(Another) Cautionary Tale

nospam@example.com (Karl Denninger) — Mon, 11 Jan 2010 11:59:00 -0500

There has been a tremendous correlation between dollar weakness and the stock market's strength stretching back to when the initiation of the apparent dollar carry at the beginning of last year (2009.)

But starting in December this correlation broke down, as the following chart shows:

Here's the concern, as outlined by a zoom-in:

Note that we went - almost instantly, and with very little "transition" - from a negative correlation (that is, dollar up = stocks down and vice-versa) to the inverse, but with a few day delay in the stock market response.

Why is this important? Primarily because of this chart:

Note the support shelf. It's rather important, and this morning it broke - hard.

Now this may be nothing, but that move upward may also be nothing more than a retrace - otherwise called "a bounce" - from the more than six-month decline.

If it is, we are about to enter a really nasty downturn for the dollar, and if the correlation stays positive instead of inverted with the stock market, equities may well get a truly ugly surprise.

This pattern is somewhat nascent, but it ties in with the huge inverted head and shoulders that is found in the long bond, shown here:

Sharply-higher long rates (in this case, targeting 6.8%) are not positive for equities at all. Besides the fact that higher long rates compress multiples in the stock market (due to the yield being better on bonds) it also impacts borrowing costs for everyone.

This move would also imply 30 year mortgage rates around 7.5%. A current $200,000 loan financed at 5% produces a payment of $1069.18 for principal and interest. The same payment financed at 7.5% buys only a $153,868.48 house, or a nearly 25% additional decrease in every home's value in America.

Does this outcome have to happen? Of course not. But the "stars are coming into alignment", with oil recently breaking a pennant flag that targets $100/bbl:

All-in-all this appears to be a time to be extra-vigilant, to protect profits and if initiating new long positions to do with both tight stops and smaller-than-normal size.

With earnings kicking off this afternoon, complacency (as measured by the VIX) back where it was in the latter half of 2007 and everyone prognosticating "great things" for both the markets and economic recovery, divergences such as this are unwise to ignore.

History says that strong upward moves do not die on bad news - they die on good news that "isn't good enough" when traders find themselves without proper protection for their positions, lulled into complacency and salivating at all the "long side" profits they are sure will be imminently forthcoming.

CAUTION: Carry Correlation Update

nospam@example.com (Karl Denninger) — Fri, 20 Nov 2009 12:14:00 -0500

Be very cautious of any thesis you have on continued advancement of the market based on "dollar depreciation."

This is the correlation chart from today thus far:

This may be a one-day anomaly. But it is the most-serious break of the correlation that has been deteriorating for the last two days.

If it breaks entirely the reaction in the market is likely to be extremely violent.

Carry-based asset "appreciation" is inherently unstable, much as is juggling bottles of nitroglycerine.

All is well provided you don't drop one.

Forewarned is forearmed.

The Market Ticker - Technical Analysis

(Another) Cautionary Tale

CAUTION: Carry Correlation Update