Friday, September 3, 2010

MTU Weekend Ed. - An Informative Roller Coaster Ride (9/3/10 Close)

Spurious correlation or disturbing market dynamics
The AUD/JPY cross rate and the SP500 index have possessed a near perfect correlation in 2010 (Chart 1 bar=AUDJPY, line=SPX(esu0)). Moreover, such perfect correlations have also been present on an intra-day basis on many occasions. If this linkage between the two markets is not entirely spurious, it would be truly disturbing.

While it is acceptable to find traces of risk taking in U.S. stocks derived from FX carry funding, it is extraordinary to see such a tight correlation for so many months. One does not need to cook up a conspiracy theory to be disturbed by such observations, for the persistent and tight correlation implies that the marginal price setters in both markets are incredibly one and the same. The rest are price takers. Which group do you belong to?

For the sake of completeness, the other possibility that the underlying forces are driving pricing in both markets in an identical fashion is extremely unlikely, even in hindsight.

An informative roller coaster ride in stocks
The triple test of the 1040 area in SPX over the past two weeks and the subsequent violent rebound has not only factually postponed the anticipated sell-off but also raised the odds that the entire structure since the April top is a mere correction within a larger upward movement.

This bullish interpretation has NOT achieved the primary count status yet, but Chart 2 and Chart 3 highlight two triangles that facilitate the bullish interpretation. The smaller triangle in Chart 2 paints a near-immediate bullish picture, while the larger triangle in Chart 3 suggests a rally beyond the April high after one more round of sell-off below the July low (which could be deep but is not required.)

In all likelihood, the August high may be taken out after a potential pullback next week. In addition to potential wave structures, this upside potential is inferred in the cycle chart (Chart 4) which projected this week's low accurately, the VIX (Chart 5) and the violation of the August high in FTSE (Chart 6).

Top near term scenarios (stocks)

Chart 7 tracks four big picture wave counts that are the most relevant. Chart 8 presents a more detailed count on the E-mini. I'd rank each scenario based on its likelihood as follows, from the more likely ones to the less likely ones. The note in Chart 8 regarding the Aug29-Aug31 sell-off is a key element which enables one to assess the pecking order.

* Minute wave [c]-up of minor wave 2-up is in progress. Expect a moderate pullback before taking out the June and August highs, but not the April high.

* Minute wave [ii]-up of minor wave 3-down is in progress. Expect a deep pullback followed by a moderate advance. The August high holds. The subsequent sell-off will be deep, lengthy, and will most likely take out the March 2009 low.

* Minor wave E of the large triangle (B) is in progress. This is the scenario highlighted in Chart 3. The subsequent sell-off is typically moderate, but could be deep if it is extended or the entire structure is the first in a combination.

* Minute wave [ii]-up of minor wave 3-down is complete at today's high or early next week. The subsequent sell-off will be deep, lengthy, and most likely taking out the March 2009 low.

Note that each of these scenarios either calls for a near term pullback or a sell-off.

Chart 9 offers a squiggle count of the violent advance over the past week. Chart 10 closes in on Friday's action - the last of the last squiggles.

Bonds – topped for good if they have topped.
Bonds likely have topped as discussed over the past two weeks. See The Bond Mania (8/20/10) . Chart 11 updates.