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A Review of Our 3 Favorite Leading Stock Market Indicators

by Brett on July 25, 2010

These days we are keeping a keen eye on markets that have been reliable leading indicators of the stock market.  Since 2004 or so, markets have become quite interrelated, creating a lot of interesting relationships in markets that previously had little or no correlation.

The correlation of course peaked during the 2007-2009 downturn, when EVERYTHING dropped by about 50% (except for US Treasuries and the US Dollar).  I still believe that was the market tipping its hand, showing a glimpse of an even worse crash to come.

When that crash would (finally) start was something we took at look at this January, when we analyzed the Top 3 Investment Themes to Watch in 2010.  On March 29th, just weeks before US equities topped, we revisited the charts of some key leading indicators, and concluded that the reflation rally was perhaps on its last legs:

These non-confirmations could be ominous bearish divergences, indicating the reflation rally is on it’s last legs. The rally appears tired, but is not over yet.

Since it appears that this conclusion was, thus far at least, correct, I’d like to revisit some of our favorite charts – taking a long term perspective – to see were we are at.

Crude Oil – Trading Sideways

Crude caught my eye on Friday when I saw a headline that it was making two-month highs.  Taking a longer term view of crude oil, it’s performance looks less impressive:

Crude Oil Price Chart July 2010

Crude oil rallied fast and furiously to retake about half of its 2008 losses.  It has since stalled.  (Source: StockCharts.com)

Crude oil last bottomed in December 2008, about 3 months before stocks.  For an indication that this rally is “still on”, we’d expect to see new recovery highs for crude oil in conjunction with new highs in US equities.  Currently both are below their April highs, and both appear to be i nthe process of rolling over.

Chinese Stocks Head Down – Again

In January’s article, we pointed to China as the “Global Economic Savior” of the world:

China has been billed as the posterchild of the global economic bounceback. Which seems appropriate, as it was also the star of the 2003-2007 credit fueled equity liftoff globally.

“China is fine,” pundits say. Well, perhaps. But rather than rely on various analyses and opinions on China, I’ll stick with the lazy man’s approach – watching the stock market itself.

In late November, we pointed to a potential downturn in Chinese equities as some dark clouds on the financial horizon.

How’s China done since then? While still perched above its 200-day SMA, the Shanghai Composite appears to be embarking upon a third attempt to take out its early August highs.

A third failure would increase the likelihood of a Chinese breakdown, and a breach of the 200-day SMA (red line above) definitely would. And if that happens, look out! I’m not sure the re-flation trade could withstand this.

Chinese stocks indeed failed to take out their previous recovery highs.  They now trade below their 200-day SMA, and the trend is DOWN.

China Shanghai Index Stock Price Index Chart 2010

China rolls over – again.  (Source: StockCharts.com)

The US Dollar: The Linchpin of Global Liquidity Flows

For some time, we identified the dollar as the “linchpin” of the financial markets.  Since 2004, it’s been dollar down, everything else up – or dollar up, everything else down.  (Also see: Are any markets safe right now?)

In January, the dollar had already turned up:

Can the reflation trade continue to motor along if the dollar mounts a sustained rally? If the first wave of the global meltdown was any indication, then probably not. We haven’t yet seen any evidence to invalidate the “all the same markets” hypothesis.

Is the dollar’s recent upturn tipping off an impending markets downturn? In my opinion, this is the primary theme to keep an eye on in the first quarter of 2010.

The equity markets did make it through the first quarter on the upswing, but ultimately stalled in April.  The dollar, in the meantime, looks like it’s taking a breather:

US Dollar Price Chart 2010

The dollar rallied like hell from November ‘09 til June ‘10.  (Source: StockCharts.com)

By June, we saw extreme bullish sentiment readings on the dollar – and were due for a pullback.  That has since happened.  Are we now setup for another leg up in the dollar?  One that would coincide nicely with a wicked leg down in stocks…and just about everything else?

Bottom Line: Investor sentiment is fairly bullish these days, on the heels of a fairly positive earnings season to date.  But, some longer term charts are not looking as rosy.  The price action in Crude Oil, Chinese Stocks, and the US Dollar may be indicating that the next leg down in US stocks indeed began in April.

Related recommended reading: John Hussman on why the S&P 500 is overvalued by 50%


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