Article originally submitted to subscribers on 12th October 2006...
Recent stock market (SM) strength took a lot of people - including me - by surprise!
In the face of ongoing negative news, a weak housing picture, slowing economy, an unpopular war etc. etc the SM has marched to its own Drummer and powered upwards making new all time Highs.
During this period of SM strength, the price of Oil fell by 25%; Long-term interest rates declined by almost 15% and the Dollar remained exceptionally firm.
The major victims of falling Oil and Interest rates have been Commodity Stocks that have been Clobbered!
So where too now?
Last Friday's news of stronger than expected employment numbers caused Bond prices to dive (interest rates to move higher). Evidence is mounting that Bonds have put in a short-term top and interest rates may move upwards over the next few weeks (bond prices move inversely to Interest Rates).
Chart 1 - US 10 Year Bonds making a short-term Top (support @ 106.75 and 104)
After their recent battering, Oil and Gold Stocks (HUI) looks like they may be bottoming.
Chart 2 - HUI and Oil Index (black line) bottoming - positive divergences with lower price and higher MACD and RSI (blue)
This now leaves us at an interesting juncture, the factors that supported a rising Stock Market (falling Oil and Interest Rates) now appear to be reversing and I'm wondering what the SM will do?
Chart 3 - Dow Industrials are over-bought
The SM looks over-bought and due for a correction.
Firstly, the MACD and RSI have moved into over-bought levels (blue rectangle).
Secondly, there are negative divergences in that the MACD and RSI have failed to make new highs despite price reaching an all time high.
How deep a correction will the SM undergo?
That's the Million $ question!
A normal correction within a Bull move would take the Dow to the previous high at 11,670
A more serious intermediate correction to 11,250.
And very serious technical damage below 10,700
Right now there are no indications or clues either way.
We wait patiently for the market to signal its intent...
One could imagine that if the negative correlation between Gold Stocks and the SM persisted, the fact that Gold Stocks are bottoming, may indicate that the rise in the Dow may be halted or reversed. [This may also potentially be a sign of a top in the Dollar but I wouldn't bet on it].
A reversal of the Dow here would create a MAJOR Double Top on the Dow (the first top being in 2000 - not shown) and could feasibly mark the end of the cyclical Bull market that began in 2003. But let's not get ahead of ourselves and once again, wait for the market to signal its intent.
However, for Gold Stocks to really accelerate into the next phase we would need to see an easing of monetary conditions through a widening of the yield curve - which we have not seen yet.
Chart 4 - Yield curve is showing signs of a top. A move below .99 would indicate a widening trend has been established
How would Monetary-easing come about?
Long Bond rates although vulnerable to a correction are probably unlikely to soar higher anytime soon due to continued slowing of economic growth. Therefore, any easing will most likely be as a result of Short-term rates falling against long-term rates. And that means a Fed induced rate cutting cycle!
What would cause the Fed to begin cutting rates?
Possibly a low probability event like a catastrophic terrorist attack or a Rouge nation launching Nukes or perhaps a Slow but steady fizzle of the Housing Bubble. In short, anything that will erode CONFIDENCE.
We are now at price extremes in the SM and correction lows in Commodity markets. It is reasonable to assume that as interest rates correct the SM will work its way lower and Gold Stocks higher. But in the absence of an external catalyst (War) that causes the Fed to ease short-term rates, the Markets may be range bound for the next 6 months!
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SIDENOTE: It is with great interest that I read that the Reserve Bank of Australia (RBA) is talking about RAISING interest rates.
Talk about a difference in position!
In the US, everyone is wondering when the Fed will begin reducing rates. Aussies are wondering when the next rate rise will take place.
And I'm asking myself, what does the RBA see that is making it so skittish on inflation?
I note agriculture prices have risen quite a bit and that's inflationary, but the price of Petrol (Gas) has been coming down and that should cap inflationary pressures.
Here's my theory:
The RBA is concerned about the level of Private Equity and Hedge Fund speculation - they've said as much on a few occasions. The Alternative Investment Markets are HOT.
Alternative Investments are usually funded by a Healthy Dose of debt financing. Its this that has the RBA worried. If Aussie asset prices were to turn down there could be Hell to Pay.
I think the RBA is trying to cool off the Alternative Investment Market.
My guess is that if the Dow held up at current levels and housing didn't fall apart completely (not my view) a more intense level of Alternative Investing would take place in the US. Then the Fed may surprise us all and begin talking about rate increases again.
END SIDENOTE
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