Wednesday, July 8, 2009

WorldMarketsGuide Preview: Stocks Officially Downtrend, Forex, Commodities Follow--How Long?

(As of approximately 13:00 GMT Wednesday, 9:00 am EST)


S&P, other major world stock indexes make third "lower-high-lower-low" to officially form a new down trends.

Forex, commodity markets continue to follow stocks, fall also. However, safe-haven currency pairs begin up trends.


While there is debate over what precise criteria define a trend, most would agree that a sequence of three lower highs and lower lows on a daily chart can be called a down trend. Tuesday's trading on the daily candlestick chart of almost any major stock market shows the same basic picture, a significant drop over 1% that makes the third lower high and lower low, creating a downward sloping trading channel.

Until yesterday, almost every stock, commodity, and currency market was in a horizontal trading channel for the past 4-6 weeks (depending on the instrument clearly they were approaching and testing support. The question was whether support would hold and the drift down was just part of a continued oscillation within a flat trading tunnel. The question now appears answered.

There were exceptions.

Crude oil, remained among the most volatile instruments of the year, was already in a clear downtrend and hitting lows not seen in nearly 7 weeks.

Currency pairs with a clearly safer "base currency" (i.e. currency in the numerator or to the left of the "/" line) were rising towards the upper end of their channel. The JPY is considered the safest currency, followed by the USD, then the CHF.

Global Stock Indexes

The short version: down, mostly 1%-2.3%, forming a sequence of 3 recent lower-highs-and-lower-lows. Thus global stocks have moved from a horizontal trading channel to a downward sloping channel that breaks below 4-6 week support, as illustrated below.

This move is very significant, because it signaled, as it usually has in the past few years, similar moves in commodities and currencies, except for the safe-haven currency pairs. Why?

Stock Indexes Have Generally Lead Commodity and Currency Markets

The driving force behind most markets, certainly over the past few years, has been trader sentiment or expectations about the state of regional and world economic growth prospects. As optimism rises, stocks, commodities, and higher yielding currencies generally rise in price on the assumption of increasing economic activity, demand for commodities, goods, and services, and rising corporate earnings. When economic prospects look gloomier, the opposite happens, and markets fall.

Global stock markets have generally been the leading, clearest indicator of these expectations, with currency and commodity markets usually responding to stock market movements rather than the other way around (with exceptions, of course).

Moreover, given the highly related nature of global stock markets, these markets very often move together, and even more often trend together over time. Thus stock indexes have often been the leading indicator of not only what happens with currencies and commodities, but also of how markets that open later in the day will at least begin their trading, if not follow the same direction.

Note the correlations in the below illustration showing how futures markets for these instruments closed at the end of the trading day GMT (that is, they continue trading in Asia and Europe even after the actual stock markets have closed. The trading day begins in Asia, represented in the upper left by the Japan's Nikkei stock index futures daily chart with July 2nd highlighted. Then Europe opens, here represented below the Nikkei chart by the German Dax 30 stock index futures daily chart. The last major markets of the day are in the Americas, as represented on the bottom left by the S&P 500 stock index futures daily chart. On the top right is crude oil, below which is the AUD/JPY and AUD/USD currency pairs.

Remember that on July 2nd markets waited for the main economic event of the week, US non-farms payrolls report. Uncertain and nervous, traders were taking profits, thus Asia had already closed down, and Europe was also down generally over 2%. The very disappointing NFP results drove the US and Europe down hard.

As the world's largest economy, a recovering US is essential for a global recovery. The World Bank had already downgraded its world economic forecast on June 22 (the prior large decline) but the OECD had issued a more optimistic view based on a more positive view of the US economy's recovery. The poor NFP numbers may have undermined the OECD report. Thus after a month of mixed news, pessimism took over and stocks continued to drop.

Note how the charts on the right side move roughly in step with the mood as reflected in the stock indexes from July 2nd onward. On the top right is crude oil, one of the most volatile commodities recently. Below are charts of the AUD, considered one of the riskiest currencies, as the base currency, against the USD, then JPY (the safe haven currencies) as the cross currencies.

Note how all have moved together.

Comparison of Daily Stock Index Movements with Representative Commodity and Currency Markets

This synchronization between global stock indexes with commodities and currencies has usually held up over the past few years regarding short term movements. Exceptions do exist. For example, a major long term spike up in crude prices could scare stocks into decline as their costs would rise and consumers would have less to spend after paying for essential energy needs.

Thus stocks and other markets have mostly broken below 4-6 week support, and are now in what seem to be at least near term down trends.

The Next Big Question

Now that the 4-6 week flat trading channels appear to have broken down, the question is how long the current down move will last.

Will the next levels of support hold and form a new, wider horizontal trading range, or are markets headed back to test November or even March lows?


If the above is clear, then you know how currencies have generally behaved. Most have behaved according to the ideas illustrated in the above chart comparison. Pairs with safer base currencies compared to their cross currency have generally gone up, while those with riskier base currencies have dropped, as shown above with the AUD charts.

Exceptions do exist, especially when the difference in risk level is not so clear. For example, a look at a daily chart of the USD/CHF shows the pair still in a tight trading range. Both are considered safer currencies.

The recent trend since July 2nd's NFP report inspired fear-fest shows the market still considers the USD slightly safer, though it's debatable which is actually safer.

USD/CHF Daily Chart: USD moving up but still within 4 week horizontal range

Remember, market perceptions do not always coincide with reality (how's that for understatement?)

For example, if you look at a USD/CAD chart, you'll see the USD had been steadily rising against the CAD for over a month as the global stock rally stalled on waning optimism. This suggests the markets consider the USD safer. Is it? The Canadian financial and housing sectors are in much better shape, having avoided most of the sub-prime fiasco. Yes, Canada is an export based economy that depends on the US for most of it's sales, but that doesn't make it worse off than the US. The oil, gas, metals, grain, and other commodities can be sent elsewhere, especially if Chinese and Indian growth are as expected.


Similarly, while most commodities are down-trending, there are those that are holding on to their 4-6 week ranges. Note the below chart.

Gold Daily Chart: Still in Recent Horizontal Price Channel


Thus there are trends for trend traders, and horizontal ranges for those preferring that kind of situation. Of course, plenty of movement in crude.

As noted before, the next big news will be earnings, especially those from the financial sector, which have been the root of all major sentiment shifts and thus market moves in the past two years. These begin today in earnest, but the bank earnings will be coming next week.

Do we have any hints? None really, however note that the surprisingly positive Q1 bank earnings were leaked early, as Team Washington & Wall Street sought to get the positive feelings out as fast as possible in order to stabilize markets that were at multi-year lows. Would a lack of such leaks before the bank earnings announcements suggest the opposite news is coming?

If so, the recent slide may appear modest indeed.

Disclaimer: Opinions herein stated are those of the author and do not necessarily reflect those of AVAFX.

Disclosure: The author may have positions in the above instruments.

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