This Time Technical and Fundamental Analysis Agree: It's a Bear

Includes: AGG, DIA, QQQ, SPY, UDN, UUP
by: Ivan Mutaftchiev

The rally of the past 2 weeks seemed to come to a pause on Friday, July 8th when the markets opened down and continued lower on the news of lack of improvement in unemployment numbers. As bad as the unemployment story was, it hardly came as a surprise to many. The disconnect between the recovery of the job market and that of the stock market has been dubbed a "jobless recovery," and considered part of the "new normal" for some time. The selloff was not sustained and by the end of the day, the U.S. equity markets had recovered about half of the morning decline. Other than triggering a profit taking day, which was well due after 8 straight days of gains, Friday's action has little significance in the long term.

Monday, July 11th however, was a different animal altogether. This time there was a significant economic/fundamental reason for the decline and Monday's price action will leave a big red flag on the charts of technicians as well.

The Fundamental Factors. The growing sense of fear and panic related to the U.S. debt reduction negotiations and the raising of the debt ceiling coming out of Washington has made a lot of headlines lately. In spite of being an important political and macroeconomic matter, the U.S. debt concerns are not what caused Monday's selloff. Politicians may tell you that it is, but how do you then explain the fact that the U.S. dollar is up a big 1.35% on a day when everyone is worried if the U.S. can continue paying its bills ?

The main economic factor for Monday's big decline is the same one that has been influencing the market direction for a year - Europe. The worries about the sovereign debt of certain European countries and the potential disbanding of the euro currency system are the major risk factor of the global economy and will remain crucial for years to come.

The state of world economic stability (in Europe or elsewhere) is very well measured by the price of the dollar. In the article "What Really Fueled the 2010/2011 Bull Market," it was proven that the weakening trend of the dollar is highly correlated with the bull market in U.S. equities that started in the fall of 2010 and ended in early May 2011. The fact that a weak dollar is good for equity markets may sound counter-intuitive. Not so however, if you consider that the dollar is not only the currency of the United States of America, but also the world's main reserve currency and safest store of value. During the 2008/2009 crisis when U.S. banks were on the brink of collapse, foreign governments and institutions were actually scrambling for the safety of the U.S. dollar and U.S. government bonds. In this globalized economy, the dollar is more than just the currency of the USA - it is a safe haven for the world's savings. Consequently, dollar appreciation is a clear evidence of growing instability and systemic risk across international markets, foreign governments and banking systems.

You may argue that the inflated dollar is the last currency to be the world's reserve and in a stable and safe world economy: you would be correct. When the Greek sovereign debt crisis seemed to be resolved in the fall of 2010, the dollar started a long term decline and the global stock markets began to climb higher. But as soon as worries about refinancing the Greek debt resumed in May of 2010, the depreciation of the dollar was halted and so was the bull market in stocks. After the Greek debt was refinanced near the end of May, the bull market seemed poised to continue. Then on Monday, July 11, the dollar jumped 1.35% as Italian government bond yields increased sharply, reflecting the fear of the investment community that Italy may be the next Greece.

Daily Chart of SPY as of July 11, 2011Click to enlarge
(Click to enlarge)

The Technical Indicators. While economists and fundamental analysts are concerned with what is happening in the economy and why, their tools do not provide the timing and the early confirmation of the trends they study. I can argue that the news out of Italy may be the beginning of another period of global instability and depressed economic growth, but if the market ignores the Italian story and continues higher, it will disprove my economic analysis. So I'd like to review Monday's market decline from a purely technical perspective in search of proof.

Technical rules state that a rally is often reversed, when after a long series of higher days, a huge down day occurs. With both NASDAQ and the S&P 500 down 2% Monday, it will certainly qualify as one of the biggest one day declines of late. In addition, as the market certainly appears to have topped, the high of July 7th will be a lower high than that of May 1st, indicating that the markets are in a confirmed downtrend.

It seems that both fundamental and technical indicators are in agreement that the U.S. equity markets are entering a significant bear phase.

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.