April 26, 2010

Japanese vs US Domestic Equity

(Click to enlarge the graphic).

The S&P 500 is widely reported to be nearing critical resistance, but what clues may be drawn from the Japanese market?

The weekly charts above plot the iShares MSCI Japan Index ETF (EWJ, red bars, lower left), SPDR S&P 500 ETF (purple bars, lower right), SPDR Gold Trust ETF (GLD, gold bars, lower of both charts). A resulting ratio plot of each index (Japan on the left, S&P 500 on the right) plotted in Gold is drawn atop all three instruments. Black vertical dashed lines denote dates of interest, with Fibonacci retracement grids drawn for two specific periods each. All charts are drawn with semi-log scaling.

Obviously purchasing power has eroded around the globe in recent years. The precipitous ascent in commodity prices in 08 largely contributed to the matter, but the continued rise of Gold thereafter created an otherwise unseen malaise over global equity markets. The outcome is easily identified above using the ratio plots offered, this in spite of the voluminous recovery in global equity over the last 12 calendar months. Indeed, few can argue with equity results based in total return off the bottom valued in US Dollars.

What's most interesting regarding the charts above is the disparity as regards resolutions to consolidation in each instrument. To wit, note that the Japanese market priced in Gold has repeatedly consolidated in a triangle, whereas the S&P500 similarly priced has consolidated in a rectangle. On a price retracement basis, both seemingly return to 38% of their former swing value (measured from their respective breakout thrusts vice the absolute high) yet resolve themselves rather differently. One could argue Japan has led to the downside in each instance.

We've remarked previously that many global markets (equity and commodity alike) actually bottomed in Dec 08 vice Mar 09; Gold is one such market. Clearly the rampant fear of holding long equity, accompanied by massive capitulation, drove the precious metal higher with relative ease during that span. Thereafter, the hard bounce in equity off Mar 09 lows in Japanese and US Domestic issues was impressive. More impressive is the recovery itself priced in Gold - until consolidation came in the form of these markets rising on low volume and volatility.

What happens next is difficult to tell. Clearly we have a decoupling of Global markets unprecedented in both scope and scale. The US Dollar continues to rise, yet that story is mixed when individual currency pairs are compared; commodities have risen (albeit modestly), yet there are distinct winners in that asset class as well (see Nickel); and here we have Gold, seemingly struggling to make new highs. How will that circumstance abate, and what might that mean for long equity and the US Dollar?

It's hard to argue long equity is rising on low volume amidst a low interest rate environment. This does not, by itself, spell the end of long equity's ascent. Rather, a total analysis of the business cycle is warranted. For the moment, we have Bonds sideways against a landscape of a teetering normal yield curve. Two year treasury futures are perhaps wildly overbought, and have broken a several month uptrend; five and ten year treasury futures gave up the ghost in Dec 09, and have fallen, though some might contend mildly. If two years break hard down, then we can expect the short end of the curve to rise and perhaps even drive the entire complex decidedly inverted. Seemingly the only solution would be to raise rates on the long end in concert. This would not bode well for bonds, let alone equities.

The US Dollar could benefit from such a move. Always sensitive to interest rates, the greenback's rise seems to be "dialing in" a rise in rates. We've remarked in weeks past that the Dow Utilities are factoring in a possible rise in rates as well - time will tell if this thesis holds. The disconnect, however, could come in the form of what happens with Gold (and commodities in general). Is it possible we could see a rise in Gold and a rise in the US Dollar? Could we in fact decouple?

The classic business cycle tells us Bonds rise, followed by Stocks, and then Commodities. What's inferred, though lost on many, is that there can be moments where a mixture of directions is in play. Specifically, markets seem poised to have a period of falling Bonds, rising Stocks, and (perhaps) rising Commodities. Gold, and in turn the US Dollar, stand to benefit in turn. Hence, we could see a period, its length of little to no consequence, where everything but Bonds - namely Gold, US Dollars and Stocks - could be rising in unison.

Looking at the charts above, what could drive these ratio plots lower still? A few scenarios come to mind. Starting with the upside, equity could break higher more quickly than Gold. Given the current state of the market that appears less than likely. To the downside, equity could continue to rise on weak volume while Gold breaks higher with greater conviction. Technicians could make good odds on that bet in the near to medium term. Finally, a more precipitous breakdown could take please should equity could collapse while Gold either holds its own or perhaps even falls with less devaluation than that of global Stocks. Odds here seem light at best until we get deeper into the business cycle.

No matter which outcome presents itself, its clear this correction is getting long in the tooth as regards the ratios plotted above. Technicians should continue to stitch together a conviction-based thesis as regards the current relationship between Gold, the US Dollar, and the state of the business cycle. If anything can be gleaned from the past few market cycles, its time we recognize that the world is in a state of "investment flux" and long held attitudes surrounding inter market relationships are being challenged. Pricing markets in terms of their purchasing power helps to decode the way forward, and is a suitable weapon in the technician's arsenal.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

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