Caution Returning to the Market?

An interesting day on several fronts.  First, after trading higher for the majority of the session, equity markets couldn't manage to hold on to their gains and finished modestly lower despite the release of fairly positive retail sales data before the bell.  Fixed income, on the other hand, continued yesterday's rally and saw Treasury yields fall across the curve.  The U.S. Dollar was under pressure dramatically all day and saw the Dollar Index fall nearly 1% on the day to its lowest level since early August.  And, of course, the big story of the day was gold's rally to a new all time high of $1,274.70.  While each of these developments is interesting in their own right, I believe that, if looked at collectively, we begin to see signs of fear creeping back into the marketplace.  Up until today, equity traders have seized upon nearly every positive economic data point as a reason to bid share prices higher.  Clearly this was not the case today, which is a significant change in price behavior in my opinion.  The fact that this potential change in sentiment is occurring near the critical resistance point of 1,131 on the S&P 500 further strengthens the notion that risk-oriented assets may on the brink of pull back and safe havens are ripe for a bounce.  To be sure, one day does not constitute a trend, but the overall behavior of the markets today had a distinctly cautious feel that has been absent over the past couple of weeks.

So what do the technicals say about today's trading?  Have a look at the daily chart of the S&P 500.

As you can see, the appearance of a 'doji' (a Japanese candlestick formation that indicates a market is ripe to move in the opposite direction of the current trend) on the daily chart suggests that the rally is losing considerable steam and is prone to reversing.  Note that the appearance of a doji in early July coincided with the bottom of the June sell off.  Furthermore, the chart gap that I mentioned in last night's post has remained unfilled, which should continue to bring technical sellers into the marketplace.  For those unaware of the implications of chart gaps, think of them as points where the market has gotten ahead of itself.  In this case, the market became significantly more bullish between Monday and Tuesday and, therefore, prices opened above Monday's high trade.  This means that the overall market became more bullish on Tuesday than Monday's most bullish trader.  Needless to say, this is a dramatic shift in sentiment in a very short period of time and indicates that prices went too far too fast.  As such, the gap that is left is like an air pocket:  So long as you stay out of it there isn't too much turbulence.  But once you break into it, your likely to see a short, fast drop (rise if the market is trending lower).  The bigger, the gap, the bigger the potential turbulence.  Fortunately for the bulls, this gap is fairly small.  However, in light of the potential shift in sentiment that I'm seeing, the fact that a chart gap below current levels remains in place suggests, to me, that this market is truly overbought and ripe for some sort of correction.

Check out the longer-term weekly chart and the numerous failures near the 200-day exponential moving average.  This is certainly suggestive of an equity market that is ripe for some kind of pullback. 

If my thesis about investor sentiment shifting to the bearish side of the ledger is correct, the action in the U.S. Dollar is quite concerning.  To this point, a dip in risk-based assets has been paralleled by a pick up of buying in the U.S. currency as investors sought safe assets in which to invest their capital.  However, look at the weekly chart of the U.S. Dollar Index below.

As you can see, despite the slight weakness in equities, the dollar was sold rather hard today.  This continues a larger trend that has been in place for the better part of two months now.  However, the fact that equity weakness did not elicit any meaningful bidding of the U.S. Dollar is illuminating.  It is possible, but by no means confirmed at this point, that investors around the world are growing more an more concerned about the fiscal state of the United States and, therefore, are shedding dollar-based positions in an effort to diversify their holdings.  To an extent, today's move to new highs in the gold market supports this notion.  While dollar weakness has, in the past, coincided with higher gold values, this relationship virtually disappeared the past few months.  The fact that it may have come to life once again today says a lot about where the concerns potentially lie.  If this dollar selling proves sustained, investors will likely move away from concerns about domestic deflation and once again focus on potential inflation.  Without a doubt, this is a trend worth monitoring very closely.

As I said at the outset, today was a very interesting day.  Lots of interesting developments, though nothing to hang your hat on as yet.  Equity volumes remain light, though, so it's still perilous to read too much into any one day's performance.  That said, I remain skeptical of the equity rally in here and will continue to remain defensive for the foreseeable future.  The fact that equities sold off in the face of positive economic data, however, says a lot about where things are likely headed.  A bullish market moves higher on mediocre news and jumps to new highs on good news.  We were within striking distance of the 1,131 level and didn't even get close to punching through.  Who knows?  Maybe we'll move through this level on tomorrow's open?  But, with my money on the line, I wouldn't bet on it.  At least not for now.  Until tomorrow.....