Serious Divergence: Dow, S&P Vs. EUR/USD

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Includes: AAPL, FXE, IWM, TLT, UDN, UUP, VZ, XLE, XLU
by: Mercenary Trader

Aug 22 - Tuesday's trading saw a surprising divergence, as a powerful surge in the euro (EURUSD) telegraphed "risk on" and the message failed to hold.

The major U.S. indices (Dow, S&P, Nasdaq) and bellwether Apple (NASDAQ:AAPL) at first heeded the risk on message, trading higher overnight and showing significant strength in the early part of the trading day. At the day's high point the major indices were up solidly, the Dow and S&P penetrating multi-year highs.

Then it all went south in a manner that should be considered mildly alarming to bulls.

New multi-year highs for the Dow and S&P represented a significant psychological inflection point. For the rally mentality to be healthy, one would have expected the bulls to "storm the barricades" and not look back - especially given the powerful all-clear message telegraphed by EURUSD strength.

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For quite some time now, the troubles in Europe have amounted to a combination lament, excuse, and hope source for bullish market commentators. We have heard things like:

"Europe is so screwed up… if not for them this market would be much higher, better reflecting positive economy prospects."

"Our optimistic forecasts are being tempered by the threat of macro crisis and the general fear climate created by Europe."

"If / when Europe resolves itself, that will be a sign that healthy markets can REALLY get going."

We have all heard some variation of the notion, "Once Europe is fixed, the bulls will have room to run." And yet, on Tuesday, we received the loudest price action "risk on" signal yet, in respect to positive shifting prospects for the eurozone and EURUSD, and yet the major indices declined.

This divergence is worth emphasizing because the U.S. market's retreat was more than just a rejection of new multi-year highs. It was a rejection against the backdrop of one of the strongest, clearest "risk on" signals you can get.

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As emphasized in previous notes, we have been more than willing to participate in this rally via "rented longs."

But, as also previously stated, we have kept a wary eye on the exits and maintained a roster of short positions just in case. On Tuesday we added meaningfully to our short positions heading into the closing bell (as documented here). We believe that small caps in particular look vulnerable here, for multiple reasons:

  • This fresh round of weakness was not Europe / China based
  • Small caps have been significant laggards to high quality large caps
  • He that shall be first in "risk on," shall be last (feel the most pain) in "risk off"

It remains possible that the bulls shake off this divergence, and go back to grinding higher into the teeth of September's myriad danger points. But we believe that this sharp reversal speaks to a greater underlying weakness in the bull case than might otherwise have been expected, and greater nervous anticipation of potential rally-wrecking events such as the Bernanke Jackson Hole Speech, the threat of declining corporate profit margins, the waning of the Presidential election cycle bid, and of course the poisoned chalice of QE3 (which may cause severe illness upon drinking).

We are still maintaining bullish exposure (primarily through TAN) but, as of Tuesday's close, we have now flipped significantly net short. This positioning can change quickly, as always, but if this divergence is as serious as we suspect - in terms of exposing the ephemerality and hollowness of the bull case - then it may soon become clear that many of the powerful up-thrust moves in recent evidence were mainly headfakes, i.e. bull traps.

This is no environment for the fearful or the slow-footed. It is trading territory, through and through, with the biggest rewards awaiting those who can patiently "jockey for position," limiting risk and adjusting exposure levels as such to be in position for the next big trend when it comes.

NEWS FLOW

Via the UK Telegraph: "Germany's director at the European Central Bank has thrown his weight behind mass purchases of Spanish and Italian debt to prevent the disintegration of the euro, marking a crucial turning point in the eurozone debt crisis."

Such would explain the EURUSD surge and bullish close above 50 EMA levels. But again, the lack of stateside response to this is something of a head scratcher.

Perhaps more capital will now be rushing headlong into euroland, to snap up cheaper assets there?

Or was Europe something of a sideshow and/or an isolated factor all along, relative to the strong cluster of other reasons U.S. equities remain in a secular bear market?

Interesting but tactically irrelevant given the EURUSD's reaction… is the Bundesbank (aka "Buba") revealing itself to be an impotent figurehead?

The Australian dollar (AUDUSD) remains one of our high conviction shorts. The RBA (Royal Bank of Australia) has noted with concern the effects of an overstrong currency on Australia's economy, especially given the weakening picture for natural resources. A reversal of foreign inflows into Australian government bonds could also lead to a swift decline for AUDUSD.

Seriously, Lockhart? Does anyone really care what you think? At what point, and in what way shape or form, have the hawks had any kind of credible sway over this Fed?

The British Pound (GBPUSD) saw a powerful technical breakout today, rising above the 200 day EMA, presumably on the assumption that the UK government will be forced to tighten the fiscal belt again. Longer term, though, this looks like a recipe for delayed disaster (and a much lower GBP when the government caves in the face of economic slowdown pressures).

China continues to slowly implode. Nobody is really talking about it because most of the go-to talking heads on CNBC are broken record China bulls who, as Also Sprach Analyst has put it, seem determined to be bullish on China "next quarter" for an indefinite period of time.

As the likelihood of a China macro crisis grows, it will be interesting to see how the mainstream media deals with it. The whole China story has the smell of subprime to it - not just because China has its own shady version of an out-of-control subprime market, but because "the Chinese government is too rich to lose" is taken as an indisputable gospel truth, just as it was once taken as gospel truth that "home prices can never fall."

Remind me, why does anyone pay attention to sell side analysts again?

Just what we need. Another creeping crisis… perhaps one of the biggest reasons of all to be bullish stocks, in nominal terms anyway, is that things are indeed likely to get so bad that the Federal Reserve and/or the U.S. government could actually become desperate enough to throw an insane Hail Mary such as privatizing social security into the stock market, or simply tasking the Fed to buy U.S. equities directly.

Such would lead to value-destructive pandemonium as far as the real economy goes, but for traders it sure would be fun.

CHART NOTES

  • Major divergence between "risk on" EURUSD, major U.S. indices
  • Dow, S&P clear reversal / rejection at multi-year highs
  • Small caps (NYSEARCA:IWM) significantly weaker than large caps
  • Energy stocks (NYSEARCA:XLE) threatening to roll over
  • Utilities (NYSEARCA:XLU) in notable decline
  • Major Dow components (MO, VZ) in notable decline
  • Long bonds (NYSEARCA:TLT) bullish engulfing reversal
  • AUDUSD failure to hold 20 EMA bounce

JS (jack@mercenarytrader.com)

Disclosure: I am long TAN. 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.