“Caution Flag” Signals Further Market Drop (USO, UUP)

I hope you had a chance to read my article on Tuesday, titled “Which Signals Tell You That the Market Is About to Drop?” As we’ve seen, a market correction has already started, and I believe that the markets may continue to drop lower.

That’s why I want to show you another “caution flag” to watch out for when markets start to drop.

I spend at least seven hours a day staring at market action. Part of my obsession is noting all of the reactions of the market to different news items, economic data, and increases and decreases in correlation.

Take a look at this chart. It might seem complicated, but each line is important, so let’s walk through it step by step.

I started noticing peculiar behavior just a couple of weeks ago when I was comparing how the S&P 500 (black line) was moving in relation to oil (green line) and the dollar (red line). In the chart below I used the SPX to represent the market, United States Oil Fund (NYSE:USO) to represent oil prices and the PowerShares DB U.S. Dollar Index Bullish ETF (NYSE:UUP) to represent the dollar compared to other major currencies.

U.S. Dollar and S&P 500
View Larger Chart

When Correlations Break Down

There are two areas I want you to pay attention to in the chart above. The first is between vertical lines 1 and 2, which to me was the first warning. In this time frame, the U.S. dollar (red) was actually on the upswing and so was the S&P 500 (black). I’ve marked these movements with red and black arrows. This has NOT been the typical correlation between the two. Generally, the two were negatively correlated, meaning that when one went up, the other went down, and vice versa.

Perhaps it was because crude oil was also moving lower in that period, toward the bottom of its most recent range (marked with the green line and green arrow). Up until the 17th of February, crude oil was in a channel roughly between $85 and $93 ($90 crude oil is deemed “tolerable” by most experts).

Line 2 shows an inflection point, which occurred right around the 18th of February. This is where everything starts to change. Here we see the U.S. dollar continuing to drop (which used to be good for the market) but we also see the market struggling, volatile and channeling. Right after line 2, crude oil spiked out of its most recent range and moved to the $95 and $100 a barrel area. This started the shift in market attitude.

West Texas Crude didn’t close above $100 until early March, which is when the market really started to falter.

The divergence between the U.S. dollar and the stock market is a huge caution flag for bullish investors, but not just because of the unusual chart pattern, but the sentiments that lie behind those lines.

A Sharp Shift in Sentiment

It took scares in the Middle East for us to realize how overdone the U.S. equity markets have gotten. To date, according to my research, there have been NO major disruptions in supply; OPEC countries like Saudi Arabia agreed to absorb the 1.6 million barrel production of Libyan crude lost in its shutdowns. Libya represents less than 2% of global production. Yet oil is up over 30% in less than a month.

Please don’t get me wrong; the uprisings and changes that are occurring in the Middle East are significant, both culturally and economically, and by NO means am I discounting them. A severe disruption in Saudi Arabia could have dramatic effects on supply, but that has yet to be seen. Many experts believe that we will not see a major disruption in oil coming from Saudi Arabia, which is the world’s second-largest producer of oil.

But for all this geopolitical influence, there might be another factor contributing to higher oil prices — and thus the market decline.

Has anyone thought about the U.S. dollar in the toilet as being at least a partial cause for the rally in crude oil? Remember 2008?

I do believe that the premiums in crude are warranted, just maybe not to the extent that they have been bid up. The EIA Projects that WTI (West Texas Crude) will be priced around $102 by the end of the year.

Let’s translate what that might mean for markets.

Right now fear of a weak consumer with minimal discretionary income and rising costs all around him make it hard to justify higher stock prices. When the consumer starts to look healthy and the U.S. dollar continues to weaken, even when oil begins to spike, you may get a temporary boost in stock prices, but that rise becomes hard to justify when the consumer has no money to spend and is lucky to have a job.

Of course, it’s hard to figure out who is the dog and tail in the current state of things. In my eyes, the consumer tends to be the dog and whatever forces pushing and pulling on him have ramifications that cross over into many different markets and sometimes have a boomerang effect.

The Boomerang and Technicals

The proverbial boomerang coming around right now has a several parts:

  • The higher cost of foodstuffs, driven by a weakened dollar and perceived strength of global consumer demand.
  • High energy and fuel prices also driven by weak dollar, anticipated global demand increases and Mideast unrest.
  • The reluctance of companies to hire new workers, because of higher input and shipping costs and the need to meet elevated earnings expectations.
  • No vehicle for the average consumer to hedge inflation (your house normally helps, but not so now).

All this leads to less money for the consumer to spend, higher costs of living (inflation) and fewer jobs. When the market actually sees this reality (like it is now), stocks can move sharply lower.

When stocks drop, they begin to form patterns and change trend, like I showed you in the chart above. Sometimes this causes millions of technical analysts like me to sell my long positions and perhaps turn bearish.

A major violation that every investor should watch for is the S&P 500 breaking below its 50-day moving average. This is a signal for many short- to intermediate-term traders to sell.

At this point, until companies prove us otherwise, I would be extremely cautious about buying anything.

Earnings season kicks off April 11 — If reports are strong, it will be salvation for the equity markets. But weak or even in-line earnings will further accelerate the change in trend that we are seeing.

Written By Jared Levy For The Taipan Publishing Group

Jared Levy is Co-Editor of Smart Investing Daily, a free e-letter dedicated to guiding investors through the world of finance in order to make smart investing decisions. His passion is teaching the public how to successfully trade and invest while keeping risk low. Jared has spent the past 15 years of his career in the finance and options industry, working as a retail money manager, a floor specialist for Fortune 1000 companies, and most recently a senior derivatives strategist. He was one of the Philadelphia Stock Exchange’s youngest-ever members to become a market maker on three major U.S. exchanges.

Article brought to you by Taipan Publishing Group, www.taipanpublishinggroup.com.

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