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In this article, I will be examining recent developments in stocks, and commodities to see what they mean for the stock market. With stocks at or near all-time highs, and commodities at there lowest point of the year, I thought now would be a good time to assess the investment landscape of these two asset classes.

Stocks

Development 1: Lack of Confirmation.

The Dow Jones Industrial Average (DIA) has hit a new all-time high repeatedly over the last week, and the Dow Jones Transports (IYT) is hitting new all-time highs as well, which has confirmed the move according to Dow Theory, which is a good sign for the market. However, to many investors the S&P 500 (SPY) is a more representative gauge of the stock market because of the diversity of stocks compared to the Dow, which only holds thirty stocks, and uses an outdated price weighted methodology. The S&P 500 has yet to break through its all time high, which to me is a warning sign, which should not be ignored. When other major indexes like the Dow, Dow Transports, Small cap stocks (IWM), and Mid Cap Stocks (MDY) are all making new highs and the S&P 500 is not, that divergence is something that should be considered thoroughly. Based on this divergence, if the S&P 500 does not break out to a new all-time high I believe the stock market will be in for a sideways market, or a large correction.

Development 2: Margin Debt Expansion

A recent article and chart I saw by zerohedge.com according to the authors showed "Leverage, as measured by NYSE Margin Debt, rose a huge 31.6% year-on-year [YOY] and 10.2% month-over-month [MOM] to $364bn in January, compared to the July 2007 peak of $381bn." Simply put, the amount of money borrowed to invest in stocks is near its all-time high, so using a poker term; investors are near the point of being "all-in". Going forward, if so many investors are maxed out, and if the market shows any signs of weakness, many of those investors will run for the exits, and with the high amount of leverage the correction will be even more severe.

Commodities

Development 1: The Economy & Stocks Diverging from Commodities

The last two bull market tops, in 2000 and 2007 the economy was growing a much faster pace compared to today. From 1998 until 2000, GDP growth according to tradingeconomics.com went from 3.1% to 7.4%, which is a massive increase. In 2000, when the GDP was growing at its incredible pace, the price of crude oil went from $17 a barrel at the beginning of 1998 to a high of $35 a barrel in 2000, which is just over doubling in about a three-year period. Now, when we look at the stock market peak in 2007 we see close to the same pattern. GDP growth at the beginning of 2005 was 3.3% and in 2007, it had reached a peak of 3.6%, which was not the big jump like in 2000, but in late 2006 the GDP growth rate reached a high of 5.1%. During that period of GDP growth, the price of crude oil went from $42 a barrel at the beginning of 2005, and grew to a high of $97 a barrel. Just like the peak in 2000, the price of crude oil more than doubled in a three-year period.

So what does this history lesson teach us about the present? These past examples show that when the real economy is growing, commodities AND stocks will follow. Using the examples I gave to compare the current situation to, there is clearly a divergence, in one of the three areas, the economy, stocks, or commodities. Stocks are rising because of the growth in the economy because of an improving housing market, increased manufacturing, and better consumer spending. Therefore, the odd one left out of the party is commodities.

This divergence between stocks and commodities can be seen in the ratio chart below comparing the SPY to PowerShares DB Commodity Index Tracking ETF (DBC). The chart below shows the ratio of SPY [Stocks] to Commodities [DBC] was at its highest point on January 16, 2007 with a ratio of 5.78. Currently the ratio of SPY to DBC stands at 5.70, which is very close to the all-time high. Either stocks have to fall, or commodities have to rise, to have the ratio return to the historical mean.

(click to enlarge)(click to enlarge)

Development 2: Currency Wars

Because commodities are priced in dollars, therefore, when the dollar index rises, the prices of commodities fall, and the opposite occurs when the dollar index falls. This is bad news for commodities in the current currency war environment, because the euro and yen make up 70% of the dollar index, and with the euro and yen falling recently the dollar has gained strength, and pushed commodities lower. If either of the developments for stocks I outlined above happens, the dollar will gain strength because of market weakness, and that dollar strength will further hurt commodities.

Conclusion

Based on my reasoning and data from above, I believe stocks and commodities are both in for a serious correction. In a previous article, I wrote last month about stocks having the potential to fall 20% in the next year, the recent developments I outlined above I believe have further strengthened my viewpoint that stocks and commodities will have a serious correction. Below is a short list of some of the investment options that could be worth looking into, and could perform well or protect your portfolio from a downturn in the stock market.

Stock Funds:

1. ProShares Short S&P 500 ETF (SH)

Description: "ProShares Short S&P500 seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the S&P 500." [SH Fund Page]

2. AdvisorShares Ranger Equity Bear ETF (HDGE)

Description: "The investment objective of the Ranger Equity Bear ETF is capital appreciation through short sales of domestically traded equity securities. [HDGE Fund Page]

3. QuantShares U.S. Market Neutral Anti-Beta ETF (BTAL)

Description: "The target index, which is compiled by Dow Jones Indexes, is equal weighted, dollar neutral, sector neutral, and is not levered. The index rebalances monthly by identifying the lowest beta stocks as long positions and highest beta stocks as short positions, of approximately equal dollar amounts, within each sector." [BTAL Fund Page]


Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BTAL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer

Source: Stocks And Commodities Signaling A Downturn