Trader’s Narrative

What better way to reliquify the world financial markets than sacrificing a currency?

If you’ll recall this is a well worn script. The last time we had a financial crisis, it was the Yen that was used as the vehicle of choice. Massive amounts of capital were borrowed in Yen and invested in other risky assets with the nudge-wink agreement of central banks that it was a one way trade.

Today it is the US dollar that is being sacrificed at the altar of the new bull market… in everything. Roubini has been among the most vocal to raise the alarm. But almost everyone else has decided to enjoy the trade while it lasts.

Of course, the sensible thing is to realize that you can’t drink yourself sober, just as you can’t dig yourself out of a hole. But since when have monetary policy wonks been fans of reality?

While it is difficult to prove definitively that the US dollar carry trade is the reason almost every single asset class has appreciated, its footprints are hard to miss. Here are David Rosenberg’s recent observations on the correlations across asset classes:

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April.

There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring.

Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

The scary consequence of the US dollar carry trade is that it has pushed almost all risky assets to be correlated. And when the music stops and someone starts to unwind the trade, it will get ugly. When everything you hold is correlated to each other and everything else in the market, even a small tremor of selling will lead to an avalanche as the value of your portfolio starts to decline all at once.

If you expect gold to be a safe haven, you’ll be sorely disappointed. Historically, gold and gold stocks have never been a stronghold in a severe sell off. So maybe that’s why short term T-Bill rates have been pushed so low.

With today’s close the S&P 500 index arrived at a new high for the year. So far, it has risen 22.8% - not bad at all compared to the average historical return. And the year isn’t even over yet. If we look at the performance from the very bottom of the lows in March, it is even more remarkable at 63%.

But even as the stock market continues to power ahead, and longevity of this rally continues to strain all credulity, we can’t ignore that the market breadth is down right horrible. Usually, the measure of advancing vs. declining stocks rises and falls like a tide, keeping a rhythm with the indexes.

Right now however, the 20 day average of Nasdaq’s daily advancing and declining issues is acting the way it would at intermediate lows - even though we’ve well into an uptrend:

This means that fewer and fewer stocks are pushing the averages higher. When we start to see less participation from the wider spectrum of stocks trading on the exchange, we don’t have a healthy rally. My hunch is that most of gains can be laid at the feet of the large caps either because of their international sales exposure or because of the dollar carry trade (sell the dollar and buy anything risky). Check out the Russell 2000 - it has yet to confirm a new year to date high as the S&P 500 index. The same can be said for the equal weight S&P 500 index.

Another cause for concern is just how quickly the index has been able to rise on the back of fewer and fewer rallying stocks. For a bull market to be considered healthy, it has to have staying power. This is an endurance run after all, not a sprint. I measure the speed of a rally by comparing the closing daily price to the long term trend as measured by the 200 day moving average.

While the 200 day moving average has been rising, it hasn’t been able to climb as fast or faster than the price it tracks. So the distance between them as a ratio has increased. With today’s strong close, the S&p 500 index is now 19.3% higher than its long term trend line. That’s slightly more than the last time this same metric made me raise the caution flag: Stocks Have Little Room to the Upside.

That was 11 points lower than we are now. Running the numbers with a 20% and 21% ceiling, we get 1117 points and 1127 points respectively. So imagining that we leapfrog 8 to 18 points from here, we will have hit an invisible wall. Check out the previous link above to see a chart.

So odds are that we either correct here (again) to give the long term moving average a bit of time to catch up. Or prices meander to and fro, not really going anywhere and boring both bears and bulls. There is very little probability, from a historical study of the market, that we will see a rush higher.

The US dollar index is back down to the lowest levels for the year. But as I mentioned in the Politics of the US Dollar, it has yet to fall below the 2008 lows. Right now it is about 5% above that floor.

A bright side of the weak US dollar is the earnings boost it gives to US corporations with major international sales:

Source: Bloomberg

Today Geithner told Japanese reporters, “I believe deeply that it’s very important for the U.S. and the economic health of the U.S. that we maintain a strong dollar.” This is the same “strong dollar” pablum that all Secretaries of the Treasury have to peddle as part of their job.

But the unvarnished truth is that the US dollar is being sacrificed so that the US economy can continue with the least amount of structural changes. Instead of having to actually face the bloated deficits and debt racked by the US consumer and the US government, it is much easier to simply reflate your way out. The only sticking point is that this trick is an easy one and much too transparent. Almost every single developed country is racing each other to the bottom.

It is entertaining to watch from our perch as traders. But don’t forget that the stock market can defy the dollar and climb, as it has for the majority of this year. In fact, the dollar carry trade is pretty much single-handedly responsible for the rescue of the world economy from total collapse. As long as it is a controlled decline, it is welcomed.

You can either argue whether this is any way to manage an economy or realize what is going on and make decisions to profit from it.

This is a guest post by Wayne Whaley, CTA:

Before presenting my latest seasonality study - which may be the most statistically significant - here is a short summary of the previous three studies that I have shared with you. Enjoy.

End of Year Positive Bias
Since 1950, the average annual return on the S&P 500 index has been 8.05%. Over half of that (4.25%) annual return has on average occurred in the three months, November to January.

(Abnormally) Positive Septembers
September is usually the weakest month of the year. But when September has a positive return, the last 3 months of the year have a strong positive bias (21-4) and an average gain of 4.84%. For full details, see: When September Flexes Its Muscle

Positive Septembers - Negative Octobers
If the a positive September is followed by a negative October, then the odds for the last two months of the year go to 10-1 with an average gain of 4.71%.

Seasonality When Jan-Oct Returns Are +10%
If the first ten months of the year provide a 10% or more return, then the final two months of the year are 21-3, with an average gain of 4.99% (see table to the left for details). Perhaps more interestingly, there was not a one percent loss in the the 24 observations.

If the end of the year rally doesn’t materialize with the tail wind of the above statistics at its back, it should be viewed as very bearish for the first quarter of 2010.

Guest post by Robert Folsom, senior writer for Elliott Wave International

The following text is courtesy of Elliott Wave International. Until Nov. 11, EWI is allowing non-subscribers to download their latest market analysis and forecasts for free, including Robert Prechter’s latest Elliott Wave Theorist and Steve Hochberg’s and Pete Kendall’s latest Elliott Wave Financial Forecast.

Learn more about FreeWeek, and download your free reports here.

As you read and look at this page, please know that the chart is the star of the show. My description will add only a few details.

The chart published less than two weeks ago in Bob Prechter’s Elliott Wave Theorist. The rectangular box is plain to see: It envelopes the huge S&P 500 rally that began last March — a gain of 61.5% and 430 points, as of Oct. 18.

But there’s a two-part truth to the rally — and that is what the box really shows.

Part one shows the “wall of worry” — basically March through August. That’s when the media and experts were overwhelmingly negative about stocks. They were surprised by the rally. Remember?

Part two shows the more recent time of “euphoria” — basically September and October. The media and experts turned positive. The market was all about “green shoots” and “recovery.”

You see when most of the rally unfolded. Six months of serious worry produces a 373-point climb, whereas “two months of euphoria produces only 57 S&P points.”

Now, the two-part truth about this rally is an easy story to tell. It’s literally a few lines and notations on a price chart. Yet have you seen or read ANYTHING like this in the past two weeks? Has anyone else pointed out that over the past two months, the stock market “rally” has in fact slowed to a crawl?

As you looked at the chart, perhaps you noticed that the decline, which began in 2007, and in turn the recent rally, are both on a similarly large scale. The full version of this chart shows how important that “similarity of scale” really is (Elliott labels were excluded in consideration of Theorist subscribers).

Price action in the stock market this week has only strengthened the analysis in Bob Prechter’s October Theorist issue.

What’s more, you can read the very latest forecasts in the just-published November issue of the Elliott Wave Financial Forecast — both publications (plus the tri-weekly Short Term Update) are yours for free — only during FreeWeek (now through Nov. 11).

Learn more about FreeWeek, and download the November Theorist

Robert Folsom is a financial writer and editor for Elliott Wave International. He has covered politics, popular culture, economics and the financial markets for two decades, via print, radio and the Internet. Robert earned his degree in political science from Columbia University in 1985.