Bill L.'s  Instablog

I have been anticipating a reversal in the dollar which I now believe is imminent as more contrarian evidence continues to build in the dollar’s favor (see previous articles for more details). Most recently Bloomberg reports that several countries in Europe are trying to take advantage of the falling dollar, “Sept. 18 -- Germany and Austria led governments and companies in Europe selling $21.7 billion of bonds in the U.S. currency this week to take advantage of the reduced cost of exchanging the proceeds back into Euros.” Other countries including Belgium and Spain have also begun selling Dollar bonds. Dollar bears will see the headline and see confirming evidence, however timing is everything and to me the timing here is very interesting. Sentiment surveys show that nearly everyone is currently bearish on the dollar, in fact people are about as bearish today on the dollar, as people were on stocks in early March, and of course that proved to be one of the best buying opportunities in history.  
 

Governments are typified by slow, lumbering, bureaucratic behavior and they act in a “horse has already left the barn” fashion. With that in mind, let us further reflect on these bearish headlines. These Governments are basically selling Dollars for Euros, in the belief that dollars will continue to decline, and the Euro will continue to go up. A brilliant move… had they done this several years ago, but no, they are doing this now that the US Dollar is hovering just above its all time lows. In essence these Governments are trying to pull off a 22 billion Dollar currency pair trade… the problem is Governments are not that smart. The fact that these Governments are trying to act like a hedge fund, guarantees that they will fail miserably, and will instead suffer a loss.
 

In GC Seldon’s classic book, “Psychology of the Stock Market” Seldon states that, “The greatest fault of ninety-nine out of one hundred active traders is being bullish at high prices and bearish at low prices.” In early March stocks became momentarily cheap as nearly everyone was bearish on stocks. Headlines reflected this by showing images of floor traders in shock, along with proclamations that the collapse of the world financial system was nigh. Again, that turned out to be one of the best buying opportunities of all time. Today, the actions being taken by these foreign governments and headlines such as this, “Sept. 19 (Bloomberg) -- The dollar dropped to the lowest level in a year versus the euro as Federal Reserve Chairman Ben S. Bernake's declaration that the recession is likely over led investors to sell the U.S. currency and buy riskier assets,” shows a similar mindset regarding the dollar. Now that no one wants to own dollars, it is probably a good time to own dollars.
 

I have previously made a contrarian case for the dollar approaching a bottom and stocks and commodities nearing tops. Continuing on that theme I also wanted to look at the bond market as well as update the status on the dollar, commodities, and the stock market

First let's take a look at the TLT, a proxy for the long bond.

 

From this chart we can make several observations. First, we can see treasuries (bars) rallying as investors flocked to safety in anticipation of carnage in the stock market (SPY yellow line).  We can also see that the bond market then begin to decline approximately 2.5 months before the stock market began to rally, and did not make a new high in early March. This non-confirmation of the March low in stocks was in fact foreshadowing the current rally in equities. Now the TLT may be signaling something else; after making a low on a spike in volume (which often signals an important trend change) the TLT has been rallying for about 2.5 months. This is interesting for two reasons. First, treasuries are typically seen as a “safe” investment, so that fact that treasuries are rallying with stocks (risky assets) is curious. Second, there has been much talk of rampant inflation as the economy begins to recover, and inflation typically destroys fixed income investments such as bonds. So in summary, bonds have been rising despite apparent increasing risk appetite for stocks, and inflation fears.

I would also mention that this type of behavior, bonds rising despite good gains in the equity markets has occurred before. For example, let’s look at the all time highs achieved in 2007. The SPY is represented by the yellow line, the TLT by bars. The bond market seemed to sense the impending danger and had been rallying for months before the stock market finally succumb to the credit crisis.



 

Dollar Close to a Bottom:

In my last article I made the case for the dollar finding a bottom. I believe the media has greatly exaggerated the probability of inflation in the near future. The Fed does not actually print money, but increases credit. While this can be inflationary as dollars multiply through loans, this requires the public to borrow, and the recent numbers show that consumer borrowing is down, and consumer credit is being drawn in.
 

On the technical side momentum in the UUP (dollar bull ETF) has been showing some divergences as the dollar approached a zone of support. Furthermore, bullish sentiment (daily-sentiment index) has reached as low as 3% and remains at prerequisite levels for a major reversal. I would also note that despite two years of the “printing presses” going, the dollar has basically not made any downward progress past previous lows, despite the expansion of the monetary base.
 

We can see from the chart that despite several consecutive lows, that these lows have not been confirmed by momentum. This indicates that the strength of each selling wave has been declining. While the dollar has breached the first firm level of support, surprisingly the uptrend in momentum remain intact. In aggregate sentiment, the zone of support, momentum, and the confirmation in the bond market are all strongly implying that the dollar should find a major bottom in this zone.

Gold Takes Another Run at 1000

Gold has edged higher as the dollar broke the first level in the zone of support we discussed. Gold is now entering a zone of resistance that it has failed to penetrate five times in the last two year. The residual strength index does not indicate that this current attempt has any stronger momentum than previous rallies. Furthermore, sentiment in precious metals is very high, at requisite levels for a major top. In the context of extreme sentiment, only par momentum, and a tough zone of resistance, gold may run a bit higher but I am not expecting a large break out.

I would note that a clear break above the zone of resistance could be interpreted as a break out from a very large triangle pattern. A breakout above this zone with confirmations will change my view, but buying in anticipation of a break out is in my opinion, the HIGH risk move.

Silver Continues Higher

Silver has been entering the zone of previous highs as the dollar has begun entering its zone of previous lows. This zone is very large, making a break out play much tougher, but as it stands I do not expect silver to break above these levels. My reasoning being that while prices have advanced the backdrop looks very challenging to future increases in price. Momentum does not confirm the price action. Furthermore sentiment is at very high levels, in fact registering highs over 90% bulls in the daily sentiment index, and like gold, the extreme sentiment levels lead me to believe that there are relatively few bulls left to drive up prices further.

The Stock Market: alas all good things…

The run in the stock market has been one for the record books, however the mantra is buy low, sell high and after a record 50%+ rally in 5 months, the stock market is starting to look tired. While the uptrend remains very much intact, there are a mounting number of red flags. These include the following.

Volume: As stocks are approaching a gap which should act as a very strong zone of resistance, we have seen one of the most persistent declines in volume in history. Typically, you would want to see volume expanding during a rally, and when volume is declining during a rally, this casts doubt on its sustainability. Furthermore we have started to see a pattern of low volume up days, then large volume down days. This is illustrated in the graph below by the large spike in selling volume, breaking the declining volume trend. Furthermore, as I mentioned in previous articles, trading volume in the NYSE is dominated in shares of Citi, AIG, Fannie, and Freddie, and other companies that only exist today because of massive government intervention. Money chasing a relatively small, select group of highly speculative issues indicates that this trend is in its later stages.



 

Momentum: Momentum indicators are also diverging from the trend, we can see here that the RSI has begun to diverge and trend lower despite higher highs in prices. While this is not an action signal in of itself, it is another red flag.

Breadth: This divergent behavior is also clear in the McClellan Summation Index, which shows three clear lower highs, despite three higher highs in prices.

 

Sentiment: Sentiment has also reached extremes with a reading as high as 89% in the daily sentiment index. To put this into perspective, in October 2007 when the stock market made an all time high, the daily sentiment index recorded of high of 88%. Mutual fund cash levels are implying that fund managers are also very bullish; cash levels have again dropped to the record low level of 3.5% (where cash levels where in 2007 when the market peaked).

 

Summary:

Treasuries have begun to rally despite good performance in risky assets. Historically when they disagree the bond market is usually proven correct; a negative for stocks. Furthermore the dollar looks set to bottom while stocks and commodities beginning to show signs of topping. All asset class have been trading with a historically high degree of correlation, so if the dollar does indeed bottom here, this will negatively affect stocks and precious metals. Sentiment is probably the best stand alone indicator for predicting  an area where a major reversal will occur; dollar sentiment is at record lows, while sentiment in stocks and precious metals are at record highs. All these observations occurring together paint a very cohesive picture that risky assets are near tops, and value is now in cash and treasuries.

A wide variety of sentiment surveys have been showing optimism levels at or even above the October 2007 peak in the stock market, meanwhile the masses seem to dismiss these items and instead focus on the continuing flow of bullish headline news. However, experience tells us that running with the herd is profitable only for so long; the time to buy was when there was blood on the streets, and the time to sell is when there is unbridled pervasive optimism. I believe that time is fast approaching.
 

Bear markets end on bad news, the same way bull markets end on good news. In early March the mainstream media was reporting that the best investment strategy was to sell stocks, and go long guns ‘n ammo, perhaps diversify into some canned food. The exact opposite turned out to be true; that was one of the best buying opportunities in history. Now, the main stream media, is widely reporting the depression has been vanquished in a mere 17 months. A whole 7 months faster than it took to recover from the dot.com recession (24 months) and a whopping decade faster than it took to emerge from the Great Depression(29 to 40ish?). While you may argue that this is indeed the start of a new bull market, I’m sure some part of even the most bullish investor’s brain wonders if we have come too-far-too-fast.
 

There is a fine line in the market that few see, and that is the line between a healthy market and lemmings about to go off a cliff. Breadth indicators such as the NYSE TRIN have now reached its lowest level since October 2007 when the stock market peaked. What this is telling us is that most of the money is flowing into relatively a few issues. Ok so is that a good or bad thing? Well it has been widely reported that most of the daily trading volume in the NYSE is dominated by trading in AIG, Citi, CIT Group, Fannie, Freddie, and a whole host of near bankrupt institutions. Unfortunately, this does not sound like a healthy rational market to me, no it sounds to me more like a gambler who just lost his whole paycheck, and is returning to the table where he just lost with the proceeds from his hocked watch, ready for one last all in.

Now contrarian investing is certainly not an exact science, and I cannot say for what day things will suddenly turn around. Furthermore many will see it as subjective, that I am only counting the headlines I wish to see. But when I start see headlines on CNCB to “buy all dips” so the market doesn’t “run away” from you, this is when I get worried. Again, many will argue that I have selective myopia. I contend however that once a strategy become so robotic such as “buy all dips,” that is exactly when that strategy will fail in a monumental fashion.  Meanwhile we are also starting to see technical evidence that weakness may be creeping into the market. Note the chart below showing a bearish divergence in momentum, failing to confirm the new highs.

• Headlines: very bullish/optimistic, coast is clear
• Sentiment: at the prerequisite levels for a huge top
  
• Money Managers: buying because of performance anxiety, not value
  
• Retail Investor: starting to treat the stock market like a dice game, buying stocks that were it not for Uncle Sam, wouldn’t exist today.
  
• Insiders: selling at historic high rates
• Technicals: failing to confirm new highs
  
• Economic Reality: poor, 2nd derivative imporvement

If you are bullish, I would opt for cash over the course of the next month or so; to see how this situation resolves itself during this historically weak period. Those who are more aggressive my want to short either the stock market or those stocks that have truly come too far too fast (see my article on BRCD). But regardless on your long term view of market direction, the technical weakness and lemming optimism should warrant a serious dose of caution to those who are thinking of playing the long side of this market in the near term.

Disclosure: Long SPY Puts, Long BRCD Puts