The Coming Shift In Market Leadership

Includes: DRR, ERO, EUO, FXE, GLD, SPY
by: Jay Norris

If you are a trader today you likely understand that we are in an economic environment where it's difficult to hold on to an opinion for longer than it takes to close the next daily bar on the chart. Market movement has always enjoyed an element of mystery when it comes to differentiating between corrective price action versus sustainable trending behavior, but more so today. Traders and investors definitely need to keep their finger on the pulse of short-term market developments given the increasing competition for which is more influential: central banker activity, or day to day economic events. And at no time in the past has it been more important to understand that markets spring from one source: money, which creates market correlations. In other words, markets, and the people who create them, definitely do not move independent of each other, and in fact mimic each other in pattern and timing.

Currently the S&P 500 has been the alpha market, with the other asset class markets and commodities falling in line behind it. The S&P 500 is after all a stock index that is comprised of some of the most successful companies in the world. These companies have a long history of success in good times and uncertain times, and were not created to fail --the past few years being proof of this. Despite a steadily slowing economy, companies continue to find ways to remain profitable and the stock market continues to climb the wall of worry. Moving higher along with the S&P 500, over the last few years and in some ways competing with it, has been gold. Both gold and the S&P 500 have doubled since early 2009. Gold is a leading indicator market also, albeit with a less predictable pedigree during good times. Gold has a great record of predicting fear in the markets; when gold goes up, it means investors are foregoing yield. Investors passing up yield and instead buying gold, a commodity which incurs a cost of carry - storage --is a sure sign of economic uncertainty, i.e.: fear.

Current Correlations

What was most interesting to us over the last two weeks is how commodities and gold specifically have been moving lower while the S&P has been moving sideways. No matter how you analyze it, you have to consider the possibility that uncertainty and fear are coming out of the market. Taking a slightly longer-term view we can see that from the summer lows to now, despite the sizable rally in gold, the S&P 500 outperformed the popular commodity. This is in itself not surprising. Mainstream investors still favor blue chip stocks over gold, and with interest rates at such low levels this is unlikely to change. For all its allure, gold is still apparently an investment for more specialized investors; hedge funds for example. When we consider the behavior of macro hedge funds, recent price action in the financial markets starts to make more sense. Take away individual stocks and some of macro funds' biggest positions heading into the 3rd quarter were long gold, and short the Euro. Long gold worked well, though only kept up with stock index benchmarks, while short Euro bets proved down right painful. Even stocks such as Alcoa (NYSE:AA), Sysco (NYSE:SYY), Comcast (NASDAQ:CMCSA), and Merck (NYSE:MRK), which were reported to be favorite short targets of hedge funds, are up nicely since summer. This paints a picture of poor hedge fund returns which only looks worse compared to gains by U.S. stock indices.

It's Always in the Math

While this may come as a surprise to many analysts and economic pundits the majority of investors don't make monetary decisions by reading complicated analysis and stock, currency and commodity charts. They make those decisions based on simple math. They see that the blue chip component of their 401K outperformed the more exotic choices. So they increase their allocation to the one that worked best. Same for wealthier savers and investors; they see the garden variety index funds outperformed their hedge fund holdings, and they downsize their hedge fund contributions and increase their indices exposure. The collective actions of all these investors obviously have a marked effect on the markets in the following quarter and year.

Our predictions going forward:

  • S&P 500: continues to lead on the upside
  • Gold: a lower high in 2012 to the 2011 high makes for a secondary correction - several months to as many as 8-months
  • Euro: resumption of primary bear pattern

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.