Tuesday’s sell-off, or 2 day rally

Monday I wrote a Chart School article in regards to the need to watch the dollar index for a potential turn higher. My belief is that if the dollar were to turn higher and embark on a strong rally, the stock and commodity markets would in turn begin to decline.  This correlation is relatively well known, but some readers have emailed inquiring for more input on this correlation.

I don’t spend a lot of time trying to decipher the “whys” within the markets, but instead I let the charts themselves to do the talking. For this discussion, I will use the SPY (S&P ETF), UUP (US Dollar ETF), GLD (Gold ETF), SLV (Silver ETF), and the VIX index. First, take a look at the following charts of the SPY, GLD, and SLV:

 

Lets first recognize the correlation between the stock market (SPY) and the commodity markets (GLD and SLV).  Specifically, notice the green-circled areas on the 3 charts. Tuesday’s drops were all in sync, and on much higher volume than Wednesday’s rally. So, although the stock market regained all of its Tuesday losses between Wednesday and this morning, the rally has been on lighter volume and the commodity markets have yet to follow. Is this divergence between commodities and stocks a reason for concern?

Now, to see the inverse correlation of the above markets to the dollar, please review the chart below of the UUP:

You can see that the dollar (UUP) has been moving in the exact opposite direction as the stock and commodity markets. Once again, notice the green-circled area and you will see a jump on Tuesday rather than a rally. You will also notice the same volume increase and decrease. As with the commodity divergence, you will see that the dollar has yet to hit a new low even though the stock market has hit new highs over the last 2 days. Who’s right: The stock market, or commodities and the dollar?

Well, are traders/investors getting less fearful, or more fearful? Let’s look at the VIX, which is the volatility index:

A common definition of the VIX is “the fear gauge”.  The idea is simply that when the VIX rises, traders and investors are getting more fearful. So, although it isn’t necessarily “lock in step”, when the VIX moves higher the stock market commonly falls and vice-versa. Interestingly, as the stock markets have inched higher, so has the VIX. Are traders and investors getting more fearful of a market fall? Are the commodity and currency markets confirming this?

Bottom line, the charts above clearly demonstrate that when the dollar is rising/falling, commodity and stock markets are falling/rising and vice-versa. Even though the stock market has continued higher after Tuesday’s sell-off, commodities and the dollar have diverged along with volume.

The Tale of the Tape: The market rally, or potential topping point, hinge on the dollar’s movement. The US Dollar Index (please review Monday’s article: http://www.themeshreport.com/time-to-look-at-the-dollar/) has approached a very significant trend line of support. Unless the dollar breaks lower and the commodities catch up with the stock market, a sell-off seems to be impending.

So, enter new long positions with caution. Protect your portfolio and feel free to “dip your toe in the water” with a short position, but don’t get crazy. Watch the US Dollar Index and commodities for an “all clear” signal, which for the US Dollar Index would be a break of support.

No matter what your strategy or when you decide to enter, always remember to use protective stops and you’ll be around for the next trade.  Capital preservation is always key!

Good luck!

Christian Tharp, CMT