The following (daily) chart shows the Dow Jones Industrial Average (Dow) as it has enjoyed a steady trend to the upside over the course of the past year. However on a more immediate basis the Dow has established a triangle consolidation pattern through a series of “lower high’s and higher low’s”, where its projected support & resistance levels now emerge at approximately 12,200 – 12,900 respectively. While ‘bulls’ can still make a case the Dow is still technically in an up-trend, traders continue to recite “sell in May and go away” as stocks have failed to accomplish ‘higher high’s’ achieved earlier this year. In addition, we may look no further than last summer (2011’) for the last time the stock market experienced its last significant downturn.
When discussing equities traders will also look to the bond markets in search of confirmation of the same underlying economic conditions. The following chart shows the US 10-year bond, where bond yields typically move in the same direction as stocks and bond (yields) continue to compete against one another for the limited investor capital. The chart below shows a general trend to the downside bond yields have enjoyed over the course of more than a year, which presents an interesting ‘divergence’, or disagreement between financial assets. Simply put, as stocks continue to enjoy a general trend to the upside including new highs in April-May of this year, bond yields continue to decline, which reflects the following phenomenon; While investment capital has continued to move into equities, a relatively greater amount of investment capital has sought the ‘safe-haven’ in US treasuries. As investors purchase bonds, and their prices rise, their respective yields decline. So the new historic lows achieved in the bond market reflect the fact that bonds continue to be the choice of buyers. Under more ‘normal’ or expected market behavior, as stocks rose we would have expected bond yields to also rise. However those yields have instead continued to decline perhaps as a result of a general lack of confidence in the overall economic conditions.
We may also consider the market from the perspective of volatility, and the degree to which the markets tend to oscillate between its recent ‘swing lows’ and ‘swing highs’. Specifically we may consider the ‘VIX’ (Volatility Index) also known as the ‘fear index’, which essentially measures the premiums on those options in the S&P 500 index. Generally speaking as stocks rise the VIX tends to decline as a fewer amount of options are used to hedge stock positions, simply due to the fact that traders do not perceive the market ‘as risky’ as long as stocks continue to rise. However once equities begin to decline, investors in search of protection will look to the options market and in turn the VIX will tend to rise. Simply put, stocks and the VIX tend to enjoy a negative or opposite correlation to each other. We can see over the course of more than a year, the VIX has continued to achieve ‘lower highs’ as a result of a general feeling of optimism and complacency continues to emerge in the equity markets. Recently as the Dow retreated the VIX touched highs just above 25, which historically may still be considered closer to the lower end of its long-term range. If a general feeling of pessimism returns to the equity markets, traders may also expect this to occur along with a rising VIX indicator.
We may now consider the economy from a different point of view such as the USD (currency). The following (daily) chart below shows a steady trend to the upside that has emerged during roughly the same period of time. Generally speaking the USD tends to move in the same direction as the anticipation of interest rates determined by the central bank: FOMC. As economic conditions improve the USD (USD/CHF) may tend to rise with the expectation the Fed could be closer to raising the key benchmark interest rate, while poor economic conditions could equally lead to lower interest rates and perhaps even the possibility of a USD diluting round of stimulus such as Quantitative Easing. However the USD also tends to move as it is treated as a ‘safe-haven’ of capital, where investors may sell other currencies and purchase the USD with the intentions of protecting their investment capital from perhaps worse conditions that may emerge in other economies outside of the US. More over the USD has also enjoyed a negative (opposite) correlation to commodities such as Gold, which in recent years has enjoyed a very significant move higher as a result of poor economic conditions and the very stimulus measures created to help encourage growth in the US.
Putting this all together, the market’s current behavior may shed some lights as to the current and potential future state of the US economy. While stocks have risen, investment capital continues to prefer the safety of bonds, while a general feeling of complacency has helped the VIX remain near historic lows. Over the same period of time the USD has continued to rise, perhaps or far worse economic conditions overseas still make the USD the choice of investment capital that continue to search for the best possible return with the relatively lowest amount of risk.
We wish you the best of luck in all your trading endeavors.