Tuesday, March 3, 2009

Intermarket Analysis

The US and other western markets are already down substantially from November lows. S&P 500 has fallen steeply and looks set to make new lows today. The Giant double top formation in S&P 500 on a monthly graph doesn’t augur well for stocks in the long term unless it trades above 850 for months.

As USD index edges up through the level of 89 there is strong wave of selling in various markets. Most of the stock market around the world has traded deep in the red today. As mentioned in the last article that gold forms its tops in the first quarter of a year, it is beginning to look that gold might actually be forming a short term top.

To come to a conclusion on any one market thorough different market signals we would need confirmation. The ‘safe haven’ bid which has been in the headlines for most part of the last six months is waning. The USD has risen in spite of a fall in the US bonds and a fall in the safe haven gold. If USD keeps its head above 89.25 on a closing basis this week, we would see a rather strong leg down in all the asset classes in the world other than bonds.

For this to happen we would need evidence that inflationary expectation is weak and is getting worse.

Take a look at the ratio of CRB commodity index to the US 30 yr bond prices.

In the previous market correction of 2000, this ratio declined to 1.4823 which is the low for the last 50 years. A rising ratio indicates the relative strength of commodity prices to bond yields. A rising ratio indicates a rise in inflation and is generally a leading indicator of inflation. Using this as a proxy for inflation expectation, there is little reason to expect that deflationary threat is waning.

Commodity prices generally lead CPI changes by a very small margin

This indicates that commodity prices can continue to remain soft for time to come and bonds are expected to do relatively well over the next few quarters. If we go back in history, the deflationary expectations usually run for 6 to 8 years. Since the fall in commodity prices is very steep we can see bouts of recovery and some volatility in the above ratio.

If the inflation expectation is very weak and markets are still factoring in strong deflationary trend then the underlying strength in the precious metal markets is nothing but a psychological euphoric buying for ‘safety’. As and when market participants start to see value in other asset classes such as equities, there would be a flight out of precious metals to equities.

In the last two articles I have repeatedly mentioned that US stocks might form a cyclical bottom in the next two to three months (may be as early as end of March). This would trigger a strong leg down for gold.

Meanwhile, the downward strength in the US markets is still unabated. Equities continue to remain a ‘sell’ unless the trend reverses i.e. the trend remains down unless proven otherwise.

Currency Markets

USD Index

USD index has broken to the upside. 89.25 is the level to watch for this week’s close. This would lead to USD index testing levels of 93 and 95 in the short term. It is important to mention here that USD is in a long term bear market and this multi year correction rally would take a lot of time to run its course.

EUR, JPY, GBP and all Asian currencies are trading lower against the USD for the last few weeks are the trend is now accelerating in some currency markets. USD index remains bullish on a short to medium term basis and will continue to remain a huge negative for Asian equity markets. Especially for a country like ours which has a huge energy import bill.

US stock market

US stocks are falling without any respite and the last few downticks have been on large volumes. This means that market remains poised to test further lows before starting to recover.

S&P 500 index would see a very strong support at 685 and 640 levels. It would be adventurous to add here that 640 – 685 might be a cyclical low for S&P 500 for a subsequent rally to 800 levels.

US Bond markets

US 30 yr Govt Bond

The US 30 yr Govt bond has broken down from the given levels in the last article. This strengthens the view that bonds made a top in December 2008. US bonds remain bearish in the short term and its long term picture is now starting to change.

Commodity Market

CRB index

Commodity prices have been rather sideways in the last few weeks. There was a strong rebound in the energy prices which led to a recovery last week. Commodity prices remain in a strong bear trend.

As mentioned in the previous updates and other view, S&P bank index is now outperforming the S&P 500. This is a telling sign that we are nearing some important support levels in US stock market.

The Amex Broker’s index has also held up relatively well and shows that market bottom signals are now emerging in the US markets.

The major theme emerging from this market scenario is that deflation threat is still strong but US bonds have started to indicate that markets are beginning to factor in some economic growth. However this has not been reflected into the commodity markets. In the short term, continue to look for weakness in the US equity markets and major commodity markets. S&P 500 would face strong support at 685 and then at 640.

Asian equity markets might break lower due to a stronger USD. Indian markets might face strong selling pressure due to intense INR weakness.