The Beginning of the Next Leg Down, or Just a Correction?

That is the question everyone wants to know. Are we simply consolidating before assets move up, or are we getting ready to turn over and crash again?

It's a difficult question to answer.

The first thing to realize is that trends in the short term lead to events in the intermediate term, which then lead to the long term.

Because of fundamentals, we know the likely outcome of the long term. What is difficult is understanding how the short and intermediate term may influence the long term.

Also, in the very short term (next few days), it is virtually impossible to predict events.

So our goal is to predict primarily the intermediate term changes based on both short term events and trends while keeping in mind the long term possible outcomes.

With that said, one of the main themes we've been discussing is the asset correlation that is occurring. In a critical period such as this, we need to ensure that the fundamental theme of correlation is or is not intact. To check the dollar/stock market inverse correlation, we're plotting the S&P 500 versus the dollar. The inverse correlation is quite easy to see.

Note that since March, the stock market has risen while the dollar has fallen. The down trend of the dollar is showing with the red descending line from March through today. The up trend line of the S&P, which is the best measure of US equities, is shown in blue.

The blue horizontal lines are areas of support for stocks--areas where there will likely be some buying. If and when stocks fall below these levels, it shows increasing degrees of weakness. We expect a pullback to the 970 level, and possibly a very minor bounce. Then a bigger pullback to the 946 level, which is the strong support for the S&P. If this level is breached, we'd get concerned that the short term correction could turn into an intermediate term correction. In m

The red horizontal lines are areas of resistance for the dollar. The first level of resistance is 79.50, which may hold, meaning the dollar move is over. There is a possibility that 79.82. If we break above that level, we're going to be looking at an intermediate term move. That would be a break out of our descending right triangle pattern that formed in March and an indication that we may have trouble on our hands like we did last fall.

Below we have a short term (daily) chart of the S&P 500.

Note that we have an "active" inverse head and shoulders pattern right around the key neckline support level of 946 (purple line). Again, that level is critical. At the same time, we have been running along the upper boundary of the megaphone pattern that we pointed out in prior discussions (green trend lines).

It is definitely time to be cautious. For a continued stock market rally, we'd like to see a pull back to the neckline level of 946 or so, then a turn back to the upside on high volume. The RSI should not fall below the trendlines (the solid red line is the March trend, the dotted red line is the "critical" line.)

At this stage, we believe we'll do just that. A pull back within the area circled and a serious bounce on the trend line. A violation of those trendlines will be a big sell signal.

The chart below is of the intermediate term S&P 500.

Note that we are overbought (Slow stochastic above 80) on this chart. You can also easily see the "possible" active inverse head and shoulders (Only "possible" because the volume didn't really take off when the neckline was pierced). The count for this pattern takes us to 1350! Hard to believe given the lousy economic conditions we have. At this stage, we tend to believe we're simply going to pull back toward the neckline at 950 level and then make a run toward 1350. However, we also believe at this stage that the rally may fail around 1100 due to some proprietary, internal measures. That would be enough to suck in many more bulls before the end. We'll be watching for the RSI to fall to the red trend line and bounce. A break of the trendline will be a warning, though not necessarily a showstopper.

Of course, the dollar governs all. Below is a clearer chart of the dollar since March.

You can see that as long as the dollar stays below the red trendline connecting the rallies, the downtrend is intact in the short term. The RSI is right around 50 right now, and since March, that level has only been violated once. A violation of the 50 level will be a "yellow flag," but not a panic signal unless the equity market also violates the levels described above.

A closer look at the dollar in the last few months can be seen below.

We can see that today, the dollar just touched the key resistance level of 79.55, which is the 50 day moving average. That may hold the dollar down, and if so, it will generally just move sideways within the larger triangle (on the previous chart) until it gets "overbought" on the slow stochastic and turns over. That's our first scenario, and that can happen in a fairly short period of time.

Above the 50 dma, we have the top of the Bollinger Band at 79.82 as resistance.

A breach above that level accompanied by problems in equities, and we're going to have to determine if we're about to revisit the credit crisis again.

We'll finish up with gold.

Longer term, gold is gearing up for a very big move if it can break the 1000 level decisively because of a complex inverse head and shoulders that counts to the 1300 range. In the intermediate term, gold is in a symmetrical triangle, which is going to have to break one direction or the other in the next few weeks. Unless we have a return to the credit crisis, we anticipate the dollar turning over and gold breaking out of the triangle to the upside. If we return to the credit crisis, we anticipate gold and the dollar breaking to the upside. You can't go wrong with gold in this environment.

But when to buy?


You can see the symmetrical triangle clearly here. Maybe a day or two of down movement and the slow stochastic moving to oversold (below 20) will be a good trading entry point. For longer term investment, we are accumulating here since it appears 930 will be difficult to break below.

In summary, either the dollar move is just about done, or we're in for a multi-month run up in the dollar. At this stage, we're not of the opinion that this is anything more than a short term move, but we will know for sure in a few days. With the correlation holding, the implication is potentially a monster move up in stocks, commodities, and especially gold.

However, if the dollar moves up and breaks out of its general downtrend in the next few days, it will be time to move to cash and gold to wait out another crash in markets.

Fundamentally, we know that the Fed and the US government needs the dollar to fall in a controlled manner. We will not be in the business of fighting the Fed as it tries to weaken the dollar over time.