Monthly View of the SP 500

Apr 24, 2008: 9:21 AM CST

Let’s pull the camera back on the market to see where the S&P is on a monthly chart for broader insights:

Currently, price is trapped between its 20 and 50 period exponential moving averages.

The last time this happened was in 2001, right in the middle of a major bear market move. Are there similarities this time as well?

The averages often provide key resistance and support to advancing (and declining) moves, and as a market changes trend, deeper and deeper retracements occur.

The 1,400 area has strong resistance on the daily and weekly chart, but did you know it was also a strong area of resistance on the monthly chart as well?

Currently the 50 period EMA is providing support to the market, and it has yet to close beneath this key average yet.

Also, notice that the last five months in the market have closed lower than they opened. Early 2007 gave us the last occurrence of a back-to-back monthly decline, and before that we’d have to go back to early 2004.

The last time the market declined five months in a row was early 2002. April currently is poised to give us our first higher monthly close for the year.

Notice also how volume in the market has trended higher, only to spike radically higher at the start of 2008.

To end, let me simplify the graph above by plotting only the 20 month exponential moving average:

Three times since 2000, the market has crossed (with a close above or below) its 20 month moving average. Each time, the ‘trading signal’ or position (posture) signal was rather accurate.

The market crossed and closed beneath this important average in January, 2008. Was this another larger signal to exit longer-term positions?

Bulls would certainly like to see a clean close (or a series of closes) above the key average, but until then, the market may remain ‘guilty until proven innocent’ by rising above this often watched average.

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Gold and the US Dollar

Apr 23, 2008: 10:52 PM CST

Continuing our brief study of intermarket relationships, let’s look at two markets with a powerful negative correlation: The US Dollar Index and the Gold Market.

Gold traditionally is a hedge against inflation, and inflation often is correlated with a weak dollar and higher commodity prices across the board (which is the environment we see now).

As the dollar declines, commodity prices (including gold) often rally, linking the inverse relationship. Let’s zoom down from a monthly chart down to the daily chart:

Notice the shift that occurred at the ‘turn of the century’ where gold prices were at their lowest levels of the last decade and the US Dollar Index (along with the Stock Market) was making new highs. The market shifted in 2001 (as the recession began) and the price of gold (per ounce) has never looked back.

The US Dollar, on the other hand, is another story. The Dollar index peaked at 120 and is now 41% lower than it was at its peak. Gold, on the other hand, rose from $250 (per ounce) to a peak above $1,000 an ounce, rising 400% in the same 8 year period.

This also means that the value of a US dollar is worth much less in terms of gold prices than it was in 2,000. In 2000, if you were offered $1,000 in gold that you stored away, if you cashed in today, you would get back $4,000 (if converted into dollars). Of course, those dollars are worth less today than they were then, so it may be better to keep the investment in gold! But that is for another lesson.

Let’s keep our focus on these two markets for the meantime.

Weekly charts show the same strong inverse relationship:

Again, the picture is the same. Since early 2007, gold prices have almost doubled while the US Dollar Index fell 20 points (weakening against other currencies).

If the US Dollar Index reverses trend, then expect gold’s trend to pause or reverse as well. Until that happens, the current trend remains in force.

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Stock Market and Gold Correlation

Apr 23, 2008: 12:16 PM CST

Intermarket analysis is a fascinating branch of market research, and I wanted to show you the performance of gold and the US Stock Market.

There’s been an inverse relationship, such that when gold rises, the market is generally falling and vice versa.

Gold is traditionally seen as a hedge against inflation, and inflation typically is seen as being negative for the stock market.

Also, in uncertain economic times (especially with a falling US Dollar), gold is a more attractive investment than US Stocks and so the two asset classes, much like stocks and bonds, compete for your investment capital.

This correlation holds on the longer time frame charts as well:

Notice that gold prices in 2006 around $600 were not a problem for the stock market. As signs of recession began to emerge, and investors began to be ’spooked’ by deteriorating financial conditions, larger investors likely began rotating out of the US Stock Market and into other markets such as gold, bonds, etc.

We see the rotation accelerate as the stock market began to fall going into 2008, when the price of gold ’skyrocketed’ from just under $700 per ounce to over $1,000 per ounce in March 2008. The S&P fell from a peak of 1,575 to just above 1,250 during the same period.

The recent fall of gold prices has contributed – with other factors – to a rise in the current stock market since March.

While there may be some correlation between gold prices and the US Stock Market, gold prices are much more inversely correlated with the US Dollar Index.

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Stock Correlation with the 10 Year Yield

Apr 23, 2008: 6:58 AM CST

I’m not sure how much you follow intermarket correlations, but there’s one relationship I’d like to highlight to you.

The S&P 500 Index has been extremely correlated with the 10 Year Treasury Note Yield ($TNX), and continues to be so today.

Generally (as demonstrated over the last 100 years, but not over the last 10 years), rising yields are bad for the stock market and falling yields are good for the stock market, but yields and the S&P market have traded near lock-step since just before 2008 began.

Recall that bond yields are inverse to bond prices, so there are implications here for the bond market as well. Bonds and stocks often compete for investor funds, and assets flow back and forth between these markets.

Notice that on the recent rally (from Mid-March), Yields have risen with the market, meaning bond prices have fallen, adding to the correlation (money has flown out of bonds and into stocks, driving yields down).

To show you how recently the correlation began, let’s view a weekly chart:

Let’s pull it back to 2000 on a monthly chart:

Notice how the 10 Year Yields follow the stock market decline from 2000 into 2003 swing for swing.

Also, notice that 10 Year Yields hit the same level they did near the 2003 stock market bottom.

As yields fell along with stock prices, investors shifted more and more into bonds (causing bond prices – not shown on these charts – to go higher).

It’s a fascinating correlation, and one to which you might want to pay attention.

(Rates closed today at 3.72% – that’s what the $37.20 on the left side of the chart means)

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A Day of Divergences and Interesting Trades

Apr 22, 2008: 9:20 PM CST

As I always recommend, take a look at your chosen market and chosen time frame and annotate the action and ideal trades for the day, so you can better analyze these patterns in real time.

Let’s look at the DIA (Dow Jones ETF) on the 5-minute chart (any of the 3 major US Stock Indexes have similar intraday patterns).

Let’s take it point by point.

The day opened up with a downside gap of 30 Dow Points, which would lead you to enter a ‘gap fade’ trade. Unfortunately, this trade didn’t ‘work out’ as expected and many traders had their stops hit.

1. A large resistance area, and moving average overlap trade (combined with a new momentum low ‘impulse sell’ trade) triggered a potential ’short-sell’ entry (target: intraday low or just beyond)

Price then began to falter beneath the key 20 period moving average, and with negative breadth, led you to continue to trade to the short side.

2. Annotation #2 identifies what I call an “F You!” trade (for those who are curious, the “F” stands for “fade“). I was short going into this trade and had a tighter stop than I should (combined with a larger position than I should) and a quick upthrust in price nailed all ‘properly placed’ stops and zapped away positions in less than a minute. Actually, ideal stops should have been placed beyond the falling 50 period average, but in the heat of trading, we don’t always do what we should.

I’m fine with stops, but not fine with trades that complete an “F You” pattern. This occurs when there is an obvious set-up and obvious stops that quickly comes up and fills the liquidity of resting stop orders and THEN reverses extremely rapidly and quickly back IN the direction that people expected. This development tends to frustrate traders and sometimes disillusion them.

These occurrences are rare, but if you miss them, then they can provide elegant entries. I had to chase the market down, which also was probably unintelligent, but this is why I write “idealized trades of the day” – to allow me (and you) to see patterns in calmer times outside market hours so that we can recognize them and trade them with confidence during market hours.

3. Following the large downward impulse (as expected), there was a slight retracement that resembled a 45 degree angle. That’s a bear flag! The flag broke down just before reaching resistance and achieved its price target, which wound up being the intraday low

4. Price also retraced to the falling 50 period moving average, setting up the potential for a ‘final’ trend trade as price began to build a base to trade higher and reverse. Notice the numerous positive momentum divergences that developed through the day.

5. Finally, price consolidated beneath the key 20 and 50 period moving averages, and this highlights how MAs can serve as support and resistance. Also, breakouts from consolidation can lead to higher prices (especially following positive momentum divergences).

Today was a great and interesting day that – like most days – provided many opportunities for profit. Print out your favorite chart and market and annotate it based on your understanding of trade set-ups and likely price behavior so that you can be ‘quicker on the draw’ during the trading day.

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