Article By: Nu Yu, Ph. D. (with Lorimer Wilson)
A variety of technical analyses all clearly indicate that the S&P 500's run is by no means over. Here are some charts and an analysis of what they mean for the markets, the U.S. dollar and gold.
Breakdown of Treasury Yield Ratio Suggests Changes Coming to Markets
The treasury yield ratio is the ratio of a long-term treasury yield to a short-term treasury yield. Although the yield ratio is not plotted exactly the same as the traditional yield curve, it has a similar importance in that it gauges changes in rates and maturities of treasury securities that will impact on financial markets. The yield ratio goes up as the spread between a long-term and a short-term rate widens, and vice versa.
The daily yield ratio of the 10-Year U.S. Treasury Yield ($UST10Y) to the 2-Year U.S. Treasury Yield ($UST2Y), as shown in the chart below, peaked last November 3rd at 7.85 - its highest level in 20 years - with the Fed's QE2 announcement that it intended to buy $600 billion worth of long-term treasury securities in an attempt to drive down long-term interest rates. The yield ratio decisively reversed immediately thereafter forming a 7-month roof pattern that is a typical topping formation.
Just last week, on February 8, the yield ratio penetrated through the horizontal line of the roof pattern and confirmed the reversal of the yield ratio. As the Fed keeps adding pressure to long-term interest rates by QE2, the yield ratio should be expected to continue the downtrend that will bring significant changes to a broad range of financial markets worldwide.
Decline in Treasury Yield Ratio Suggests Continuing U.S. Stock Bull-Market
During the last 20 years, there have been three occasions where a major downward slopping of the treasury yield ratio occurred. The chart below shows a comparison between the yield ratio which is plotted with a black line and the S&P 500 index which is plotted in the grey area. The first occasion was in 1992-1994 when the ratio went down from 1.67 to nearly 1.0, corresponding to a 15% advance in the S&P 500 index. The second time occurred in 1995-2000 when the yield ratio declined from 1.17 to 0.92, corresponding to a 200% advance of the S&P 500 index, and the third time happened in 2003-2007, when the yield ratio dropped from 2.8 to below 1.0, corresponding to a 73% advance in the S&P 500 index.
Every decline in the yield ratio was correlated to a major advance (a bull market) in the S&P 500 index followed by a flash crash or the start of a bear market every time the yield ratio reached the level 1 or under. The current level of the yield ratio is about 4.25, which is still historically high, and has plenty of room to the downside before it reaches 1.0 so time is on our side. The high level of the yield ratio is like a fully charged battery and it could cause the stock markets to skyrocket when the discharge of energy from the Fed's QE2 is implemented.
Breakout of Cup-with-Handle Pattern Suggests Further Upside for S&P 500
The chart below shows the S&P 500 index in a 13-month 83% advance from March of 2009 to April of 2010 leading to the formation of a Cup with Handle pattern over an 8-month period last year from May to October (cup) into November (handle) which is a bullish continuation pattern. The market then broke out the upside of the cup-with-handle pattern in the early part of last December and has an upside price target projected at 1440. This bullish projection is coincident with the bullish views of both the presidential pre-election year and the downward treasury yield ratio discussed above. (Please read Wilson's article on "why the S&P 500 is likely to top out at 1400-1500 and then tumble to 400" here.)
Breakout of $SPX:$DJW Ratio Suggests S&P 500 is Gaining Strength as Well as the $USD Index
The ratio of the S&P 500 index ($SPX) to the Dow Jones World Stock Index ($DJW) measures the relative strength between the domestic and international stock markets and when the ratio goes up, the U.S. stock market gains strength, and vice versa.
The weekly chart below shows that over a 6-year time span the relative strength ratio of the $SPX to the $DJW continuously declined with the underperformance of the U.S. markets before the decline got stalled in the early part of 2008. The ratio then formed a converging triangle during the last two and half years. Since last October it has moved up from the lower boundary of the triangle.
Last Friday, 2/11/2011, the ratio broke out to the upside from the upper boundary of the triangle which indicates that the U.S. stock market is gaining strength as the international markets decline driven by inflation concerns especially in the emerging markets like India, China, and Brazil. Tightening monetary policies to fight inflation in those countries could add pressure on their stock markets and other emerging markets could also continue underperforming. It is also a bullish sign for the U.S. dollar because the strength ratio is a leading indicator for the U.S. dollar index.
Global Stagflation Presents Uncertainty for Gold
The tightening monetary policy in the emerging markets and the easing monetary policy in the U.S. give a great uncertainty for gold. As mentioned in an article in December here gold was forming, and is continuing to form, a Bump and Run pattern in a long-term timeframe which is shown in the weekly chart below. This pattern typically occurs when excessive speculation drives prices up steeply. According to Thomas Bulkowski, this pattern consists of three main phases:
- A lead-in phase in which a lead-in trend line connecting the lows has a slope angle of about 30 degrees. Prices move in an orderly manner and the range of price oscillation defines the lead-in height between the lead-in trend line and the warning line which is parallel to the lead-in trend line.
- A bump phase where, after prices cross above the warning line, excessive speculation kicks in and the bump phase starts with fast rising prices following a sharp trend line slope with 45 degrees or more until prices reach a bump height with at least twice the lead-in height. Once the second parallel line gets crossed over, it serves as a sell line. Gold currently is in the bump phase, and its uptrend may continue as long as prices stay above the sell line.
- A run phase in which prices break below the sell line often causing a bearish reversal to happen.
There you have it! All indications at this point in time suggest that the S&P 500 (indeed markets everywhere except perhaps in the BRIC nations and some other developing countries) has nowhere to go but UP, the U.S. dollar likely up as well with an, as yet, uncertain short-term future for gold.