Upside Breakout In The Dollar Index May Be Close At Hand

• Market breadth on the rally not so hot
• Credit spreads are a likely bell weather for equities
• Dollar Index reaches critical resistance

The power of the recent rally has been a surprise to most observers including myself. The big question is whether it is part of a topping out process, an extension of the recent trading range or the launching pad for a new up leg in the bull market? I don’t think we have enough evidence to draw a meaningful conclusion to that question at the moment, but I can point to some strength and weaknesses of the advance.

Chart 1, for instance, shows that the S&P 500 ($SPX) has moved above its breakdown point and is very close to its green resistance trendline marking the previous high. On the other hand, the NYSE ($NYA), in the lower panel, is still below its breakdown point. Since this is a much broader-based measure of the market, this dichotomy indicates that the advance has been concentrated in higher cap issues.

Chart 1

That’s pretty obvious from Chart 2, which compares the small cap Russell 2000 (IWM)  to the performance of the S&P (SPY). This relationship has been falling for some time and is now experiencing declining trends for all three KSTs. Since the ratio has just reached its October 2014 low and the short-term KST is oversold, some form of bounce seems likely. However, the longer-term trend favoring large caps is probably intact.

Chart 2

Market breadth

Breadth for the S&P 500 ($SPX) has been quite strong as we can see from Chart 3, which compares the S&P A/D Line to the price of the index itself. A couple more days of strength and the A/D line will be recording new all-time highs. However, enthusiasm measured by the volume is definitely lacking. This can be seen from the performance of the Upside/downside volume line which, as the red dashed arrow indicates, has been definitely lagging.

Chart 3
Breadth on the NYSE itself has left a lot to be desired, as you can see from the weak performance on the A/D Line in comparison with that for the S&P. Note that the upside/downside volume line for the NYSE has actually been moving sideways as the S&P experienced a sharp rally. This action does not preclude new S&P 500 highs, but it does throw open a troubling aspect of the quality of the rally.

Chart 4

The cumulative number of net new highs occasionally offers useful buy and sell signals when it crosses above and below its 50-day MA. Those generated last October were not particularly timely, nor would the next buy signal if it were generated in the next few sessions. The real value of this technique, though, is to maintain exposure during strong uptrends and offer protection during major declines. Despite the strong October rally this indicator has hardly risen at all, thereby reflecting a dearth of issues breaking out to new 52-week highs.

Chart 5

Bond market quality spreads

One area I am keeping a really close eye on is the relationship between high-quality treasuries and junk bonds, as it reflects the hopes and fears of bond market participants relative to economic developments. In this respect, Chart 6 compares the S&P Composite ($SPX) with a ratio between the iBoxx High Yield ETF and the Barclays 7-10-year Trust, the HYG to the IEF. When the ratio rises it means that bond investors are gaining confidence because they are bidding up the prices of junk bonds against treasuries. A declining ratio, on the other hand, means that market participants are showing a preference for treasuries as they have become more cautious. Most of the time this relationship moves in tandem with the equity market, but the red and green dashed arrows show that discrepancies can and do appear and these often precede reversals in the prevailing trend of equities. The ratio recently violated a key (red) support trendline but has since pulled back. My feeling is that if the market itself is going to register new recovery highs it’s going to be pretty important for this relationship to move solidly above the red line. On the other hand, primary bear markets for equities are fueled by fears of a recession, and this is reflected by a falling ratio. Consequently, if we are still in a bear market, the recent rally in the IEF/HYG relationship will turn out to be a normal retracement move, which will later be followed by a move below its October 2015 low.

Chart 6

Chart 7 compares the iShares High Yield (HYG) to the Barclays High Yield ETF, the JNK. Both series have completed and broken down from head and shoulders tops and have now moved back to the breakdown areas. Since these tops extend back to the end of 2012 they are fairly significant. As it stands today, the implication is for substantially lower prices for junk bonds, absent these breaks turning out to be whipsaws.

Chart 7
Chart  8  shows the HYG in its own right compared to the S&P. There are a couple of things to note. First, the October low in the HYG was below that of August whereas the S&P was higher. Second, the S&P rallied well above its mid-September high whereas the HYG only managed to rally back to it and no more. Bottom line, the HYG has been weaker all the way through. Third, there are gaps on the HYG at lower levels. Gaps are not always filled, but there is a very high probability that they eventually are. This makes the ETF vulnerable to lower prices.  Finally, the PPO has just begun to roll over. This suggests that a test of the lows or the extended green breakout trendline is likely.

Chart 8
Returning the IEF/HYG relationship, Chart 9 features the other component, the IEF. Here we see that the price is above its 65-week EMA and both the long and intermediate KSTs are in a positive trend. The price has also broken above the green resistance trendline. The problem it faces lies in the fact that the short-term KST has just turned bearish and certainly threatens the recent upside breakout. The real make or break level, though, is at the red trendline at $107.

Chart 9

US Dollar

Chart 10 shows that the fortunes of the US Dollar are very much tied in with swings in the level of bond market confidence. The arrows flag important peaks and troughs in the US Dollar ETF, the UUP and show that more often than not are associated with reversals in the IEF/HYG relationship.  This shows that the dollar’s safe haven status, or not, is a major driving force behind its ups and downs. Also, these swings in sentiment can be gauged from the bond market as preferences move from low-quality junk to high-quality treasuries.

Chart 10

Chart 11 compares two dollar ETF’s, the UUP, which has a 58% weighting in the Euro and is therefore very Euro-centric. The other ETF is the Wisdom Tree Bullish Dollar ETF, the USDU, which is far more broadly based. The UUP has already violated its down trendline and is trying to close in on overhead resistance just a tad below $25.80. The USDU, on the other hand, has not yet broken out. That requires a daily close above the $29 area.

Chart 11

Since the KST for the UUP in Chart 12 has just turned to the upside, a successful assault on the overhead resistance is a likely bet.

Chart 12

Good luck and good charting,
Martin J Pring

The views expressed in this article are not necessarily those held by Pring Turner Capital Group