Typically on Sunday’s I do a weekly market outlook, but there’s so much happening this week in Forex, equities, commodities, Treasuries, and on the geo-political front, I don’t have the time and space to fit everything in. So, for this update I’m going to get us ready for Sunday/Monday trading in addition to hitting some core underlying fundamental factors I feel are imperative we traders need to be mindful of and thinking about as we get ready for what’s shaping up to be a challenging summer session.
S&P 500 versus the US dollar index — Battle of the gods:
In my view, out of all tradeable markets that exist on earth like Forex, stocks, bonds, andcommodities, there are just two giants… there are just two ‘gods’ of the markets, just two leading benchmarks, just two pinnacles of the entire global financial system… those two titans of all tradeable markets are the S&P 500 and the US dollar Index.
Those two ‘gods’ of the markets are always temperamental, caustic, sometimes unpredictable, and will unleash their fury when least expected, utilizing the element of surprise. As mighty as these two supreme beings sound, it is the war they wage with each other where us lowly traders can capitalize on the acrimonious relationship that exists between the S&P 500 and the US dollar Index.
For over two years I’ve been teaching traders how to use the correlation between the S&P 500 and the EUR/USD to trade and make money. I’m not going to take the time to rehash that now, but what we’re going to do is take a broader and more historical view on the S&P 500/USD Index correlation in order to gauge what the future possibly holds for the markets, specifically the currency market, and even more specifically, the EUR/USD, EUR/JPY, and GBP/JPY.
Comparison between historical bull and bear markets with the S&P 500 and USD Index–
As most of you know, my personal philosophy on trading says that because the emotions of fear and greed cause humans to control the prices of all tradeable markets, price action patterns are repeated over and over again, and prices go in a circle, not up and down. So, my goal in taking the historical price action patterns of the S&P 500 and USD Index is to help validate my theories on how the relationship of human-controlled price action leads to specific patterns of behavior within the two ‘gods’ of the markets, and in turn, how these two supreme beings act as some of the most core underlying fundamental catalysts that drive price action and market trends. The other core underlying fundamentals, of course, are interest rates and geo-political events.
Note: for those of you who are new, just a quick reminder, my theory and philosophy on trading says that a strong inverse correlation exists between the S&P 500 and US dollar, and they they are constantly at battle with each other… in general, when one is up, the other has to be down.
For the purpose of this exercise, I’m going back to just before the Bretton-Woods II era. If you’re unfamiliar with that event go back and do your homework, especially if you want to make money trading FX. What I’m going to do here is simply take each historical bull market for the S&P 500 and each historical bear market for the USD Index and compare the two to reveal what kind of correlation exists after the USD Index was established and the US dollar became the world’s reserve currency.
S&P 500 bull markets:
10/7/1966 to 11/29/1968. Lasted 748 days. Percentage change: 48.05%
5/26/1970 to 1/11/1973. Lasted 961 days. Percentage change: 73.53%
USD Index bear market:
1/31/1967 to 7/6/1973. Lasted 2,348 days. Percentage change: -24.48%
Between the two bull markets in the S&P 500 between 1966 and 1973, the USD Index remained in a constant bear market… evidence of a clear inverse relationship between the two titans.
S&P 500 bull market:
10/3/1974 to 11/28/1980. Lasted 2,248 days. Percentage change: 125.63%
USD Index bear market:
1/23/1974 to 10/30/1978. Lasted 2,348 days. Percentage change: -25.05%
Four out of the six years the S&P 500 rallied, the USD Index remained in a bear market. Then, the USD Index went on a strong bull market run between 10/30/1978 all the way to 2/25/1985, just over 6-years. During this time, between 11/28/1980 and 8/12/1982, the S&P 500 went through a bear market lasting 622 days and losing 27.11%. So, at this point, the evidence continues to strongly favor the inverse correlation between the two.
S&P 500 bull market:
8/12/1982 to 8/25/1987. Lasted 1,839 days. Percentage change: 228.81%
USD Index bear market:
2/25/1985 to 12/31/1987. Lasted 1,039 days. Percentage change: -48.15%
OK, here we can see an interesting correlation… as we talked about above, there was one S&P 500 bear market during the USD Index’s sustained rally, but look what happened when the S&P 500 hit another bear market in August 1987… just four months later the USD Index’s bear market was over and the USD Index went on a bull market rally from 12/31/1987 to 6/14/1989, gaining 23.74% while the S&P 500 went on another bear market that lost 33%.
S&P 500 bull market:
12/4/1987 to 3/24/2000. Lasted 4,494 days. Percentage change: 582.15%
USD Index bear market:
6/14/1989 to 2/11/1991. Lasted 531 days. Percentage change: -23.83%
Now, between 2/11/1991 and 7/5/2001, the USD Index went on a strong bull run that lasted 3,797 days. During this time, the S&P 500 went through a bear market from 3/24/2000 to 9/21/2001. That S&P 500 bear market lasted 546 days and the interesting fact is, less than two months before the USD Index’s bull rally came to an end, the start of the S&P 500’s next bull rally began… more signs of the inverse relationship.
S&P 500 bull markets:
9/21/2001 to 1/4/2002. Lasted 105 days. Percentage change: 21.40%
10/9/2002 to 7/19/2007. Lasted 1,744 days. Percentage change: 99.94%
USD Index bear market:
7/5/2001 to 11/7/2007. Lasted 2,316 days. Percentage change: -37.69%
Now the inverse correlation between the two titans becomes clear as day. The last USD Index bear market ended less than 4-months after the S&P 500’s historic bull market ended. The USD Index was brutalized between 2001 and 2007, and even into the first 4-months of 2008 while it’s inverse correlated markets continued to make strong gains.
Lets think this through a little deeper… what else happened between 2001 and July of 2008? Well, the EUR/USD was put on the tradeable market, making unprecedented gains all from about 0.8600 to 1.6000, spot crude went from about $20 a barrel to $147, The EUR/JPY went from about 99.00 to 169.00, and the GBP/JPY went from about 165.00 to 251.00.
The future of equities and the dollar–
As the S&P 500 went on a mega bull run it brought the euro, pound sterling, and spot crude with it while sending the dollar and yen to their depths, as evidenced by the 6-year+ bear market on the USD Index. So, what does this all mean for the future of the S&P 500 and the US dollar? If my theory holds true, the S&P 500 will need the USD Index to go lower and bearish in order to rally. Historical price patterns shows that both ‘gods’ of all tradeable markets cannot achieve supremacy simultaneously, they both can’t sit on the throne, one will have to yield power to the other.
If you’re a chart-type person, go back and look at how the USD Index has performed since the S&P 500 began its rally on 10-March, you’ll see exactly what I’m talking about. Again, in my view, these are some of the deepest core underlying fundamentals of all tradeable markets. We took a very broad view at this inverse correlation, but when it comes to day-to-day trading, I distill it all down on a 30-minute basis and simply trade according to the correlations of these underlying fundamentals.
If you want a good look into the future, forget the lagging indicators and keep an eye on whose winning the battle between the S&P 500 and the USD Index because it’s a beautiful leading correlation and about as simple as it gets.
Stress test results delay = bad sign for Wall St. financials:
Is good news ever delayed? I don’t think so, nobody delays good news… after delay upon delay, the markets were told and prepared for the results of the banking stress test on 4-May. Now we’re being told the results likely won’t be released until 7-May at the earliest, possibly even later.
The Fed is either buying more time to perfect a smoke and mirrors act for when the results hit the markets or they are preparing yet another bail-out package because the regulators will reveal what we already know — the US banking system continues to carry systemic risk of insolvency despite every liquidity and credit scheme enacted by the Fed since March of 2008. There are only 19 banks and financial institutions going through the stress test but those 19 institutions hold roughly 66% of all assets and 52% of all loans in the entire US banking system. Most of the banks being tested, if not all, will need to raise capital and that goes right back to the risk of insolvency.
Look at what Goldman Sachs did just one day before the preliminary results of the test were due to be released back on 1-May… Goldman, the so-called “best and the brightest” on Wall St. made new issuance of bonds and stocks to raise capital. Goldman sold $2 billion worth of 5-year notes and $750 million in a new stock offering, all without government backing. It doesn’t take a genius to read between the lines here… Goldman clearly wants to avoid being targeted by banking regulators and they want to pass the stress test with flying colors, so they went ahead and raised their capital prior to the test being completed and the results being revealed.
Last Friday three more US banks failed, bringing the total failures in 2009 to 32 banks. Just from those three bank failures on Friday it cost the FDIC $1.4 billion. Here again we see clear evidence the risk to the entire US banking system goes well beyond the 19 banks undergoing the stress test. I think nationalization is the worst-case scenario result of the stress test, and Wall St., specifically the S&P 500 financials index, will not be happy about one or more of the 19 banks being taken into receivership by the government.
Fundamentals and geo-politics:
This week is going to keep market participant’s heads spinning because of the strong mix of key fundamental events and the high level of geo-politics. In addition to the glut of inflation, housing, consumer, manufacturing, and production data on the books this week, there are several monumental interest rate events, plus NFP, plus speeches by various Fed and ECB members, and of course the growing concerns over a potential flu pandemic.
The following list are the fundamental and geo-politcal events I feel are most important this week for the EUR/USD:
- German Retail Sales (Monday)
- Pending Home Sales (Monday)
- Eurozone PPI (Tuesday)
- Fed Bernanke testimony (Tuesday)
- ISM Services (Tuesday)
- Eurozone Retail Sales (Wednesday)
- ECB Interest Rate Event/Trichet Press Conference (Thursday)
- Initial Claims (Thursday)
- Fed Bernanke Speech (Thursday)
- Bank stress test (Thursday)
- NFP/Unemployment Rate (Friday)
Also, both the RBA and BOE have interest rate events this week, the RBA, BOE, and BOJ put out their latest monetary policy statements respectively, and SNB’s Roth and Jordan have speeches. All the majors and yen crosses have major fundamentals this week in fact, so stay on the top of your game because these factors are driving money-flows and the sentiment of market participants.
Wall St.:
Both the Dow and S&P 500 managed to put in a continued strong performance the first trading day of May and this is certainly a good sign for the bulls while keeping the bears in the cave for now. I don’t believe a bad NFP will be enough to knock Wall St. down, but in order for the S&P 500 and Dow to attract enough money-flows to continue marching forward, the following correlated markets will need to work in Wall St.’s favor:
- USD Index moves lower
- Spot crude moves higher
- 10-year Treasury yield remains above 3.00%
- Treasuries continue moving bearish on the short-end of the yield curve
- No banks become nationalized as a result of the stress test
The thing to keep in mind is, from a pure price action and price behavior standpoint, it takes more conviction buying to drive prices higher than it takes for conviction selling to drive prices lower. Prices of almost any tradeable market will drift lower simply for lack of buying and not necessarily from conviction selling.
Sunday/Monday Trading:
As we noted above, these markets have quite a bit to contend with this week. Trading the first week of the month can be challenging because it’s so hectic fundamentally, and that causes many of the big market-movers to pre-position themselves ahead of key events, especially interest rate events. With all the pre-positioning and book squaring that goes on the first week of the month, my trade plan calls for strict risk and money management and paying very close attention to the time of day…
Remember, both the Forex and equities markets follow specific patterns during certain times of the day, like before Frankfurt and London closes, between the time NY closes and Tokyo opens, the 30-minutes prior to the Nikkei’s open, the 60-minutes before the European cash market opens, as Chicago future’s money-flows hit, etc. Don’t let yourself get caught off guard by neglecting the market’s patterns of behavior this week…
Gold–
The other market to keep an eye on is spot gold… gold will remain under pressure for as long as the central banks and market-movers like the IMF, World Bank, and BIS continue dropping massive tonnages of gold on the market. This is just my opinion, but I think the central banks are even finding their own reserves to be under-capitalized and they are dealing with this issue by selling gold to raise cash to pump into economic and banking stimulus. The IMF has been the most vocal and transparent about their open-market gold operations and I can assure you all the banks are doing it.
As always, it’s imperative you use proper risk and money management this week… stick to taking those 0.5% entries and keeping your usable margin at 96% or better to avoid being held hostage to the market or worse. Small losses are much easier to recover from and it’s a terrible thing on the mind of a trader to let a position get too far away or to let the usable margin get too low.
That’s all for now. As long as market conditions allow I will do a live audio Q and A in the chat on Monday at 1000 EST / 1500 GMT.
-David
