Friday, July 16, 2010

MTU Weekend Ed - The Forest and the Trees (7/16/10 Close)

The trees – near term assessment

Since the 6/21/10 high (1131.23 in SPX), which I’ve been referring to over the past two weeks as a key level to differentiate top wave counts and a key hedge-point for those who have bearish exposure, is yet to be breached and the market actually reversed hard on Friday, there’s no need yet to tweak the strategic and tactical bearish stance and complicate the thought process.

Chart 1 and Chart 2 update the top 5 near term scenarios (wave counts) that I’m monitoring. Among the five, the expanded flat 2-up of (1)-down (green labels in Chart 1) is practically eliminated as Friday’s reversal is likely too big for a small-degree fourth wave. That leaves, on the “bullish” side, Friday’s reversal as (c) of an expanded [b]-down of 2-up (blue labels in Chart 1). If this is the case, [c]-up equals [a]-up at 1151.87 in SPX. In either case (green or blue labels), there’s one more five-up to above the 6/21/10 high before the market rolls over into 3-down of (1)-down.

Perhaps the strongest collateral support for more near term bullish potential in stocks resides in the VIX. In terms of its near term wave structure, VIX still requires a final pull back as (c) of [y] of 2 before surging to higher highs (Chart 3). From a long term perspective, as I have mentioned a couple of times in the past, during the 2007 and to some extent the 2000 topping process, stocks did not top at the initial break-out of the VIX (Chart 4). Will history rhyme?

Of course, the most bearish count labels Friday’s reversal as (i)-down of [iii]-down of 3-down of (1)-down. The sell-off in the much anticipated (iii) of [iii] of 3-down should be quite dramatic and painful, if this count is playing out.

We needn’t burden ourselves too much regarding whether 2-up is still in progress or whether 3-down has started. We’ll know it when we see it – that’s what the point of recognition (the Prechter point) is for.

The forest - long term cross-asset musings

Assuming the latest financial crisis was primary wave 1 (P1), the hope-rally was primary wave 2 (P2) and the stock market is rolling over into primary wave 3 (P3), how “should” other asset classes fall into place during P3? Bonds and commodities can reasonably fall under their own weight. Gold is a wild card but either direction can fit a P3 story well. Thus, I’ll focus on the USD index (DX) a bit.

The dollar bulls anticipate USD strength (a repeat of P1 and more) at least during the initial stage of P3 and the dollar bears sees only an A-B-C second-wave correction since the 2008 low in the DX and expects DX to fall to new lows before long (Chart 5). The fundamental drivers appear equally intuitive / appealing – demand for liquidity/”quality” driven by dollar-denominated financial asset destruction and sovereign debt crisis on one hand and the unintended but logical consequences of dramatic debt-based public sector expansion on the other hand. Either scenario is dramatic in its own right.

However, currency movements are relative and the DX is even more narrowly defined against six currencies with euro (>50%), yen (>10%) and the British pounding (>10%) dominating (See lower panels of Chart 5). Thus dramatic long term movements in the DX necessitate dramatic movements in its member currencies.

The current pullback in the DX has been credibly driven and supported by the strength in yen and the rebound in euro and the pound. So far, so good.

The euro most likely NEEDS to go bust for the DX to surge much higher over the “long” run (certainly P3-like). The eventual the pullback in the yen will add fuel to the rally in the DX as well.

For dollar bears, the euro most likely NEEDS to initiate its own bull market, possibly along with the pound. This would probably imply that, in relative terms, concerns with the European economy and/or problems with European sovereign debt will dissipate, sustainably. In this case, P3 may not be what the stock bears have been expecting or there may not be a P3. The world economy is much less segmented today (and at least during the initial stage of P3) than before.

Which one sounds more likely? I have my thoughts, but time will tell.