With a considerable pop in equity prices in January, many investors are scratching their heads, not sure what to do. Most charts are overwhelmingly bullish, but overbought on a short term basis. Often the best trade is the hardest trade, and I think we may be in one of those situations. As much as it pains me to be long, knowing that a pullback is overdue, markets can remain overbought and grind their way up for extended periods of time. The following intermarket analysis examines the interplay of current global market trends. The conclusion of the article is that, while although a short term pullback can be expected, global equity markets are likely in the final leg up of the bull market that began in 2009.
If we look at U.S. and global indices, we find signs of a renewed uptrend not previously confirmed. First, on the weekly S&P 500 (SPY) chart, we can see both a long term uptrend channel from 2009, as well as a smaller trend channel from 2012 onwards. Note the consecutive higher highs and higher lows.
While the above price action in the S&P is positive, the new highs in March and September were not previously confirmed in other U.S. and world indices until the recent January pop. This confirmation amongst global equity indices is very bullish and a key component of classic Dow theory. Note the below two charts, the DJIA (DIA) on top, and the transports (IYT) below. While the Dow had made consecutive new highs, the transports had been lagging until recently. The surge in the transports was a key component in confirming that the global uptrend is still in place.
The Russel 2000 (IWM) also recently confirmed new equity market highs, and even surged to all-time highs. Small caps often lead the markets, and this is very positive for equity markets.
The Nasdaq (QQQ) is the obvious underperformer, not confirming highs seen in other markets. This is largely due in part to the poor performance of Apple (AAPL), which has significant weighting in the Nasdaq.
If Apple were to be removed, I would imagine the index would be close to new highs. The chart below shows the significant sell-off in Apple since September, despite strength being seen throughout market indices. A break of either of the two trend lines below could be significant for Apple, the Nasdaq, and to some extent U.S. equities in general.
European equities (FEZ) have broken above a key resistance level, and appear to be forming a new uptrend. This confirms price action experienced in the U.S. The 230 region in the chart below should hold for the uptrend to remain, and a break above 250 would be further confirmation of a new uptrend.
The Nikkei 225 (EWJ) had a strong breakout as well. Note that is has broken two significant down trends, and there is not much overhead resistance. This bodes well for further gains in global equity markets.
The Hang Seng Index (EWH) also had a significant breakout over the last month.
Emerging Markets (EEM) also confirmed the January equity market breakout, however much like the Hang Seng, there still exists overhead resistance.
Global Equity Market Summary
The January pop in equity prices was experienced globally. The Nikkei was the only index to still be in a downtrend, and that is clearly no longer the case. New highs have been seen in some markets, while breakouts of consolidation periods have been experienced in others. It is safe to say that global equity markets are in a strong uptrend.
For the fall of 2012 there existed a high negative correlation between the $USD (UUP) and the S&P 500. That correlation has disappeared recently and at this point the relationship is less reliable. Prior to the correlation breaking down, a breakdown of the head and shoulders pattern seen in the below chart would have been bullish for equities, but that is no longer necessarily so. Similarly, a breakout upwards is not necessarily bearish for equities. Note the longer term correlation still exits, but may be unreliable near term.
Treasury yields have moved up recently with U.S. 10-yr yields (IEF, TYD) reaching levels not experienced since April. There still exists considerable resistance in the upside, and the ten year still remains in a long term down trend, but the recent action could be the start of a new long term uptrend. Rising rates have negative implications for equities, but this is typically experienced later on in a run up in rates.
The chart of 30-yr U.S. Treasury yields is somewhat more constructive. Note two things: first a double bottom looks to be in place, and second, a two year downtrend appears to be broken. Both are very bullish for rates (bearish for bond prices), and this could be the beginning of the end of the historic run in bond prices.
Rising rates also have negative implications for Gold (GLD). Notice the high positive long-term correlation between gold and the U.S. 10-yr and the 30-yr bond prices (prices are the inverse of rates) in the chart below. As rates have appeared to put in a bottom, gold has failed to make new highs. The breakout of the wedge in 2012 failed at the 1800 level, and price continues to consolidate sideways. This likely could persist until the bull trend runs its course and fear re-enters the market.
U.S. SECTOR AND SHORT TERM ANALYSIS
If we look at the sector rotation model, it looks like markets are in the late stages of the bull market that started in 2009. The sector rotation model below illustrates where most sectors typically outperform in a typical market cycle. Ratio charts are best to analyze relative strength, and three sectors are currently exhibiting strong interpretive signals. The model, as described by John Murphy, is below.
Source: John Murphy; Intermarket Analysis
If we start with a comparison of industrials (XLI) to the S&P, we can see a reversal from underperformance to outperformance that took place in September.
The basic materials/industry sector (XLB) has followed closely in step. Notice the complete reversal of trend and recent outperformance in materials compared to the S&P since December.
Finally, energy (XLE) seems to be consolidating underneath a long term trend of underperformance. Oil (USO) has gained some momentum recently, and it can be expected that the energy sector will be the next sector set to outperform in the near future.
A breakout of the energy sector in the next couple of months would be in line with the sector rotation model. This suggests that equity markets may be approaching the final leg of the bull run-up. That being said, a breakout in energy still implies higher equity prices, but potentially the final extension of the uptrend. I personally will be watching for a breakout of the ratio chart of the staples sector to the S&P for an indication of an equity market top being put in place.
Short Term and Sentiment Analysis
In the global macro outlook I noted that the S&P is in two up-trending channels. On an even shorter term, there is actually a third upwards trend channel.
Note the September intraday high still remains in place, and there is resistance along the short term upwards channel. I don't think I am the only one hoping for either a consolidation or pullback in which to add to long positions. That being said, until any bearish price action is experienced, one likely will be best positioned long.
I also mentioned that the underperformance of Apple has undoubtedly dragged on the Nasdaq, and should be kept in focus. Due to the extensive coverage of Apple, and the significance it plays, one must keep a close eye on it. The 500 level has been widely discussed, and is clearly a significant level, both due to its recent role as support, as well as the significant of the 500 number. This level also corresponds with the neckline of the head and shoulders pattern that began in spring 2012.
If one looks at the long term arithmetic chart of Apple presented earlier, one can note a long term trend line currently coming in around 480. I would not be surprised to see price wash out both of those levels intra-week, but then regain the 480 and 500 levels on a weekly close basis. It would be bullish if the 500 level and the trend line are false breakdowns, and would likely precede a new uptrend that breaks the downtrend than began in October. This may seem overly technical, but Apple has been very technically reliable lately, and there aren't many fundamental arguments that can explain the recent volatility.
There has been a lot of talk about the VIX (VXX lately: "complacency" setting in and the VIX reaching new lows. This is true, but it is important to look back further, to previous long term market tops, for a proper analysis. If one looks at the previous market top, from 2005 to 2007, one can see volatility levels that are quite lower than those currently being seen. It is clear that as a final leg of a bull market is experienced, the VIX can grind lower and lower.
Moving averages can be of use here. Note in the chart above, that from 2003 to 2007, the 20, 55, and 200 week simple moving averages were all downwards sloping for the most part. From 2007 until 2009 they were mainly upwards sloping while equities tanked, and then reversed down in 2009 as equities began the present four year bull market. Currently the moving averages are sloping down, and one can expect that trend to continue. In the very near term however, a short term pop could be expected that relieves overbought conditions in most equity markets. The shorter term chart below illustrates past short term bounces from recent extreme lows.
If one looks at the number of stocks above their 50-day moving average, its becomes obvious that a near term pullback may be coming. Typically readings on this index below 20 are considered oversold, and readings above 80 to be overbought. This indicator has worked 4/5 times in the last year, with the oversold reading in February 2012 being premature. Used in conjunction with other tools, this is a highly effective signal for short term changes in market direction. Note the current oversold condition:
$USD, Oil, and Copper
As mentioned in the global macro outlook, there is a notable head and shoulders patterns that has developed over the last year in the $USD. However, the high negative correlation that existed through fall of 2012 has completely reversed with the January spike in equity prices. Due to this, the dollar may not be in focus as much in the near future, however it will be interesting to see where the relationship stands when a breakout occurs out of the recent consolidation.
While the recent move up in WTI Oil (USO) over the last month was significant, it still remains in a downwards trend/consolidation from February. A breakout above this trend would be very significant. Oil typically has its strongest performance at the end of bull markets. A breakout above 95, and then 100, would be very significant. This would be in line with the sector rotation discussed earlier, specifically with the XLE.
Copper (JJC), due to its significance to the overall economy, often leads equity markets. Any move to the upside will obviously be positive for equity markets. However, for the long term, I am more interested in the upwards trend line from 2010. When the time comes that it is tested, as well as the $3.40 and $3.20 levels, I think one must consider the bull market near complete.
Equity markets look to be entering the final leg up in the bull market that began in 2009. Currently most markets are overbought, and a short term pull-back can be expected.
Apple is currently at a critical level, and its direction in the next months will influence equity markets. If Apple were to sell off, it would bring down the technology sector with it, which is often a leading indicator for equity market direction.
Focus should be placed on the energy sector and the staples sector. If a breakout were to occur in energy, notably in oil, and then be followed later by relative strength in the staples sector, this would be indicative of a market top being put in place. This however could take some time to develop.
A spike in oil prices has been associated with numerous market tops, notably in 1973, 1980, 1991, 2001, and 2007. A breakout of the one year congestion to the upside could lead to the next significant retreat in equity prices.
Gold has been consolidating for over a year now, and likely will be range bound for some time.
A continuation of the recent uptrend in fixed income yields would signal the end of the historic run up in bond prices. If that were to happen, cash could flow out of bonds into equities as investors chase returns. This could extend the final leg up in equities.
A conservative approach would be to buy a small position in equity sectors exhibiting relative strength, and then look to add to positions on any near term pullbacks. Long terms stops should be in place to protect against a significant correction that will inevitably come.
*I would like to thank Chris Vermeulen at The Technical Traders for providing a second opinion