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December 6, 2009

Correlations Begone

On its face, Friday's session certainly was weird, at least with regard to equities. How many bears are wringing their hands over the weekend after watching major stock indexes print gains while precious metals tanked and the dollar posted its largest one-day gain since early summer? Certainly those who were riding the long gold / short SPX trade were reeling, and therein lies a clue to Friday's action. Markets never make things easy, even for obvious opportunities. After breaking down from a triangle consolidation, complete with a tidy back-test, the Gold/SPX traders were banking easy coin. The tree had to be shaken, and Friday's shake produced a violent gap higher in the ratio.

s&p 500 to gold ratio

Most likely, some big fish were unwinding their paired trades. Whatever the impetus may have been, the action comes with numerous clues to the undercurrents. First, the selling-on-strength data shows us that other big fish were using the rally to unload. Second, peculiar days such as Friday tend to occur near significant inflection points. Third, the facts that the dollar soared and gold tanked tells us that we are accurate with regard to our near-term expectations for a correction. I suspect equities will follow gold's lead within a session or two.

Given the force of Friday's moves, and bit of churning can be expected in gold and the dollar, and by "churning", I mean short-term consolidation. We are likely to see gold bounce a bit along with some mild dollar weakness before the next crack shows the world that a correction is on for real. Of course, any weakness in the buck will probably induce a final squeeze in equities. There has got to be a drop or two of blood left in the bear's eyeballs, don't you think?

s&p 500 weekly chart

Despite all the evidence to the contrary, I would not lightly dismiss that last 45 handles of potential upside to tag the upper bound of the crash channel. If this move were to occur, I'd expect to see it unfold very quickly... Monday or Tuesday... followed by a severe failure into the end of the week. Anyone still holding significant short lines could either jump out of them for a day or two or hedge with a gold long, betting that the SPX/Gold ratio will hold underneath the pivot noted above.

Speaking of the evidence to the contrary, let's get to it. We all know that the banks have diverged from the general market, but how about the other big component of the S&P 500, energy?

oil service stocks

I'm not sure where bulls think the SPX is going without the support of banks and energy. It's apparent that the meager attempts at new highs are being carried by a narrow list of large caps. However, market leaders such as Google, Apple, Amazon, and IBM are sporting nasty bearish candles, so maybe we don't even get that last gasp. In my opinion, a gap lower on Monday's open is to be followed. Otherwise, those wanting to get aggressively short should wait for either a tag of the upper channel line or some other new sign.

Whatever path market takes into a correction, the liklihood that an intermediate correction is upon us is high. Given that we want to aggressively buy the end of the correction, it may help to have at least a guess as to where prices can go. The purpose of this exercise is not so much to give us a buy target as to understand the potential size of the move so as to keep us in the positions were already have. The last thing any trader wants is to be panicking out of valuable positions just when he should be doubling up.

gold price chart

silver price chart

On a weekly chart, a move back down to gold $1020 doesn't look all that ominous, but on a day-to-day basis, how many weak hands do you think will be severed if our little yellow friend sheds another $130? Can any of you imagine silver at $16 again?

gold miners stock chart

us dollar index chart

Note that I said the buck "should" test its 200DMA. It is a test history would suggest. However, if the dollar rolls over again without even reaching this key moving average, it would be a testament to just how violent the next wave down will be.


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