US bulls find their wings

US equity markets are showing no sign of bowing to a correction, and they may climb higher yet.

PORTFOLIO POINT: As US equity markets continue to move higher, the S&P500 may soon test its 2011 high, and there are reasons to believe it could keep going.

Since last Tuesday’s 2% melt-up in the broader US equity markets (March 13), there has been no follow through and no pullback of any kind. I thought by the time I returned from my four-day break the situation would be clearer – it’s not.

You may remember that on March 15, I highlighted the fact that Dollar Yen (JPY) had “broken above a 5-year declining trendline.” Japan had posted its first annual trade deficit in more than 30 years and, in response, the BOJ added 10 trillion yen to its asset-purchase program (money printing) in an attempt to devalue the yen.

Above is a chart of Japan’s monthly balance of payments (trade balance) in billions of yen going back to 1985. You can see that Japan had a positive trade balance until the GFC, which turned out to be a blip on the chart.

However, since the March 2011 earthquake, Japan’s trade balance has slipped into the negative, where it has stayed. If this trend continues, it will put real pressure on Japan to fund its huge mountain of debt, which until now has been possible with internal savings.

While this could spell disaster down the track, the yen weakening has been a risk-on signal for the broader markets, as the carry trade comes back with a vengeance. The JPY weakening is bullish for Japanese exporters and, in turn, has propelled the Nikkei to over 10,000, another major positive.

It therefore makes sense that we should keep a close eye on the JPY, as it is another barometer for the risk trade.

While I highlighted some bullish divergence in the JPY last year (in green on the chart below), we have now formed a bearish divergence (in blue on the chart below). Bearish divergence is where we make a higher high in price, yet the Relative Strength Index (RSI) makes a lower high.

(Please bear in mind that in the chart below, as the JPY rises it is actually weakening, as it is quoting Dollar Yen rather than Yen Dollar).

Divergence doesn’t always lead to a correction (Apple shares are a perfect example of divergence not working). However, when combined with the Commitments of Traders (COT) report released by the Commodity Futures Trading Commission (CFTC) this week, we just might be about to see a reversal of the JPY.

CFTC classifies individual investors, hedge funds and some large financial institutions as non-commercial traders or, more commonly, speculators.

Below is the weekly chart of the Japanese Yen Net Non-Commercial Futures positions and you can see that it has plummeted from 60,000 in early October 2011 to -42,380 now. In other words, speculators have gone from being very long the JPY to short.

I have circled two other occasions when speculators have got very short the JPY – May 2010 and April 2011. Both led to sharp equity market declines.

While we are not quite at those levels, we are not far off. If the JPY is on the verge of strengthening, then perhaps this latest melt-up in US equities is a climax, rather than the start of a new and sustained run higher.

The weekly chart below of the S&P500 goes back to 2007, where you can see that it spent the whole year above 1400. After testing 1400 to the downside on two occasions in 2007, it finally broke down through that level in the first week of 2008, where it made a low of 1256.

It then rallied and retested 1400 from below; it made a high of 1440 and then failed miserably, breaking back below 1400 and falling to its ultimate low of 666 in March of 2009.

You don’t have to be an expert to realise that a sustained break above 1400 could lead to a new and higher trading range that could eventually lead to a test of all-time highs.

We now have to open our minds to the possibility that this market could go substantially higher. However, we can’t forget that the market does remain fractured. The Transports, the SOX, the Russell 2000 and the Australian dollar all remain well below their 2011 highs, while the S&P500, the Dow Jones and the Nasdaq all have bettered their 2011 highs.

The macro risk still remains and even if you are bullish, the S&P500 has risen 11% this year already and the US Banking Index is up 26% for the year, 9% of that coming in the last week alone.

The daily chart below of the S&P500 highlights that we now have divergence on the RSI and the index is still kissing the lower side of its rising wedge pattern.

I see it like this: the S&P500's most recent burst will grind to a halt shortly and then will retest that 1370 to 1380 level, which is the 2011 high and the breakout region. If that test holds and we regain 1400, then I will be impressed; if it fails and we fall back below 1370, my bearish stance will still be alive. For now, I am sitting on the sidelines.

Nymex Crude recently broke out of its rectangular sideways pattern that it had been in since November 2011. Last week, it came back down to test that break-out level (103.50). It held successfully and now looks like it is heading higher.

As long as crude remains above 103.50, don’t expect too many miracles from the US consumer. Interestingly, US consumer confidence came in slightly weaker on Friday; I am sure higher energy costs had something to do with it.

In my note 'Watershed Week for the Australian Dollar’, I said that “both the 60 and 200 day moving averages will act as support at 1.0499 and 1.0407, but I expect them both to be tested.” Well, the Australian dollar nearly got to my lower level last week, making a low of 104.23 and has since recovered swiftly, closing the week at 1.0590.

The 50% to 61.8% retracement level of the recent high to last week’s low stands at 106.40 to 106.90. I will be looking to sell that level, with a stop above 107.55.

The Ides of March came and went without anything sinister happening. The broader US equity markets have now been rising for months, showing signs of distribution, low volume, non-confirmations and extreme levels of optimism – yet they have refused to correct. Perhaps I should just relax and go with the flow. Something, however, tells me to stay alert.

Tom Lovell is an analyst and independent investor.