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How To Know When The Market Downtrend Is Over


From the start of March 2009, the S&P 500, our favorite barometer of overall global risk appetite and market sentiment, was in a strong uptrend. Because the US Dollar is among the premier flight-to-safety assets that markets buy in times of fear, it was in an almost reverse mirror-image downtrend.

A number of months ago we wrote about what it would take to stem the downtrend in the US dollar, and said one or more of the following kinds of events was needed:

The First Two:Events That Boost US Dollar Fundamentals Because They Improve Prospects for Stimulus Withdrawal and/or Rising Interest Rates: These include:

1. US jobs and spending data: Most notable, monthly US Non-farms payrolls change and unemployment rate reports.

2. Falling Demand For US Treasury Debt: That too would bring higher yields (though long term, not short term) and boosts US dollar demand.

The Second Two:Events That Feed Demand For The Dollar As A Safe Haven.

3. General Fear-Inducing Events: Feed demand for safe haven currencies like the dollar.

4. Any News That Undermines Euro Demand: Because the EUR/USD comprises about 30% of all forex trade, that means for every euro sold or bought, a US dollar is used and vice versa, thus the two are almost forced to move in opposite directions, like children on a seesaw. The recent credit rating downgrades to Greece and Spain are classic examples, for these feed doubts about the stability of the EZ and the viability of the euro.

For full details on these and likely sources of these events, see: Beware The 4 Key Events For The US Dollar, Global Markets, in 2010.

Because of the strong negative correlation between the US dollar and risk assets like stocks, commodities or certain currencies that rise with most asset markets, like the Euro, these same event types were the ones to watch for signs of an impending downtrend in these risk assets.

Events 3 and 4 Were What Did It- As the EU/PIIGS/Greek Debt Crisis

The current downtrend in risk assets, from stocks and commodities to high yielding currencies, has been mostly driven by the EU debt crisis, a toxic combination of event types 3 and 4 that both undermines confidence in the general global recovery and in the Euro in particular. Concerns that stocks had already priced in likely growth prospects (as shown by the markets' tepid "sell the news" reaction to a relatively good earnings season) were also a factor, but the EU debt crisis fear was a factor weighing against growth prospects too, and lately has dominated market movements.

After the Dubai World threatened default (still unresolved) caught international credit rating agencies by surprise and embarrassed them, they went looking where they knew they could find some major debt to downgrade and justify their existences and fees.

News soon followed of credit downgrades to the bonds of Greece and Spain, (to a lesser extent warnings to the Japan, the UK, and the US) caused gold and the Euro to start their slide around December 2nd. Global stocks began to stall and fall between January 11-20th.

Watch For These Events To Identify An Upturn In Risk Assets

Safe haven assets like the US Dollar and risk assets like stocks and risk currencies like the Euro both respond to the same forces that move market sentiment. They just react in opposite ways.

Not surprisingly, then, the list of key event types to watch for is fairly similar

The First Two:Events That Boost ECONOMIC Fundamentals Of ANY Major Economic Block Because They Improve Growth and Earnings Prospects - also for Stimulus Withdrawal and/or Rising Interest Rates for the local currency. For example

1. Jobs and spending data: These have been key metrics for central banks in deciding when it they can raise rates to prevent inflation yet not kill off their still struggling recoveries. This will be especially critical for the economies of the weakest risk currencies like the Euro and the British Pound

2. Falling Demand For Government Bonds Or Other Bonds Denominated In Risk Currency Economies (AUD, NZD, CAD, EUR, GBP), because it would suggest investors are moving back into riskier assets like stocks or commodities, even though these pay relatively high yields with lower risk .

The Second Two:Events That Feed Demand For Risk Assets.

3. General Economic Optimism Inducing Events: Feed demand for risk assets and currencies: Resolution of ongoing geopolitical or economic problems like the EU debt crisis (this is key), etc.

4. For Currencies Anything That Undermines USD Demand: Because the USD is involved in about 90% of all forex trade and commodities tend to be priced in US dollars, any sustained drop in the dollar benefits these other asset classes, as we saw from March 2009 until the beginning of 2010. As a safe haven asset, the dollar falls when there is optimism, thus when equities move higher, the safe haven currencies like the US Dollar tend to be falling and higher yielding or commodity based ones mentioned in point 2 above tend to rise with them.

5. Speculatively Driven or Genuine Supply/Demand Commodity Shortages: Will signal a bull market at least in that commodity and its related currencies, though it could easily damage other asset markets. For example, rising oil is great for the Canadian Dollar and oil itself, but ultimately damages global growth.

THE KEY EVENT TO WATCH: The EU Debt Crisis and Sovereign Bond Auctions

For now, it is difficult to imagine any kind of sustained rally while Southern Europe teeters on the brink of default and no clear plan exists to stop it. We have written extensively on the dangers and possible solutions in recent posts. See Southern Europe Will Not Be Allowed To Default as just one example of similar posts over the past weeks. As noted in these posts, it is very hard to see a solution coming by mid April, when Greece needs about 17 just to pay off maturing bonds, and a similar amount comes due in May. If just one of the troubles Southern European countries default, the rest are likely to follow quickly as bond markets seek unaffordable higher rates to compensate for higher default risk.

As we've repeatedly noted, if the collapse of just Lehman Brothers alone could cause credit markets to freeze and crash markets that were less skittish, imagine what a wave of European defaults will do to far more nervous markets.

Even the US is seeing its bond yields climb, and foreign demand for these bonds fall.

We don't know what the end consequences will be, but they won't be any less severe than we saw in the Fall of 2008, and are likely to be worse, given the amount of debt and stimulus "bullets" already fired by global governments.
 

SO, HAS THE DOWN TREND ENDED?

In short, we don't think so. Until markets are satisfied that the EU has a solid plan for avoiding the most catastrophic wave of sovereign defaults in modern times, it is difficutlt to see markets making anything more than a reaction bounce. Until we have such a plan, bias to the downside. Long safe haven assets: UUP, short risk assets: FXA FXE FXC BNZ SPY DIA FXB, and so on.

DISCLOSURE: NO POSITIONS
 

DISCLOSURE: NO POSITIONS