Saturday, December 5, 2009

Technical Update 47.09

Most indices posted large gains on the week, with previously underperforming groups (Semis, Small Caps, Transports, Utilities, Asia) taking the baton from the previous outperformers (like the Dow). Sector rotation is a signal of market strength and should not be ignored by market bears. Many of the negative divergences we have been tracking for months disappeared this week, showing a lack of ability for bears to capitalize on weakness.

There were, however, a few signals on Friday that may prove to be important for the bearish case. Nonfam payroll data was released, which beat expectations by a large margin. But after a short spike higher on the open, markets sold off for much of the rest of the day. This again proves my oft cited opinion that it is not the news that matters, but rather the reaction to it that we must give heed to.

The US Dollar was the big story on Friday, however. It posted its biggest gain in many months as the Euro and the Japanese Yen especially put in major reversals. It is my belief that the direction of the dollar holds more sway on equity markets than anything equity specific (carry trade), so it is not necessarily "cognitive dissonance in action" to ignore the many positive price movements in equities in favour of the evidence being displayed in the currency markets.

There's a lot to like in the chart above. It has decisively broken its down sloping trendline from March after briefly poking through 3 times in November. The RSI has, as pointed out over the past few weeks, displayed improving readings as the dollar has slowly drifted lower. It now pushes past the 50 barrier convincingly, which has proven to be the high water mark of the latest decline.

The weekly also displays some interesting signals. The MACD has crossed into positive territory along with the histogram. And stochastics are also looking bullish. The decline has been an 81% retrace of the previous advance, which, from an Elliott wave perspective, is not uncommon for a "wave 2" correction. This would imply sharply higher prices in a 3rd wave higher, which would greatly surpass the previous levels. Elliott waves are not always a useful tool, but when their patterns are as compelling as they are right now for the currency markets, extra attention is definitely warranted. Also of importance to the bullish outlook on the dollar is the current extreme sentiment against it, despite the fact that it is above where it was 18 months ago.

In fact, looking at the monthly chart, the extreme bearishness against the dollar looks even more unwarranted. It only sits a few percentage points below where it was in the early 90's. I'm fairly certain that if a survey of laymen were done and asked, "where is the USD relative to 17 years ago," the answers would be far lower, based on the steady barrage of "dollar doom" media coverage. I was recently forwarded an article where an interviewee responded with this intellectual gem:
As far as the "short dollar trade being too crowded," I'd dismiss it as nothing more than Nazi-style propaganda with no basis at all, only an underlying motive of trying to scare people out of their gold and silver positions so that the "bad guys" can take it from them.

I nearly hit the floor in hysterics.

As the near inverse of the dollar index, the euro also posted a large reversal day. The 50 day EMA remains as a barrier to lower prices, holding on all previous declines since the spring.

The Japanese Yen also had a sizable loss on Friday, giving up most of its previous gains of the past few months. Something looks like it went KABOOM here, and it would not surprise me at all to hear of hedge funds caught offside, betting against continuing correlations.

As always, followthrough will be the key to the importance of Friday's reversal. Over the past few months, we have documented dozens of opportunities like this for currencies, commodities and equities to change course. And in an almost comical ineptness, they have failed every time. We will know early this week, whether this is just another head-fake or the early stages of a resumption in trends that began 18 months ago.

Have a great week!

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