London Session: Have the markets got ahead of themselves?

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By Kathleen Brooks | January 30, 2013 1:26 AM EST

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After such a strong performance in January it was inevitable that the rally in stocks would slow, indeed the SPX 500 had its first down day in eight yesterday. This is perfectly normal in an uptrend, but because it meant that the SPX 500 could not make any headway above the key psychological 1,500 level this question is likely to be a hot topic today.

Analysing the future drivers of stocks

There are essentially three ways to try and find and answer to this question: 1, use technical analysis, 2, use fundamental analysis and 3, fuse fundamental with technical analysis. I prefer the latter as I think you can take the best bits from both and come up with the most satisfying answer (in my case anyway). Let's look at the technical perspective first. 1,500 is a major level of resistance both physical and psychological in the SPX 500, so one would expect some stickiness and sideways action from here. Added to that, yesterday saw the Russell 2000 index and also the Dow Jones Transportation sector reach record highs - yep, that would their highest ever levels. Since these two indices are traditionally leading indicators for the broader market then it suggests that a move to 1,565 is possible in the SPX 500 and 13,895 in the Dow Jones. Added to that, these two lead indicators rose yesterday, but the SPX 500 and Dow both closed slightly down.

The hanging man candle pattern in the SPX 500 back on 11th January is usually a sign that bullish sentiment is starting to wane. This made us cautious about stocks last week, however exercising that caution was the wrong thing to do. Since that hanging man pattern the SPX 500 has risen more than 2%. This suggests that the pattern was either a false signal (all patterns have the potential to do this), or that rather than indicate a turnaround in the SPX 500 it suggested that there could be some profit-taking as we approach this big level at 1,500, which is also perfectly normal in an uptrend.

Looking at stocks, the dollar and commodities

No market moves in isolation, so when you look at stocks it is also useful to look at Treasury yields and the dollar. Looking at Treasury yields first: these moved above 2% yesterday for the first time since April 2012. Traditionally rising yields are bad for stocks, but maybe not this time, we would argue, as rising yields are 1, coming off a low base, 2, suggest stronger confidence and a shift out of Treasuries and into equities and 3, the Fed is still buying Treasuries by the bucket load, so yields should be capped for the long-term.

The dollar has been mixed. There can be a negative correlation between stocks and the dollar - when stocks go up the dollar falls. Thus, the failure of the dollar to rally could also be considered stock positive. However, this hasn't fuelled a similar rally in commodities. The side-ways move in the dollar may be one of the reasons why commodities have not taken off like stocks. However, they could be playing catch-up. Brent crude looks poised to break above key resistance at $114 per barrel. UK oil has rallied in recent sessions after finding support at $109 - key uptrend support and also above the 200-day sma. A break above $114 could see a return to $116. The same is true of US oil. A break above $97.20 in WTI could see a return to $100.

Cautious rather than irrationally exuberant

So the technical and inter-market backdrop is still supportive for equities, which leaves the fundamental side. The US economic data has been picking up; however US Q4 GDP is expected to show a sharp contraction in the annual US growth rate from 3.1% in Q3 to 1.1%. This is still better than Europe, but is fairly lacklustre. Thus, this week's economic data will be critical including January payrolls data, the consumer confidence data released later today and also the manufacturing ISM released after payrolls on Friday. The Fed, who concludes its first meeting of 2013 tomorrow, also needs to remain accommodative so that yields are capped and don't start to weigh on growth. Thus, the fundamental drivers needed to make a fresh leg higher may be the upcoming economic data this week and next. Any signs that the market is too confident on growth prospects could be met with risk aversion. While central banks seem to be "trusted" to keep interest rates low, politicians are still a major risk. The US have only kicked the can about the debt ceiling down the road to May, public spending cuts could hit the US in the coming weeks and Italian elections next month could disrupt the stability in the currency bloc. Thus, while there may be further upside to come for stock markets, the next leg of this rally may be a lot harder than the recent one - not only are we approaching record highs in some stock markets but the chance of disappointing economic data combined with political risks have the potential to knock the markets off course. I sum up my view on the future direction of markets as cautious; I am not feeling "irrationally exuberant" right now.

Chart 1: Dow Jones Transports and SPX 500 spread.

 

As you can see, this spread has reached multi-year highs. It tends to widen during periods of high risk appetite, and narrow when risk aversion rises (like 2008, 2010 and also the US debt ceiling crisis in 2011). Thus, watch this spread to see if the US stock markets are due a correction.

Source: Forex.com and Bloomberg

 

Elsewhere, the European session was fairly quiet as can be normal prior to a Fed meeting. Stocks in Europe are slightly lower and US stocks are poised to open lower today, which would see the SPX 500 lose its grip on 1,500. In the FX market the yen and the Aussie are moving in synch and making up some lost ground, the euro and dollar are weak across the board while the pound and CAD are mixed. We said yesterday that the CAD sell-off could be overdone, and indeed 1.0100 looks like a double top. Yesterday's evening star candle pattern: a short white body, a long upper wick and then a black (down) candle, suggests that a top is in place. 1.0050 then 1.0035 is a key short term support zone.

Chart 2: USDCAD daily

 

Source: Forex.com

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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