Strange Market Correlations And The Only Fed Indicator You'll Ever Need

Includes: GS, JNJ, SPY, XOM
by: Tony Roylance

Quarter-end statements are printed and mailed, the leaves of the trees are beginning to change colors, and it's time to get back into providing market research. Seeking Alpha is primarily a website devoted to finding and researching individual stocks, and there is some phenomenal insightful equity research provided on this site for free. While I love curling up with a good 10-Q as much as the next guy, I now focus on 'the big picture' or studying the market as a whole. I started out as an equity analyst, but I quickly discovered that there are many factors involved in stock price valuation. In addition, any one of them can catch you by surprise and ruin your day. I decided to focus on striving to get the market direction right as a whole, and then narrowing down to individual sectors and equities.

An often thrown-around Wall Street statistic is that roughly 80% of a stock's movement can be attributed to the direction of the stock market as a whole. Just for fun, let's look at a chart to illustrate what I mean:

The above chart is a 5 day 10 minute chart of Goldman Sachs (NYSE:GS), Johnson & Johnson (NYSE:JNJ), and Exxon Mobil (NYSE:XOM). While the percentage change correlation is not exact, there is a very strong correlation of peaks and valleys throughout the last 5 trading sessions. Last Thursday (the 2nd day in the chart) is a perfect example of a market trading in unison, and why studying the market as a whole is essential to long-term investing success. Why do these completely unrelated companies, in completely unrelated industries, trade almost essentially the same? One is a financial services company, the other sells mostly consumer goods, and the other drills for oil!

Let's take it one step further; here's the S&P 500 ETF (NYSEARCA:SPY) overlaid with the Australian dollar/Japanese yen currency pair. We see nearly the same ebb and flow.

My point is to show you, that you can be absolutely correct in your analysis and assumptions about an individual equity, but you can still be caught completely off-guard by a foreign exchange event, an event with an unrelated company, an event in the fixed-income or credit markets, or any other event in the seemingly limitless number of market forces at work in a given trading day.

Continuing our study of market tops, and the variety of "distant early warning" indicators that I look at every week to keep my clients and myself on the right side of the market, we will once again update some of our favorites and introduce some new ones.

After I wrote my last article asking "Did the S&P 500 Just Top?" I was delighted to find that Bank of America/Merrill Lynch Global Research used my very same indicators in a research report it published two days ago. Obviously, I am not the first one to discover the utility in comparing weekly new highs and new lows in market research; however I have never seen BofA/ML use market breadth analysis in any of its previous research reports. To be fair, I don't read its research reports often, but this time found it validating my own research.

The point of the chart was to show the divergence between the S&P 500 reaching higher highs, and the lower number of new 52-week highs. I take it a step further and focus on the bottom graph, which shows the new 52-week lows. That indicator slowly begins to wake up as a market begins to roll over. I find it to be just as valuable as the 52-week high indicator. I updated the chart with the quarterly data that I use in my analysis, as it is much more responsive than the 52-week. The updated chart shows quarterly lows still at a benign level.

Each dip in the S&P 500 corresponds with an awakening of New Quarterly Lows. While we are monitoring a slight uptick, now appears to still be a buying opportunity in an otherwise bull market. We will be watching this closely and reporting changes here.

Next let's turn to the credit markets for signs of financial stress. In the past, we used to have to look at different durations of Treasuries to develop a yield curve and then look for yield curve inversions and yield spreads as indicators of stress in the markets. One used to also look at the spreads between "risky" assets such as corporate bonds and compare them to "risk-free" assets like U.S. Treasuries to get an idea of stress. Back in 2007, the TED Spread, LIBOR-OIS, and the collapse in the Baltic Dry Index all gave early warning signs of the calamity that was coming.

In my hometown of St. Louis, the Federal Reserve Bank of St. Louis has developed an excellent index that takes several measures of market-stress and combines them into a single index. The aptly named St. Louis Financial Stress Index spikes when it detects distress. A reading above 1 is a cause for alarm. Currently we are in a relatively safe zone, however, it is increasing. This will be monitored closely as well.

In conclusion, we find ourselves at about the same juncture we did at the end of August, when several other authors were predicting doom and gloom for September. I looked across my array of indicators and did not see the reason for their panic. It's still unclear how the market is going to react to the government shutdown. I am of the belief that the market predicts rather than reacts. In short, we are still invested, watching and waiting.

Disclosure: I am long SPY, MDY, IWM. 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.