Dow viewed darkly through currency lens
The eye-catching rally of the Dow Jones Industrials over the past 12 months looks good, but when viewed through the lens of currency weakness, the market may be flashing warning signs that a key reversal is nigh, according to one trader.
Glance at a chart of the Dow in US dollars, and then compare that same chart priced in South African rand and it is easy to draw conflicting conclusions about the strength of the US recovery, says Sol Palha, senior analyst with New York market advisory Tactical Investor.
The dollar-denominated Dow chart reveals a powerful nine-month rally from the 7,400 low in March to a two-year high last week, just above 10,500. Powerful evidence of a sustained recovery? Not so, according to Mr Palha, who says the same index denominated in rand shows a market that has meandered sideways for most of the year, caught in a tight trading range little higher than its March lows.
'If you price the chart in US dollars the chart looks really beautiful. I mean the pattern looks remarkably bullish. You could be fooled into thinking we are in a super bull market,' Mr Palha says. 'However, if you price this in rand it shows that the Dow is basically flat and moving sideways.'
While sceptics could argue the appreciation of the rand may be an aberration, Mr Palha says similar results could be obtained by converting the charts a number of strong currencies that have outperformed against the dollar in the past year.
What is really driving the Dow rally, Mr Palha says, is monetary inflation. Take into account the declining exchange value of the US dollar and the market appears nowhere near its former highs.
To compensate for dollar depreciation, the Dow's 2000 high of 11,700 in today's greenbacks would be more like 15,795.
'So even if we pass 11,700 right now we cannot call that a bullish breakout because we would have to break past 15,795 to call it a new bull market,' he says.
'The Dow is basically adjusting for inflation of the money supply right now. Obviously if you have more billions there chasing the same stocks, they have to go up, but it doesn't mean they've increased in value.'
Convert the price charts of any number of stocks that look good in US dollars into rand and you get similar results - sideways movement. The danger, says Mr Palha, is these patterns do not look particularly healthy as tight trading ranges tend to break in sudden and drastic moves.
'Normally a channel is very positive when you form a bottom and are moving up, [but] with the Dow it is exactly the opposite. We've formed the top and are moving sideways,' he says. 'What this is showing us is that at any given time the Dow could suddenly crash. The question is when. I would not be long-term bullish.'
One worry spot, says Mr Palha, is that retail investors who have so far remained weary of the stock market are just beginning to pile back in. 'They have been viewing this rise with scepticism, but now they are suddenly more bullish because they feel they have missed the boat. I think we are reaching the frenzy stage right now.'
Instead of the stable market that has risen consistently for nine months without a 5 per cent pull back, we may be about to enter a period of volatility more suited to professional traders. Mr Palha says the broader market has not been behaving like a normal bull market at all. Currently between 17 and 21 Dow constituents are overbought, while nine to 11 are oversold. It is the kind of churning market that gives the edge to market timers, those with good defensive strategies, and those who can trade in and out of the market on a dime. 'People who went long were actually losing money as the market went up because you have pockets of severe corrections,' he says. 'It is not an overall bull market, you have to be able to spot and pick sectors and time it.'
Ironically, the divergence between the number of overbought and oversold constituents gives Mr Palha cause to think the market has further to run in the short term. He expects the Dow to charge at the 11,000 level and possibly make a break for its all-time high of 11,700 before falling into a dramatic correction at the 9,800 level. Following this, investors should expect a succession of mini rallies marked by lower highs.
Longer term, Mr Palha says he would not be surprised to see the Dow decline to 1,500, but those days are a long way off.
'This year I am more bullish than bearish,' he says. 'At some point near the end of the year we are going to have a severe correction. In between we are going to have a lot of volatilit.'
YHis winning themes this year include commodities, biotechnology and the relatively new area of nano-technology. On the commodity front he prefers the energy sector, with emphasis on natural gas, oil services and oil-drilling companies.
He cautions that anyone playing the market should be prepared to ride out sharp pull-backs. Commodity sector stocks should be cushioned from dramatic declines, but those with stakes in technology themes may be in for pain.
Mr Palha holds a substantial position in both bullion and the shares of gold-mining companies, but he doesn't advise any buying at the moment, believing that better prices lie around the corner.