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Monday, August 17, 2009

Market Update - Equities and US Dollar

Time for a more in-depth examination of the equity markets and the US Dollar. As I have talked about in the past (and is abundantly obvious to anybody who has been watching the market longer than 5 minutes), the US Dollar and Equities have been inversely correlated. Or put another way, the weakening US Dollar has been fueling the rally since March. Analysis of this "bull market" (used very loosely) equity rally necessarily requires an examination of the US Dollar, and where it might be headed.

Before I delve into this current analysis of the Equity Markets and the US Dollar, allow me to provide some background material so you can understand where I am coming from:
Some More Wave A Thoughts - Aug 13 - My preferred EW count
A Look at Some Indicators - Aug 14 - Daily and hourly indicators as well as CPC
SPY Price and Volume - Aug 14 - Examination of Price/Vol "Energy Levels"
There is a Reason You Don't Take Hot Air Balloons Up 3 Miles - Aug 11 - Market update post
Do Your Part to Help End the Current Bull Market. Become a Bull! - Aug 9 - In-Depth Market Analysis. Both FA and TA. Highly Recommended!
USDX Count Update and Thoughts - Aug 12
Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog. - Jun 17 - In-depth analysis of the US Dollar and inflationary/deflationary pressures

Equities - EW count of SPX

Here is my longer term Primary / Intermediate scale count:

Drilling down into Wave A of the final zigzag. Per my preferred count (Some More Wave A Thoughts) last week, I believe Wave A has ended. Here is an update on the subsequent price action. New price move is clearly outside of the channel. Wave 1 and Wave 5 (minute) are roughly the same size with a clear extended 3rd. Move looks complete.

The reasons why I still like this count:

1. NDX and COMPQ (the "leaders") made new highs on Aug 12. This (IMO) is the true end of Wave A
2. The overshoot on the SPX on Aug 7th was unconfirmed by NDX and COMPQ. I believe this is a B wave within Wave 4 (B waves are often unconfirmed), driven mostly by finanicals
3. The hourly and daily indicators are rolling over in topping action. Now this can be a fakeout. They can "roll over" and simply consolidate. But the daily chart has some strong trend changes and negative divergences. I think we are correcting (probably only slightly) for a bit.

Subsequent price action is shaping up to be a flat (most likely). I believe the first leg (minute A) of this correction (minor B) is done or almost done.

Indicators - Daily, Hourly, Price/Volume Levels

The Daily indicators have finally rolled over. Negative RSI Divergence. Negative cross on MACD. Downtrending CMF, Piecing of the EMA 20 for the first time in a months, etc. Things are beginning to look legitimately bearish on the indicators. Market looks ready to finally correct for a bit.

On a 60 minute chart, the Bearish Divergence which were building up for weeks look like they have finally taken hold. Additionally, the price is clearly below the MA ribbon (MA 5 all the way up to MA 120 - very bearish), and there are CCI readings not seen since early July.

The observation that I made in SPY Price and Volume was that the Price/Vol bands tend to act like "energy levels" and that the rally spent so much energy getting to the top, that it seems like it needs to pullback and rest at the previous energy level before making another strong move up. Well it looks like the observation is panning out:

Sentiment - CPC

The sentiment surveys still say more bullish than bearish among investors. Which is a good gauge on how we are progressing along towards the end of Primary Wave 2. But for a more immediate look at sentiment (via option investors) with regards to the current rally / correction, lets take a look at the CPC.

The CPC is typically a contrarian indicator. And the last 2 weeks, while the rally was still near the top, the CPC was still registering at the bullish extreme. I remarked last week that that was some more circumstantial evidence a correction was imminent.

Currently we have a "trigger" (Black line - EMA 20 over Orange Line - MA 100) suggesting the CPC is headed up (bearish). When the CPC hangs out in the 1.2 area for a couple of days, then I think the correction will be over.

US Dollar

Robert Prechter was interviewed recently talking about a major bottom in the US Dollar and deflation. I will agree that we made a bottom in the dollar recently, but I think the qualifier "major" is up for interpretation.

Short term is all noise. And the current dollar weakness is fueling the equity rally. Long term, equities will go down (due to poor fundamentals) and the dollar will go down (due to confidence crisis) together (such as 2007-2008 and numerous other occasions)

I could spend pages and pages right here talking about why I think the dollar is not strong, why I don't think the ultimate outcome is deflationary. In fact I am really fighting the urge not to. But I have dedicated a whole other blog post to this issue, which I wrote on June 17: Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog.

Some more recent thoughts why I am long term bearish on the dollar (besides the ones found in this post):

1. GDP is fake. All consumer based GDP components are dropping drastically. All production based growth is anemic / slightly negative. And the biggest growth portion is the government.

We are deficit spending (and devaluing the dollar) on non-productive GDP growth just to make GDP look "not as bad as it really is".

2. Treasury auctions are so much worse that most people imagine. The Fed is now buying a *HUGE* portion (like 50%) of the latest treasury auctions.

They are hell-bent on keeping interest rates low at the direct expense to the value of the dollar.

And yes, while I realize that the US is not the only one doing this, no other central bank is even close to the magnitude that Fed is engaging in debt monetization.

So in terms of a bottom, yes I think we have a "temporary" bottom (for a couple of months). I think wave 1 (gray scale) is complete and we will be into a correction up (bullish for the US Dollar) for the next few months while it completes a 2 (gray scale). But I think this setups up a Head and Shoulders. However H&S or no, my preferred count is still bearish on the dollar long term.

But I believe this strict relationship is in the transition process. Currently there still is inverse correlation, but at some point that will break down. Eventually I believe equities and the dollar will fall together, as they have many times in the past.

The Long Term View

Just for kicks, here is a glimpse of the long term view from my perspective.

Here is my little speil on why I think US equity prices will still drop despite the inflationary environment

- If I thought the outcome was truly deflationary, I would be making a call for the S&P to drop to 133 (during 1929, after the initial 50% drop, the stock market dropped another 80%! over the next few years). 20% of 666 = 133. And no I do not think that is realistic given governement policies. I think something like ~400 on the S&P (~4000 on the Dow) is more realisitic
- But what the big drop in the middle of inflation?
- Because earnings still stink!
- Inflation is not enough to keep prices high (I think all the inflated money will find itself in real assets, not the stock market), however, I think inflation will keep prices in the stock market from dropping as low as they otherwise would
- Inflation will also help earnings from dropping in prices terms as low as they would go (in real terms they will be much lower)
- I have said before, that the market needs to make a bottom in terms of valuation before it can go up again, and historically that is when PE is 6-10.
- Just for kicks, lets use PE = 8 as the bottom.
- Earnings (GAAP) from good analysts (such as Mauldin) are around $40. And for the sake of argument, lets say they stay the same for the next few years (I see a much stronger argument that they will actually shrink, I see no compelling argument that they will grow). But lets say inflation keeps them about $40.
- PE of 8 * $40 earnings = $320 Price of S&P at the bottom
- This is where I get my ~400 estimate for the S&P.
- I think we will have inflation big time, but I think the market fundamentals are so bad that they will fall regardless of inflation
- Indicidentally, my gold argument still stands. Dow at the bottom of ~$4000 (not as bad as an equivalent Great Depression move) still puts Gold at $4000 eventually if you believe like I do that the Dow-Gold ratio will bottom at 1 (or even less).

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