Eurozone On The Verge Of Triggering A Shift In Trends (XLF, UUP, IYT, EEM, IWM)

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October 27, 2011 12:47pm NYSE:EEM NYSE:IWM

Chris Vermeulen: I am not one to discuss fundamentals or macro views, but this  situation in Europe is beginning to morph into a media frenzy. Price  action in the marketplace is changing rapidly in short periods of time  based on the latest press releases coming from the Eurozone summit.

I cannot help but comment on the seemingly arbitrary actions coming  from this high profile meeting. Nothing has happened that market  participants were not already privy too. The European Union is going to  strengthen their EFSF fund by levering it up roughly 4 : 1. I have yet  to hear how exactly they plan on doing this, but this action was no  surprise to anyone that has read an article about the sovereign debt  crisis in the past month.

There was also discussion about backstopping European banks’ capital  position. Since European banks are holding billions (Euros) of risky  sovereign debt instruments, it would make sense that their  capitalization is a primary concern of Eurozone leaders based on current  fiscal conditions. I would argue that the banks should be well  capitalized regardless of economic or fiscal conditions in order for a  nation to have a strong, vibrant economy that has the potential to grow  organically.

The final piece of this week’s political nonsense involves  write-downs on Greek debt in the neighborhood of 50% – 60% in order to  stabilize Greece’s debt to GDP ratio. Apparently Eurozone leaders want  to structure the write down so as to avoid payouts by credit default  swaps which act as insurance against default. How does a bond take a 50%  – 60% valuation mark down without a creating an event that would  trigger the payout of CDS swaps?

If a write down of that magnitude does not trigger the CDS swaps,  then I would argue they are useless as a tool to hedge against the  default risk carried by sovereign debt instruments. If the CDS swaps do  not payout as projected by European politicians, the risk assumed by  those purchasing government debt obligations around the world would be  altered immediately.

The impact this might have on the future pricing of risk for  government debt instruments could be extremely detrimental to their  ability to raise funds in the private market. Additionally, the write  downs would hurt European banks’ capital positions immediately. If the  CDS swaps were to pay out, bank capital ratios would suffer as those who  took on counter party risk would be forced to cover their obligations  thereby straining capital positions even further potentially.

Price action today suggested that the equity markets approved of the  package that European leaders were working on. However, the biggest push  higher came when news was released that China was interested in  purchasing high quality debt instruments as a means to help prop up  poorly capitalized banks and sovereign nations in the Eurozone through  an IMF facility.

The market did an immediate about-face which saw the Dollar selloff  while the S&P 500 rallied higher into the close reversing a great  deal of Tuesday’s losses. Inquiring minds wish to know where we go from  here? I would be lying if I said I knew for sure which direction Mr.  Market favored, however that did not stop me from looking for possible  clues.

It has been a while since I checked out the short-term momentum  charts that are focused on the number of stocks in U.S. domestic equity  markets that are trading above their 20 & 50 period moving averages.  The charts below illustrate the current market momentum:

Equities Trading Above the 20 Period Moving Average

Stock Above the 20 Day Average

It is rather obvious that when we look at the number of stocks  trading above their 20 period moving average that momentum is running  quite high presently. This chart would indicate that in the short-term  time frames equities are currently overbought.

Equities Trading Above the 50 Period Moving Average

Stock Above the 50 Day Average

A similar conclusion can be drawn when we look at the number of  stocks trading above their 50 period moving averages. It is rather  obvious at this point in time that in the short to intermediate term  time frames, stocks are currently at overbought levels. This is not to  say that stocks will not continue to work higher, but a pullback is  becoming more and more likely.

Additional evidence that would support the possibility that a  pullback is likely would be the  recent bottom being carved out in the  price action of the U.S. Dollar Index.  The U.S. Dollar has been under selling pressure since the beginning of  October, but has recently started to show signs that it could be  stabilizing and setting up to rally higher.

The daily chart of the U.S. Dollar Index is shown below:

US Dollar Chart

The U.S. Dollar Index (NYSE:UUP) is sitting right at major support and is  oversold based on historical price action. If the Dollar begins to push  higher in coming days and weeks it is going to push equity prices  considerably lower. Other risk assets such as gold, silver, and oil  would also be negatively impacted by higher Dollar prices.

Members of my service know that I focus on several sectors to help  give me a better idea about the broader equity markets. I regularly look  at the financial sector (NYSE:XLF), the Dow Jones Transportation Index  (NYSE:IYT), emerging markets (NYSE:EEM), and the Russell 2000 Index (NYSE:IWM) for  clues about future price action in the S&P 500.

During my regular evening scan I noticed that all 4 sector/index  ETF’s are trading at or near major overhead resistance. With the  exception of the Dow Jones Transportation Index (NYSE:IYT), the other 3  underlying assets have yet to breakout over their August 31st highs. The significance of August 31st is that is the date when the S&P 500 Index put in a major reversal  right at the 1,230 price level before turning lower. It took nearly two  months to regain the 1,230 level and its significance continues to hold  sway.

The daily chart of IWM is shown below illustrating its failure to breakout over the August 31st highs:

IWM Russell 2000 ETF

The chart above illustrates clearly that IWM has failed to breakout above the August 31st highs. I am going to be watching IWM, XLF, & EEM closely in coming  days to see if they are able to breakout similarly to the S&P 500.  If they start to rollover, it will not be long before the S&P 500  likely follows suit.

Currently the underlying signals are arguing for lower prices in the  short to intermediate term. While it is entirely possible that the  S&P 500 rallies higher from here, it is without question that  current market conditions are overbought in the short to intermediate  terms.

Key sectors and indices are not showing follow through to the upside  to help solidify the S&P 500′s recent break above the key 1,230  price level. Additionally, the U.S. Dollar Index is currently trading  right at key support in addition to being oversold. At this time I am  not playing the S&P 500 in either direction, but I will be watching  the underlying price action in the U.S. Dollar Index closely. I will be  watching for additional clues in the days ahead.

Market and headline risk is high presently.

Written By Chris Vermeulen From The Gold And Oil

My name is Chris Vermeulen the Founder of TheGoldAndOilGuy. I have  more than a decade of extensive experience trading stocks, indices,  ETFs, CFDs and Futures. My trading style has been thoroughly refined  over the years, blending the best cutting-edge approaches that have only  been possible with modern systems and diverse technologies. I believe I  represent the ideal combination of trading styles and trade setups  including a number of trading breakthroughs entirely on my own. It is  this blend of the time-tested and innovatively new that allows me to  take advantage of bull, bear and flat markets regardless of how each  week plays out. I’ve repeatedly observed that one of the biggest keys to  making a lot of money in challenging markets involves aiming for big,  quick returns, while maintaining an extraordinary focus on minimizing  risk. This may be what most distinguishes what I provide vs. the  experiences delivered by the vast majority of other newsletters.

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