Watch Interest Rates Next For Clue As To When Downside Risks Dominate Again.

Watch Interest Rates Next For Clue as to When Downside Risks Dominate Again.

In last week's column we suggested watching to dollar for an upside breakout and going short the Yen or long the JPY.  We suggested buying UUP if the dollar broke out.  As you can see from chart 1, the dollar did indeed breakout last week.  UUP has soared as a result.  In addition we suggested watching the CRB and Oil for clear breakdowns, which also developed, and our suggested DDP short commodity ETF has done nicely since then as well.

 
Chart 1:  Dollar clearly breaks out to signal negative currency and commodity environment.  Courtesy Bloomberg

As evidence grows that weakening global growth is spreading abroad, the next key to watch will be global bond markets.  We recently got major base breakouts on weekly charts in Japanese, UK, and European bonds.  Short rates should be next and eventually the US bond market will even begin to rally more sharply.  That will be the point that investors are realizing the downside risks are trumping inflation risks - and central banks will begin to have more leeway to fight downside risks more aggressively.  Until then, central banks remain in a box, fiscal policy stimulus that will be needed remains absent, and downside risks will likely have to grow before they can be fully attacked.  Short commodities and long dollar oriented trades are likely to do well as long as downside risks must grow - but keep your eye on bonds for the beginning of the next phase ahead.

 
Chart 2:  Long dollar ETF has gained after dollar breakout with dollar index so far.  Courtesy Bloomberg

 
Chart 3:  CRB breaks down as suggested too.  Courtesy Bloomberg

 
Chart 4:  So short commodity ETF has gained nicely since breakdown in CRB.  Courtesy Bloomberg

 
Chart 5:  Japanese bonds broke out of head & shoulder bottom to signal weaker Japanese economy.  Crtsy Bloomberg

 
Chart 6:  UK Gilts also broke out of base to signal weaker UK growth likely on the horizon.  Courtesy Bloomberg

 
Chart 7:  European bonds also break out of double bottom base to signal weaker EU growth.  Courtesy Bloomberg

 
Chart 8:  But US bonds are still focused on inflation concern and unable to rally sharply here.  Courtesy Bloomberg
 
Chart 9:  And therefore US mortgage rates continue to creep higher when they most need to fall.  Crtsy Bloomberg

 
Chart 10:  So there is no letup in the housing price decline...Courtesy Bloomberg
It is difficult to see the economy or stocks embarking on a sustainable rebound when housing prices are still falling.  Mortgage rates are rising at a time when they need to fall to relieve pressures on housing.  They are not - and until they do as the foreclosure and delinquency rates soar, more housing is being dumped, putting pressure on housing prices, leading to more walk-aways from those underwater with mortgages more than homes are worth.  The negative feedback loop appears underway and until it is stopped, it is likely to continue.  At some point downside risks will escalate in market investors minds and bonds can rally more thoroughly while central banks can ease more aggressively.

In stocks while we have now had two follow-through days on the upside, we have not yet had a 90% up-day - nor are we seeing the type of global plurality, group leadership, or breadth typical of even a catchable bear rally yet, and some global markets are making new lows while two distribution days have already developed.  We continue to keep an open mind and watch for more volume, breadth, and leadership on the upside before trying to catch any buy signals in what we still strongly suspect is another bear market rally in stocks.  Note the chart at the bottom of the column which shows Top RS/EPS New Highs versus Bottom RS/EPS New Lows.  TRE New Highs are not yet consistently 40 above BRE New lows, so a decent upside potential environment is not yet close to being signaled.  Normally we would like to see five trading days in a row of a 40+ advantage before believing that a truly decent upside environment is developing.  While new high leadership is broadening some (a positive sign), new high leadership remains heavily focused in bio-tech, health care, some machinery groups, and some tech groups.  Those wanting to play this rally could focus on ETF's in these groups like IBB and IYH, or in stocks in these top groups that are breaking out and close to criteria.

We also suspect that watching financials for a breakdown under the lows of the last few weeks might be a good way to judge when downside risks are resuming in stocks.

However, investors are still encouraged to mostly stand aside from this dangerous market environment.  Continue to watch payrolls, consumption, bond markets, and market internals for clues as to when this downward spiral will end.  If it ends soon and before too much more downside action in stocks, a global recession can still be avoided.  If it does not, and the recession grows into a consumption decline then there will be more rounds of write-offs from consumer debt and more broad-based earnings declines that will feed into a deep and more global recession than we've witnessed in many decades.  One wonders if the sharp dollar rally is only discounting falling economies abroad, or a more dire consumption recession beginning to develop.

The market remains in its most dangerous negative phase.  The Fed remains stuck in a box where it cannot raise rates because that would kill banks and the housing market that are already on the ropes, but it cannot lower rates because inflation is flaring from higher oil and food price seepage that will lag the commodity downturn before peaking.   Lower oil prices are certainly helpful at relieving inflationary pressures, so the seeds of an eventual recovery are being planted here.  Yet it remains important how long central banks are hamstrung before inflationary pressures ease up to determine how much damage is done economically in the interim. 

Our long/short strategy remains happily 100% in T-bills awaiting new trades.  Since our last update we got close calls on the buy side from MPWR with no close calls on the short-side, and no valid signals either short or long.  Check out www.midasresourcegroup.com for daily listings of Top EPS/RS New Highs and Bottom EPS/RS New Lows to make sure you catch all potential breakouts meeting our criteria.  As the chart at the bottom of the page illustrates, we do not have top RS/EPS new highs or bottom RS/EPS new lows in a clearly dominant position (40 over the other for 5 or more days in a row) to signal a good environment for either long-side or short-side dominated activity. This is often the most dangerous, volatile, and tricky phase of a bear market.

For those not familiar with our long/short strategies, we suggest you
review my book "The Hedge Fund Edge," my course "The Science of Trading," my video seminar, where I discuss many new techniques, and my latest educational product, the interactive training module. Basically, we have rigorous criteria for potential long stocks that we call "upfuel," as well as rigorous criteria for potential short
 stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published
on www.midasresourcegroup.com for breakouts of four-week or longer flags, or of valid cup-and handles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags
 or cup and handles on the downside. In the U.S. market, continue to only buy or short stocks in leading or lagging industries according to our group and sub-group new high and low lists. We continue to buy new long signals and sell short new short signals until our portfolio is
100% long and 100% short (less aggressive investors stop at 50% long
 and 50% short).   We keep capital in T-bill cash while waiting for more trades.

The chart below shows that neither Top RS new highs (available on www.midasresourcegroup.com) or Bottom EPS/RS New Lows are over 40, let alone greater than their opposite series by 40 or more.  Heavy cash and alternative asset class defense should be utilized!