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A Closer Look At the Financial Markets

A note to 538 readers: I had huge formatting problems when I originally posted this article. Frankly, I don’t know what happened, but it was severe enough for me to delete the original post and rewrite the article from memory. Unfortunately, all of the original comments were also deleted. I would ask that all who posted please repost their comments. I apologize for the inconvenience.

There have been some interesting developments in the financial markets over the last few months. Today we’re going to take a closer look at what has happened.

Let’s start with the market that started it: the euro

The euro is in a clear downtrend with the first move occurring at the beginning of the year (a), followed by a relief rally (b) followed by a further move lower. Note also that prices have broken through resistance in the latest move (d). Finally, note the increased volume (e) on the sell-off. This is called a “selling climax” and is a typical volume reaction at the end of a sell-off indicating we’re near the end of the selling.

It’s important to remember why currencies fluctuate in value. When investors think a region is attractive, they purchase the currency, thereby increasing its value. The converse is also true — when investors are leaving an area for investment they sell the currency, lowering its value. Over the last few months, the situation in Greece and other countries has led to investors selling the euro.

The drop in the euro has led to an increase in the dollar:

Note that as the euro has moved lower, the dollar has moved higher almost in an exact inverse relationship. Prices first advanced at the beginning of the year (a), consolidated (b) and then moved higher (c). Also note that like the euro, the dollar has recently sold-off (d), breaking a recent trend-line.

As the dollar has risen, we’ve seen a drop in commodity prices:

At the beginning of the year, prices sold off (a), rallied in a counter-tern channel (b) and then sold-off again (c). They have broken key resistance over the last few weeks.

What’s important to note here is commodity prices are primarily reacting to the dollar and not real deflation — a drop in demand. While there is concern among traders about China and more specifically the People’s Bank of China’s recent raising of reserve requirements to slow the economy, the reality is the drop in commodity prices is more of a repricing of assets caused by the rising dollar.

The drop in the euro has also led to a rally in the US Treasury market:

Since the beginning of April both the middle of the curve (the 7-10 year area represented by the IEF ETF) and the long end of the Treasury market (the 20+ part of the curve as represented by the TLT ETF) have rallied (a). The primary reason for this rally is a “flight to safety” trade where investors move their assets to safer assets in times of market stress.

Finally we have the equity markets:

Notice that on the long term SPY chart, we have three different rallies. The first rally (a) was from 68-96, for a gain of 41.17%. This rally saw an 8.33% (96-88) correction at the end of its move. The second rally (b) saw a rise from 88-115 for a gain of 30.68% and a correction of 7.62% (115-106). The third rally was from 106-122 for an increase of 15.09%. Then we saw a correction from 122-106 for a decrease of 13.11% Notice that the strength of the rallies is decreasing. Also notice that the last correction wiped out the entire previous rally.

The equity markets are evenly balanced between bulls and bears right now. There is obvious concern, but this concern is not serious enough to keep the bears from controlling the trade.

These charts lead to the following conclusion:

1.) The euro may have reached bottom, as indicated by the high volume on the second leg of the sell-off. Bolstering this argument is Spain’s decision to publish stress test results and the EU moving closer to implementing “Euro-tarp”

2.) The drop in commodity prices is primarily a repricing of assets, caused by the increase in the dollar. In other words, we are not experiencing true deflation caused by a drop in demand.

3.) The financial press has ignored the story that US assets are still safe haven assets for traders.