Friday, July 10, 2009

WorldMarketsGuide Friday Preview: What Killed the Rally & Now What?

Markets Stabilize at Multi-Month Support, Reflect New, Higher Level of Fear

(As of approximately 11:00 GMT Friday, 7:00 am EST)


Summary

Most major world stock, commodity, and forex markets indexes have been stabilizing and trading in relatively tight trading ranges Wednesday and Thursday, reflecting indecision, await next clues from earnings.

We include a review of why markets dove after last Thursday's NFP report, and how the context in which it came was key.



Introduction: OK, Recovery Delayed, Now What?


For now, most markets have settled into tight trading ranges at lower levels, sometimes much lower levels, than they did just over a week ago.

As of last Wednesday, uncertainty over the monthly US non-farm payroll data was already pressuring most markets lower. The actual results were much worse than expected, and showed that US job losses are not bottoming out. The fine print was even worse. Average hourly wages were flat, and average hours worked was dropping. In sum, the US consumer was getting decisively poorer and more fearful, as even those with jobs were overall earning less.

To understand why this news seemed to be the final blow to hopes for a near term recovery, consider the context.

  • Global Stock Markets (and other risk-asset markets like commodities and higher yielding currencies) were at near their highs for the year, typically up 20-30%,
  • The economic news for May and June had been at best mixed, raising questions whether the rally was overdone and vulnerable to a pullback.
  • Thus most markets spent June bouncing within relatively tight trading ranges awaiting news to clarify whether the recovery was in fact coming soon enough and strong enough to justify current prices
  • Perhaps the biggest news of the month was the June 22nd World Bank's downward revision of its world economic growth forecast, which was contradicted soon after by a more optimistic report on world economic recovery from the OECD. The World Bank said that not only was there still contraction, the dive was deepening, not slowing down. The OECD contradicted that report with a more upbeat view that was based on a more optimistic view that US growth would be strong enough to outweigh an admittedly worsening situation elsewhere.

    Thus the bad news from the US NFP report undermined the OECD view, and tipped the prevailing balance of opinion towards delayed recovery and weaker economic growth for the US and most of the world.

    While markets are down since the start of the week, the past two days has seen stabilization as most markets trade in tight ranges at new, lower support levels as they await further news.

    In sum, hopes for a substantial recovery within the coming year appear to be if not gone, then certainly forgotten for now. With the start of US Q2 earnings announcement season Wednesday, markets are watching for an overall positive or negative theme from earnings results to provide the next major direction, and until the next big news seem settled into tight horizontal ranges.

    There have been exceptions.


Currencies

For example, the USD/JPY continues to dive, despite the lack of any clear news to justify the move. A combination of factors have been suggested by analysts (like narrowing spreads between rates on US and Japanese government bonds, the greater effect of lower oil prices on Japan's economy) but this is at best speculation, since they don't appear to justify such a hard dive relative to other pairs with equal or greater differences in risk.

Thus it may be that this pair is due for a possible near term stabilization and rebound, though as of this writing the decline continues with the pair around 92.60.

Commodities

While most commodities have followed stocks and have held to relatively tight ranges, there has been more movement in this group. Crude and gold continue to move down, as has soy beans.

Global Stock Indexes

Most in tight trading ranges over the past 2 days, with the DAX alone rising since Wednesday on better than expected industrial production and trade balance news.

Otherwise, stocks appear to be waiting for an overall positive or negative picture to emerge from Q2 earnings season.

Of all these earnings, the most important will come from the financial sector, for these earnings reports have been the root of the current crisis and major market shifts over the past two years. These will begin to come next week.

As noted in recent posts, we believe that the stock indexes best reflect the fear/greed level in world markets and thus drive forex and commodity markets. Here's a review of our thinking

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?


Conclusion

Thus there are trends for trend traders, and horizontal ranges for those preferring that kind of situation. Of course, there is 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 do not necessarily reflect those of AVAFX.

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