The Futures/Intermarket Report

Trading the World’s Markets                 

May 11, 2007
                                            
Matthew Caruso, CMT                                  
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The S&P 500, Gold & the Canadian Dollar

    Last week we looked at the relationships between Crude Oil and the energy sector, as well as the relationship between Gold, the U.S. Dollar and Gold stocks. The energy and gold sectors have experienced some very large gains over recent years due to the bull markets in Crude Oil and Gold as well as other similar commodities. As a result, the uptrend in stocks that began in 2002 has been a commodity driven rally. This week we will analyze several inter-market as well as sector relationships affecting the S&P 500 futures in order to help understand the strength of the current trend. This analysis can be used with the S&P 500 cash index as well

    We will begin this week’s analysis with a chart of the S&P 500 in relation to the Canadian dollar and Gold as seen in Figure 1. Of the major currencies perhaps none other is affected greater than the Canadian dollar by the price Gold and Crude Oil. Therefore, the Canadian dollar has been a good proxy for the commodity bull market. As well, Gold has traditionally been used as a proxy for metal commodities. With the stock market rally being driven by commodities, it is essential to look for signs of trend reversal in the Canadian dollar and in the price of Gold. Looking back to the spring of 2006, trend changes in the Canadian dollar and Gold have coincided or led a fall in the S&P 500. Similar instances can also be seen going back to the beginning of the stock market rally in 2002, however in order for clarity in the chart we will only look as far back as 2006.

    It is easy to see that a break of an uptrend line in Gold and the Canadian dollar leads to a fall in the S&P 500 once its uptrend line is broken as well.  This relationship is conveying the message that once the underlying strength in commodities which has propelled stock prices higher is removed, stock prices are unable to continue higher. Where does this leave us now? Gold has broken its uptrend line which begins from the March bottom and has formed a pattern of lower high and lower low which is typical of a down trend. The Canadian dollar and S&P 500 are testing their uptrend lines which began as well from the March bottom. The break of the uptrend in Gold casts some doubt to the strength of the up trend in the Canadian dollar and the S&P 500 which began after the March decline. Therefore, any break of the uptrend lines in the S&P 500 or Canadian dollar will carry an increased significance and will likely lead to a pullback in all three markets. It is important to note that the pullback that will be experienced in these markets will be proportionate to the run up preceding them. Therefore, a break of the uptrends which began in March 2007 can forecast only the possibility of a short term pullback as highlighted by previous times in Figure 1. In order to forecast a more significant decline it is necessary to look at longer term indicators of trend.


Figure 1 S&P 500 – Gold – Canadian Dollar

    Another way to view the strength of trend in the S&P 500 is view the S&P 500 relative to the consumer staples sector. This approach is intermediate to long term in nature (6 months to several years) and the previously mentioned method of analysis is better for analyzing the short term trend. The consumer staples sector consists of staple or “safe” stocks such as Budweiser and Altria. The rationality behind this approach is that as the trend of the market grows week, investors prefer the safety of staple stocks over growth stocks. Therefore a decline in the relative strength of the S&P 500 in relation to the Staples sector often leads to declines for the S&P 500. An example of this can be viewed in Figure 2.

    Breaks of the thin blue uptrend lines, which indicate the intermediate trend, have led to intermediate declines which occurred in 2004 and 2006 as highlighted by the green vertical lines. The significance of this tool is increased if the time frame analyzed is greater. For example, the break of the long term 2 year downtrend line extended over the relative strength line in 2002 led to an end of the bear market, as highlighted by the light blue vertical line. Where does this leave us now? The bull market in the S&P 500 which began in 2002 will likely remain intact as long as the thick uptrend line drawn under the relative strength line remains unbroken. The intermediate trend however is weaker than the long term trend. The reason for this is that although the S&P 500 has been making the highest highs of this bull market recently, the relative strength line has not been able to exceed the 2006 high. This is setting up a negative divergence for stocks and may lead to a decline larger than we have seen for several years. However, in order for this to occur we would need greater confirmation by price. Price trend is always the final arbiter and negative divergences should not be acted upon until price begins to change trend. Just the same, we should look out for short term and intermediate trend reversals due to the deterioration in relative strength and in Gold which has been a leading cause for this bull market.


Figure 2 S&P 500 & Relative Strength