2/13/2011

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2/13/2011

February 13, 2011 Leave a comment Go to comments

Table of Contents

Status of Key Market Parameters
U.S. Treasury Yield Ratio Broke Down a 7-month Roof Pattern
Downward Treasury Yield Ratio Historically Correlated to U.S. Stock Bull-Market
S&P 500 Index Bullish Continuation after Breakout from Cup-with-Handle Pattern
Ratio of S&P 500 Index to World Stock Index Breakout from 2.5-Year Triangle
Gold in Uncertainty with Global stagflation

Current Status of the LWX (Leading Wave Index)

The LWX Indicator in Last Four Weeks (Past)

The LWX Indicator in Next Four Weeks (Forecast)

U.S. Treasury Yield Ratio Broke Down from a 7-Month Roof Pattern

The treasury yield ratio is the ratio of a long-term treasury yield to a short-term treasury yield. Although the yield ratio is not plotted exactly same as the traditional yield curve, it has a similar importance to gauge changes in rates and maturities of treasury securities that will impact on financial markets.

The yield ratio goes up as the spread between a long-term and a short-term rates widens, and vice versa. The following chart is a daily chart of the yield ratio of the 10-Year U.S. Treasury Yield to the 2-Year U.S. Treasury Yield. This yield ratio kept climbing up from near 1 to over 7 during last four years, and it reached 7.85 in the early of last November, which is the highest level in 20 years.

However, the yield ratio decisively reversed right after November 3, 2010 when the Fed announced $600 billion QE2 that is a program of expanding the central bank’s balance sheet by buying long-term treasury securities in trying to drive down long-term interest rates.

On the yield ratio chart, the yield ratio formed a 7-month roof pattern that is a typical topping formation. Just last week, on February 8, the yield ratio penetrated through the horizontal line of the roof pattern and confirmed the reversal of the yield ratio. As the Fed keeps adding pressure to long-term interest rates by QE2, the yield ratio should be expected to continue the downtrend that will bring significant changes to a broad range of financial markets worldwide.

Downward Treasury Yield Ratio Historically correlated to U.S. Stock Bull-Market

During the last 20 years, there have been three incidences when major downward slopping on the treasury yield ratio occurred. The chart below shows the correspondence between the yield ratio (plotted in black line) and the S&P 500 index (plotted in grey area).

The first one was in 1992-1994 when the ratio went down from 1.67 to nearly 1, corresponding to a 15% advance in the S&P 500 index. The second time occurred in 1995-2000 when the yield ratio declined from 1.17 to 0.92, corresponding to a 200% advance of the S&P 500 index. The third one happened in 2003-2007, when the yield ratio dropped from 2.8 to below 1, corresponding to a 73% advance in the S&P 500 index. Almost every downward slopping of the yield ratio was correlated to a stock bull market with S&P 500 index.

Also, another observation is that the stock market either had a flash crash or started a bear market every time the yield ratio reached the level 1 or under. The current level of the yield ratio is about 4.25 that is till historically high. The ratio has plenty of room to the downside before it reaches to 1. The high level of the yield ratio is like a fully charged battery and it could skyrocket the stock market when it discharge the energy as the Fed’s QE2 is implemented.

S&P 500 Index Bullish Continuation after Breakout of Cup-with-Handle Pattern

As I discussed in my market weekly update on 12/5/2010, the S&P 500 index formed a 8-month Cup with Handle pattern last year as shown in the following weekly chart. This is a bullish continuation pattern having two parts: 1) a cup, and 2) a handle after the prior 13-month uptrend with 83% advance from March of 2009 to April of 2010 led to the cup. The cup was formed from last May to last October, and the handle was formed last November. Then the market broke out the upside of the cup-with-handle pattern in the early of last December with an upside price target projected at 1440 for the S&P 500 index.

This bullish projection is coincident with the bullish views of both the presidential pre-election year and the downward treasury yield ratio. Last Friday the S&P 500 index registered a new 52-week high with energy, semiconductors, banks, internet, and basic materials sectors recently outperforming the market.

Ratio of S&P 500 Index to World Stock Index Breakout from 2.5-Year Triangle

The ratio of the S&P 500 index to the Dow Jones World Stock Index measures the relative strength between the domestic and international stock markets. When the ratio goes up, the U.S. stock market gains strength, and vice versa.

The chart below is a weekly chart of the relative strength ratio of the S&P 500 index to the DJ World Stock Index in a 6-year time span. The ratio continuously declined with underperforming of the U.S. market before the early of 2008. But during last two and half years the decline got stalled and the ratio formed a converging triangle.

The ratio has moved up from the lower boundary of the triangle since last October. Last Friday, 2/11/2011, the ratio broke out to the upside from the upper boundary of the triangle, that indicates the U.S. stock market is gaining strength.

Recently the international markets have been driven by inflation concerns especially in the emerging markets like India, China, and Brazil. Tightening monetary policies to fight inflation in those countries could add pressure on their stock markets. The emerging markets could continue underperforming. It is also a bullish sign for the U.S. dollar because the strength ratio is a leading indicator for the U.S. dollar index.

Gold in Uncertainty with Global stagflation

The world economy is facing global stagflation typically with high inflation in India and China and high unemployment in the U.S. Tightening monetary policy of emerging markets and easing monetary policy in the U.S. give a great uncertainty for gold. As I discussed in my market weekly update on 12/5/2010, gold is forming a Bump and Run pattern in a long-term timeframe as shown in the weekly chart below. This pattern typically occurs when excessive speculation drives prices up steeply.

According to Thomas Bulkowski, this pattern consists three main phases: 1) lead-in, 2) bump, and 3) run. In the lead-in phase, a lead-in trend line connecting the lows has a slope angle of about 30 degrees. Prices move in an orderly manner and the range of price oscillation defines the lead-in hight between the lead-in trend line and the warning line which is parallel to the lead-in trend line. After prices cross above the warning line, excessive speculation kicks in and the bump phase starts with fast rising prices following a sharp trend line slope with 45 degrees or more until prices reach a bump hight with at least twice the lead-in hight. Once the second parallel line gets crossed over, it serves as the sell line.

Gold now is in the bump phase, and its uptrend may continue as long as prices stay above the sell line. But if prices break down the sell line, a bearish reversal could happen.