It has been an interesting few months in the stock market, to say the least. The S&P 500 Index (INDEXCBOE:SPX) has slowly been drifting higher in a tight uptrending channel on incredibly low levels of volume since early July.
While the general bullish trend on Wall Street has been much appreciated by everyone who owns stocks, this formation makes us a little nervous.
The fact that this gradual uptrend has not been accompanied by strong volume or strong revenue and earnings numbers from S&P 500 components, coupled with the market’s increased reliance on low interest rates and accommodative monetary policy to finance its share-buyback programs and merger and acquisition activity, tells us that the rally could come under bearish pressure after Labor Day (see Fig. 1).
To help us determine where the SPX may go next, we are looking for clues from other asset classes that are correlated with the SPX.
Correlations occur in various segments of the financial markets and are represented on a basic scale from -1 to 1 (although a correlation can have a reading that is less than -1 or greater than 1).
A positive correlation (any number greater than zero) exists when one financial asset tends to move in the same direction as another financial asset. A negative correlation (any number less than zero) exists when one financial asset tends to move in the opposite direction from another financial asset.
Here’s how these relationships are annotated on the scale:
- Correlation < -1: The asset moves in the opposite direction at a faster rate than the asset to which it is being compared
- Correlation = -1: The asset moves in the opposite direction at exactly the same rate as the asset to which it is being compared
- Correlation > -1 and < 0: The asset moves in the opposite direction at a slower rate than the asset to which it is being compared
- Correlation = 0: There is no relationship between the two assets
- Correlation > 0 and < 1: The asset moves in the same direction at a slower rate than the asset to which it is being compared
- Correlation = 1: The asset moves in the same direction at exactly the same rate as the asset to which it is being compared
- Correlation > 1: The asset moves in the same direction at a faster rate than the asset to which it is being compared
For example, Exxon Mobil Corporation (NYSE:XOM) and the price of crude oil have had a correlation of 0.383 during the past year. This means that watching the price of oil can give us a clue as to whether XOM may soon experience some positive or negative price pressure moving forward.
If oil declines, it will put negative price pressure on XOM. If oil rises, it will put positive price pressure on Exxon shares. (see Fig. 2).
You can see that the recent bounce in oil didn’t do as much to lift XOM, which tells us some general bearishness for energy stocks may be creeping into the market.
This is a much stronger positive correlation than we saw between XOM and crude oil, which means that watching the price of GLD can give us an even stronger clue as to whether NEM — and other mining stocks — may start to experience some positive or negative price pressure moving forward (see Fig. 3).
So what can we look at to find some clues as to where the SPX may go in the future?
As it turns out, the exchange rate between the U.S. dollar and the Japanese yen — as represented by the Guggenheim CurrencyShares Japanese (NYSEARCA:FXY) — has had a fairly strong inverse correlation with the SPDR S&P 500 ETF Trust (NYSEARCA:SPY).
The SPY and FXY have had a correlation of -0.397 during the past year. This means that if FXY declines, it will put positive price pressure on SPY. If FXY rises, it will put negative price pressure on SPY (see the red boxes in Fig. 4).
This relationship was driven primarily by the reaction traders on Wall Street have had to the quantitative-easing actions of the Bank of Japan.
The BOJ has been heavily involved in QE programs during the past few years. It has been “printing” money (it doesn’t actually print money, it simply makes adjustments to its ledgers, but the effect is the same — it creates money out of thin air) and injecting it into the economy by buying both Japanese bonds and stocks.
For the first couple of years, the more money the BOJ printed, the less valuable the JPY became. The less valuable the JPY became compared to the USD, the lower FXY moved.
As the JPY became cheaper and cheaper, traders on Wall Street started selling the JPY short to make money as the JPY lost value. At the same time, they took the money they received from selling the JPY short and used it to buy USD-denominated assets, like U.S. stocks, to make even more money as these assets gained value. This trading strategy is called a “carry trade.”
The risk with a carry trade comes when the value of the currency you have sold short starts to increase in value. Just like you can get squeezed out of your position when you sell a stock short and the value of the stock starts to rise, you can get squeezed out of a carry trade when the weak currency starts to gain strength.
When that happens, you are forced to sell your strong-currency assets (which are U.S. stocks, in this case) to raise enough capital to pay off your short position in the weak currency. This is called “unwinding” your carry trade.
Interestingly, that hasn’t started to happen on the scale we would have expected it to at this point.
The value of the JPY has been strengthening, which has pushed FXY higher, but the value of the SPY hasn’t declined. The negative correlation we have grown accustomed to between the FXY and the SPY has been replaced by a strong positive correlation (see the green arrows in Fig. 4).
This tells us that there are some distortions in the market, and it warns us that eventually one of these assets — the SPY or the FXY — is going to have to turn around and start moving in the opposite direction. If the FXY breaks lower, that could be good for SPY bulls, but, if the FXY continues to move higher, we anticipate that the SPY will eventually break lower as more and more carry traders unwind their positions.
We aren’t anticipating any earth-shattering moves in the S&P 500 before the Labor Day weekend — barring a huge surprise in the Nonfarm Payrolls number from the Bureau of Labor Statistics on Friday — but, as we start off September, we are concerned that the market isn’t going to have enough bullish momentum to sustain its current uptrend.
We’ll continue to watch these correlations and the Fed for clues.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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