways from May through July. At the start of August, the S&P 500 plunged through chart support (first circle) to complete a top. It took the dollar more than a month to turn up which it did this week when it reached a new six-month high (green circle). There are at least two messages in this week's dollar action. The first is that the surging dollar confirms the August stock breakdown and re-confirms their inverse relationship. The second is that it demonstrates how action in one market (in this case, stocks) can give early warning of action in the other (the dollar). [When two markets have a tendency to trend in opposite directions and one turns down, it's just a matter of time before the other turns up]. But there's more. The rising dollar since April has caused foreign shares to underperform U.S. stocks. Nowhere was that seen more clearly than in Europe.
(click to view a live version of this chart)
Chart 3
FALLING EUROPEAN SHARES FOREWARNED EURO PLUNGE ... When looking at foreign shares versus the U.S., it's always important to take currency trends into consideration. Doing so opens all kinds of possibilities for intermarket analysis and trading. A rising dollar usually hurts the relative performance of foreign shares. A rising dollar usually translates into a weak Euro. A positive correlation often exists between foreign shares and their local currency. The green line in Chart 4 shows the Euro peaking at the end of April (when the dollar bottomed), and trading sideways until the last week when it plunged to a new six-month low (green circle). The blue line is a basket of European stocks that peaked with the Euro in the spring. More importantly, European stocks plunged in early August to signal a new bear market. That hinted that the Euro would soon follow in the same direction which it did this week. Loss of confidence in the Euro contributed to Friday's sharp drop in U.S. stocks (not to mention European shares). But there's more. The solid line below Chart 4 is a relative strength ratio of Europe 350 iShares (IEV) versus the S&P 500. That RS line has been dropping since June as European shares fell faster than those in the U.S. That was a direct result of the rising dollar and weakening Euro. Given the tight linkage among global shares, it was another early warning that it was just a matter of time before European problems would cross the pond.
(click to view a live version of this chart)
Chart 4
INTERMARKET TRENDS CONFIRM AND OFTEN LEAD... The whole idea of intermarket analysis is to study price action in one market to help predict the direction of another. In other words, to use one market as a confirming or leading indicator of another. When two markets are positively correlated (trend in the same direction), a sharp move in one will often warn of a similar move in the other in the same direction. That was the case with the drop in bond yields and crude oil warning of a drop in stocks. When two markets are negatively correlated (trend in opposite directions), a drop in one warns of a coming jump in the other. That was the case when the August drop in stocks led to a September jump in the dollar. Relative weakness in European stocks forewarned of a weaker Euro and problems in the U.S. In some cases, market turns in related markets take place at the same time and don't give any lead time. That's still valuable information, however, because action in one market is "confirming" the action in the other. That's nice to know when you're considering a trade. I hope you can see the possibilities that knowledge of these relationships opens up for trading purposes. Recent trends have followed the "new normal" intermarket script very closely. Combined with traditional charting, intermarket analysis gives the trader and investor a big edge. The fact that global markets have followed the intermarket script described above so closely also demonstrates that recent market trends in all the financial markets have been both rational and predictable (for the most part). But that only works for you if understand the rules under which they operate.
(click to view a live version of this chart)
Chart 5
S&P REMAINS IN BEAR MARKET ... One of the rules markets operate under is that a bear market will keep dropping until it shows signs of a bottom or until it reaches an important support level. The weekly bars in Chart 5 show neither of those things happening. The S&P 500 remains in a downtrend that started in early August and is confirmed by the 10-week EMA (blue line) trading below its 40-week EMA (red line). In fact, the spread between the two EMAs is widening. Weekly MACD lines also remain negative. This week's bounce looks like just a short-term rebound in a larger downtrend. My next downside target remains to the mid-2010 lows near 1025 in the S&P 500.
