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3 Things - New Highs, Dollar Rally, Margin Debt

Submitted by Lance Roberts via STA Wealth Management,

These New Highs Look Like The Old Highs

There has been much commentary over the past week as the S&P 500 reached new highs. The issue, for me, is that these "new" highs look much like the old highs that we have seen since October of last year.

Each successive new high has been driven by a rather spectacular advance, historically unprecedented, subsequently followed by a sharp decline that leave investors a bit paralyzed.

As I discussed yesterday, momentum has been a key driver in the market as of late as the “fear” of missing further gains has overridden the logic of deteriorating fundamentals. As shown in the chart above, each decline has stopped at bullish trend line. The exception was the October decline which held longer term support but rallied back on the announcement of a massive QE push by Japan. Currently, the “bulls” remain in charge of the market for now.

The current advance to “new highs” in the market looks much like the “old highs.” The issue will be whether the ensuing correction, which may be underway now, will continue to hold the “bullish trend” while working off the overbought condition of the market on a short-term basis.

It is worth noting that at some point the trend will fail. It will be then that the mentality of the “herd” reverses and the chase of “returns” becomes a chase for “safety.”


Is The US Dollar Rally Complete

One the impacts to corporate earnings, due to the impact on exports which makes of roughly 40% of corporate profits, has been the recent surge in the U.S. Dollar. The dollar became the “safe haven” of choice as the Federal Reserve wound down the latest version of QE, and the deflationary pressures in Europe gained traction pushing the majority of those economies towards recession. Furthermore, the fear of a “Greek Exit” from the Eurozone made holding Euro’s less favorable in the event of financial disruption.

As shown in the chart below this pushed the dollar from near historically low levels to an extremely overbought condition in a relatively short period. However, the current dollar rally is not unprecedented.  As shown below, the dollar had similar rallies in 2008 and 2010. The difference this time is that the dollar rally hasn't resulted in falling asset prices. Yet.

With the dollar now 3-standard deviations overbought, and pushing a 50% Fibonacci Retracement, the US Dollar trade has become extremely crowded.

The risk to the dollar trade currently is a shift in money flows from the U.S. Dollar back into the Eurozone. IF, and this is a rather big “if”, the ECB is successful in generating a positive feedback loop into the Eurozone via their bond buying scheme, there could be a rather substantial reversal of those long dollar flows.

This is a bet that is currently being made by most asset managers as they “front ran” the ECB and piled into European stocks.

The interesting point here is that someone is going to be VERY wrong. However, the last time that there was this much bullishness on Eurozone equities was in 2006 just before the dollar started to fall.


Margin Debt Sends A Warning Signal

I discussed earlier this week a variety of warning signs that are popping up across the financial markets and the economy. The latest indicator to send off a warning was margin debt.

As I have discussed previously:

"What is important to remember is that margin debt 'fuels' major market reversions as 'margin calls' lead to increased selling pressure to meet required settlements.  Unfortunately, since margin debt is a function of portfolio collateral, when the collateral is reduced it requires more forced selling to meet margin requirements.  If the market declines further, the problem becomes quickly exacerbated.  This is one of the main reasons why the market reversions in 2001 and 2008 were so steep.  The danger of high levels of margin debt, as we have currently, is that the right catalyst could ignite a selling panic.


The issue is not whether margin debt will matter, just 'when.'  Unfortunately, for many unwitting investors, when that time comes margin debt will matter 'a lot.'"

Importantly, it is not the "rise" in margin debt that is worrisome. As long as margin debt is rising it is providing support to rising asset prices. However, as Norman Fosback, former President of the Institute for Econometric Research, pointed out in his book "Stock Market Logic", it is the fall.

"If the current level of margin debt is above the 12-month average, the series is deemed to be in an uptrend, margin traders are buying, and stock prices should continue upwards. By the same line of reasoning, sell signals are rendered when the current monthly reading is below the 12-month average. This is evidence of stock liquidation by margin traders, a phenomenon that usually spurs prices downward."

As shown in the chart below, only for the 4th time since 1995 have margin debt levels fallen below their 12-month moving average. (There was a small tick below the 12-month average in 1998 during the Asian-Contagion/LTCM crisis)

Each decline below the 12-month average in the past has coincided with fairly large market corrections. While the current decline in margin debt does NOT mean that we are about to enter into the next major market reversion, it does suggest that the current bull market trend could be at substantial risk.

Lastly, we can take a look at the Relative Strength of margin debt as compared to the S&P 500 going back to 1959. While declining levels of relative strength are not ALWAYS indicative of a decline in asset prices, there is a fairly high correlation when the RSI begins to fall from 80 or above to 60 or below. Currently, RSI for margin debt is at 58.06.

As I summed up previously:

"What the data doesn't tell us is whether it [the next correction] will be a 'buy the dip' opportunity or something much more significant. Given the length of current economic expansion and cyclical bull market, the fact that the Fed is extracting liquidity from the markets, and the current extension of the markets above their long-term moving averages, there is cause for real concern."

And then there's this...

Chart: US margin debt ringing the bell?

— Callum Thomas (@Callum_Thomas)