Lots of Movement, Little Direction

I've got company headed to the house tonight and have some things to get done prior to their arrival, so I'll go ahead and apologize for the shorter than normal post today.  For what it's worth, I've been reading a lot of interesting papers/articles the last few days that will make for great posts, so stay tuned.  It'll be worth the wait.

With that out of the way and as the title of this posting implies, the trading action today was quite volatile, though most markets closed at or near unchanged.  This spike in volatility is something I suggested might occur as a result of so many markets being perched at or near their breakout/breakdown levels.  The charts below clearly show this to be the case for both the S&P 500 and the Dow Transportation Average.

As you can see on the daily S&P chart, the market found support right at its near-term upward sloping trend line.  For the bulls, this bounce and close above (barely) the 1,100 level are positive signs, but far from convincing at this point.  More than anything, this is a sign that the markets are still in a holding pattern until something pushes the action in a specific direction.  Look at the daily chart for the Transports.  As you can see, the index simply vacillated between the 50% and 61.8% Fibonacci retracement levels.  Yet another sign that this market is dazed and confused.  Volume over the past few sessions, again, held at dreary levels, further adding to the murkiness of it all.

I have spoken a few times of my interest in identifying trends that are diverging from their expected paths.  In my view, these are signs that things are out of kilter in at least one of the divergent markets and, therefore, there are profitable trades to be made by taking advantage of this development.  Below are a couple of comparison charts I pulled together today that were quite interesting.

As you can see, the near lock-step movement between the Euro (as valued versus the U.S. Dollar) and COMEX Gold prices has been completely disconnected since late last year.  In that time, gold has continued to rally while the Euro, until recently, sold off rather dramatically.  This says a couple of things to me.  First, investors are looking less and less to gold as a means of currency hedging and, therefore, gold has been trading purely on momentum.  This is not to say that the momentum can't continue, but this does imply that a pullback in gold prices could be over due and fairly dramatic if/when the correction occurs.  Second, the recent upward move in the Euro has been met with lower gold prices.  Again, the currency effects appear to be completely disconnected from gold prices.  It is possible that European investors flocked to the safety of gold while the Euro moved lower and are only now selling their positions, but this doesn't seem likely.  At the very least, this makes me want to steer clear of the gold market for the time being as it's so difficult to assess its ultimate direction.  Those willing to take some risk might try a short play on the commodity, but tight stops will be needed along the way as prices tend to move quickly in the gold market.

Another interesting chart that shows how corporate bond prices have continued to rally despite the recent down turn in equity prices.  As you can see, corporate bond prices tend to be a leading indicator for share prices, so this divergence could suggest that the rally that I'm expecting is on the way.  It could also mean that shareholders have decided to move up the capital structure to the relative 'safety' of bonds as a way to lock in yield and reduce the volatility in principal balances.  However, given the amount of debt issued by corporations over the past two years, the willingness of investors to snap up these issues in spite of the additional supply suggests that they believe the business prospects for these firms are at least intact and somewhat stable.  This would be supportive of share prices as well.  With no clear cut way to discern which market is over/under valued, a spread trade would be a good way to take advantage of this disconnect.  By shorting the corporate bond index and buying an equal amount of the S&P 500, any compression in this divergence should yield a fairly nice profit for investors.  This could be done by shorting an ETF like the LQD (investment grade corporate bond index fund) and buying the SPY (S&P 500 tracking ETF), which would cost about $0.50 per share to initiate.  While likely not a strategy for the average investor, it's at least worth thinking through the logic as a way to get a better sense of the market.

And with that, I'm off to play host.  I'll be waiting with baited breath for the GDP numbers tomorrow as I think it's going to push us out of this range bound trade.  Hopefully, I'll be on the right side of this volatility.  Until tomorrow.....