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Risk Aversion Returning To The Market

One of my favorite tools for getting a read on the markets is the spread chart.  Spread charts are great for seeing how markets react in relation to one another, thus giving a snapshot of money flows to allow us to prepare for the next move.  Think of the market as a huge cruise ship, and money flow as the rudder.  Very large ships do not make 90 degree turns.  They take time to alter their course.  Money flow works underneath the market in the same way.  If you detect this flow early enough, you can be ready when the turn begins.

Today I will examine the spread between the Mexican Peso (NYSEARCA:FXM) and the Swiss Franc (NYSEARCA:FXF).  The peso is a currency that is sought when traders have a higher appetite for risk.  The franc on the other hand, is seen as more of a 'safe haven' or defensive currency which sees an increase in money flows during times of distress.

In the chart below I have plotted the FXM:FXF spread (black line) with the S&P 500 (red line).  When the black line is rising, that means that the peso is outperforming the franc which means that traders have a higher appetite for risk.  When the black line is falling, riskier trades are being unwound as traders get more defensive. 

As you can see, there is a good correlation between this spread and the S&P 500.  When higher risk is desired in the currency markets, that is good for equities.  This chart is most useful when divergences appear such as the one in place now because it tips us off that there is money flowing underneath the market, possibly weakening the foundation of the March - June rally. 

Take a look at the left side of the chart in the fall of 2008 and notice that the FMX:FXF spread began its final leg down in November, while equities rallied off of the November 20 low and into early January 2009.  With equities heading one way and trader appetite for risk the other, that set the table for an ugly opening to 2009.  That divergence had us ready for the 28% drop that unfolded in the S&P. 

The same setup is in place today as the FXM:FXF spread peaked in late April while the S&P continued to its June high.  This should be a giant red flag to traders to not be so trusting of 'green shoots' and other fairy tales the government and media are trying to sell us.  If professional traders who do this for a living are taking risk off the table, shouldn't you do the same?