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October 3, 2010

Correlations Begone

In recent posts I've outlined a case for equities to return to bear market mode and that to do so, the inverse correlation between stocks and the dollar must be broken because of the expectation for the buck to plunge into a 3-year low in coming months. With the dollar now in free fall, let's see how equities are holding up.

dollar S&P 500 correlation

Now, I realize that nine days is a rather short period of time, but 3.5 points on the dollar index is not insignificant. The fact that such a plunge provided no impetus for stocks to move higher may be an important warning sign for bulls. Furthermore, we were greeted with reports this weekend that China wants to buy Greek bonds. Such news should bolster the euro and frighten the Treasury market. Unless this news is already discounted, we could see a quick dive early in the coming week to an important support level on the dollar chart.

u.s. dollar weekly chart

If we do, indeed, witness a quick move down to that trend line, traders should keep a keen eye on how equities behave. If another two points of weakness in the DX cannot move stocks, the next bounce in the buck is likely to spill quite a bit of equity blood.

I've also noted that for equities to roll into bear mode, we would need to see the energy complex in decline. This assessment did not hold much water last week, as we saw a 7% rally in crude oil do nothing to bolster stocks. I'm willing to bet, however, that if energy prices fall, stocks will get dragged down hard.

Oil price chart

These quick, 4 to 5-day spikes in crude price have tended to be exhaustive. As a parallel to dollar action, it will be very important to note how equities behave when oil suffers a pull-back.

The next few session are going to be very telling with regard to the bearish interpretation for stocks.


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