Will the Euro Continue to Rally?Jan 09, 2012
The euro has been falling while U.S. stocks are rallying. This is unusual and contrary to the pair’s customary correlation. Will the euro drag down U.S. stocks, or is the euro about to decouple?
Peanut butter and jelly, hot dogs and buns, bratwurst and sauerkraut, euro and S&P, some things were just made for each other.
For much of the last 15 years the S&P 500 and euro (the EU currency) have been moving in the same direction. Since its May 4, 2011 high (the euro topped two days after U.S. stocks) the euro has tumbled 15%. Worse yet, the euro has been falling over the past few weeks even though the S&P has remained stable.
Will the S&P soon catch up with the euro, or is the euro about to decouple its positive correlation with U.S. equities?
Euro problems are the reason for the bad euro season. U.S. stocks got to enjoy the Santa Claus Rally while the euro was stuck with debt concerns that include:
- Eurozone governments need to refinance more than $1.3 trillion in debt in 2012.
- Yields on Italian bonds crept up about 7% again (above 7% yields send Greece into a tailspin).
- Standard & Poor’s is expected to strip France of its AAA rating as early as this month.
- Spain’s banks need to raise an extra $65 billion to cover bad property loans.
- In February, Italy needs to sell more debt than could be covered even if investors used all the proceeds of maturing securities to buy the bonds.
Things are so bad for the euro, they are good. So it seems at least. The chart below shows the euro holdings of the “smart” and “dumb” money published by the Commodity Futures Trading Commission.
The first gray graph shows total non-reportable short positions. Non-reportable are small traders considered the dumb money. The second gray graph shows reportable commercial short positions. Commercial traders are the “pros” that actually provide a commodity or instrument and are considered the smart money.
The data shows that non-reportable short positions are pretty high right now (data as of Tuesday) while commercial traders have closed nearly all their short positions. Based on COT sentiment data, the euro should be close to a bottom, at least a temporary one.
Cause for U.S. Stock Rally?
But wouldn’t a rising euro translate into rising U.S. stocks? Under normal circumstances, yes it would.
A look at the chart below shows that a rising euro usually correlates with a rising S&P 500. The red boxes highlight periods of falling euro and rising S&P (such as lately).
The green box identifies a period of time when a rising euro (NYSEArca: FXE) coincided with falling (even rapidly falling) U.S. stock prices. This happened from October 2007 – July 2008.
Putting Odds in Your Favor
It’s no secret that I declared the rally from the October lows to be a counter trend rally. Back on October 2, I stated via the ETF Profit Strategy updated that: “I don’t think October will “kill” this bear market, but it should spur a powerful counter trend rally. Towards the end of this rally Wall Street may applaud the Fed for launching Operation Twist and QE3 may be considered unnecessary. This kind of positive environment would be fertile soil for the next bear market leg (Q1 or Q2 2012). From a technical point of view this counter trend rally should end somewhere around 1,275 – 1,300.”
To identify high-probability trade setups, I like to see technicals, sentiment, and seasonality point in the same direction, such as they did in early October. From a seasonal perspective, October has the reputation of a “bear market killer.”
Sentiment polls showed the most bearish readings in over a year and the VIX (Chicago Options: ^VIX) was close to the 2010 high. At the same time, the S&P had reached rock bottom support.
Based on the weight of evidence, the October 2 ETF Profit Strategy update also predicted that: “The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.” On October 4, the S&P briefly dipped below 1,088 and closed the day at 1,124. A massive counter trend rally was born that day.
The Next Setup?
Seasonality is once again turning bearish (or at the very least less bullish). Since 2002, the S&P reached a January top followed by a drop greater than 8% five (out of ten) times.
Last week 49.5% of all investment advisors and newsletter-writing colleagues (polled by II) were bullish on stocks (the highest reading since July) while only 17% of individual investors (polled by AAII) were bearish, the second lowest reading in six years. The VIX closed at 20.63, the lowest reading since July 26.
From a technical point of view, the S&P (SNP: ^GSPC) is about to reach a daunting resistance cluster comprised of Fibonacci levels and various long and short-term trend lines.
The Dow (DJI: ^DJI) is about to encounter two trend lines that go back nearly five years. The resistance clusters for the Nasdaq (Nasdaq: ^IXIC), Russell 2000 (Chicago Options: ^RUT), and financials (NYSEArca: XLF) are not as glaring but they’re there.
The only thing that doesn’t quite fit into the equation is the euro’s sentiment data illustrated above. Nevertheless, the weight of evidence suggests that a turnaround, and possibly another significant market top, may be just around the corner.
The high probability strategy is to short U.S. stocks as soon as the resistance cluster is reached or support is broken.
The ETF Profit Strategy Newsletter identifies the target of this rally along with a short, mid and long-term outlook and the corresponding ETF profit strategies.