Divergences Are Leading to a Less-Forgiving Market
Watch the US Dollar for clues about the short-term direction.
The S&P 500 Index fell 2.1 points, to 1091.4 last week. This keeps the market, as represented by the S&P 500, to within a few points of a new rally high.
Over the last few weeks, as the S&P 500 has gone on to make new highs, the broader market indices, especially those that focus on smaller stocks (e.g. Russell 2000) have lagged the big-cap stocks. Consequently, even as the S&P 500 made a new rally (closing) high of 1,110 last week, the Russell 2000 hasn't even approached its previous high of mid-October.
We've been following similar divergences in our technical indicators, which track the broader market. In the past few weeks, we've discussed how the percentage of stocks above their 40-day moving average as well as the McClellan Summation Index failed to confirm the new rally high in the S&P 500 last week.
There are three ways in which these divergences can be resolved:
1. Markets enter a trading range and “mark time” while internal sector rotation continues. Eventually, this trading range breaks to the upside or downside.
2. The markets continue their uptrend with increasingly selective breadth. The large-cap, high-profile leaders (like Google (GOOG), Apple (AAPL), and Amazon (AMZN) etc.) continue to demonstrate strength while the broader market languishes. After a few months, the market “caves in” to these deteriorating conditions in the broader market and suffers a meaningful correction.
3. The market “shrugs off” recent broad-market weakness and the uptrend continues with renewed vigor: The breadth and broader market indexes “catch up” and make new highs along with the S&P 500, reconfirming the uptrend that has been in place since March.
If the third alternative has to come to pass, certainly the market is doing a great job of hiding it. At this time, I think we're either entering a trading range or a continued uptrend with increased levels of selectivity (narrower breadth).
Either of these two options means that the market is going to become less forgiving, and it's going to get more difficult to score easy winners going forward.
The market has shown strong gains since the lows in March. Several investors are relieved that their depressed stock holdings have recovered to this extent in such a short period of time. As more of them move to the safety of cash and short-term government bonds, the yield of the three-month T-bill briefly dipped into negative territory last week.
In the short term, much depends on the direction of the US Dollar. The Dollar has declined against most major currencies in a significant way since March ’09, and even more since 2002. In fact, in the last seven years, the US Dollar has lost more than one-third of its purchasing power versus other currencies, which is a stunning erosion in value of the world’s reserve currency.
Lately, there has been a fairly strong correlation between the decline in the US Dollar and the strength in commodities and US equities. A sudden snap-back in the price of the Dollar versus other currencies is likely to result in a sharp setback to equities and commodities.
A daily chart of the US Dollar shows early indications of stabilization in its downtrend. Even if a recovery in the Dollar proves fleeting, it will weigh heavily on stocks in the short term.
Click to enlarge
The short-term trend has turned down, while the intermediate-term trend remains up. Broader market divergences remain in play, and most technical indicators are in neither overbought nor oversold at this stage. We'll be watching the US Dollar for clues about the short-term direction of the market.
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