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Two Things You'll Want To Watch Right Now

 February 15, 2013 10:22 AM

(BY Costas Bocelli) The pain trade continues for the under-invested... and for the speculative bears, too.

With six-straight weeks of gains in the S&P 500, it's now the longest winning streak to start a calendar year since 1971!  With the index modestly higher through Wednesday, we're likely headed for a seventh.

That pullback that everyone's been eagerly anticipating has remained elusive.  And even though all the indexes are overextended, with short-term trading conditions dangerously overbought, the market's path seems to be stuck in the sole direction that's causing the most discomfort as possible among investors... and that is up!

But we know that the market will eventually relent with some type of corrective action.  It always does.  The trick is locating the "where and when," which has confounded many market participants.

[Related -Tackling China's Debt Problem: Can Debt-Equity Conversions Help?]

A good friend of mine who happens to be grouped in the under-invested category asked for my opinion.  He's been waiting for that pullback and is now feeling more anxious than ever as the market continues to make new highs while his cash remains idle.

"Costas, What do you think?  The market keeps going higher from here?  What other signs can I look for to help me decide what I should do?"

So I thought today's article would be quite fitting to not only contextualize our recent conversation, but to also share that information with you as well.

I first told him that sitting patiently in cash is okay.  You'll always have plenty of opportunities to invest, even in instances when the market makes another significant leg higher without your participation.  The notion of being comfortable -- not feeling pressured or rushed -- is a far better mindset when making investment decisions.

[Related -Will Job Growth Kill The Bear-Market Signal For Stocks?]

Second, I reiterated my technical outlook for the market in the near-term.  And while the market keeps grinding higher, I still believe that the risk for a near-term decline remains a higher probability.  Lots of bullish energy has been exerted, and the market internals are more and more looking like they're on the verge of exhaustion.

Thirdly, the President's State of the Union address didn't exactly strike a bi-partisan tone.  In fact, it felt very polarizing.  The fiscal divide between the two parties seems sharper than ever, and will likely be a major headwind as we draw nearer to the March 1 deadline on the spending sequester.

Then, I told him to start watching these two securities and pay particular attention to certain levels should a breach happen to occur...

I first directed him to the US Dollar index (DXY).  The US dollar index has been a good medium-term indicator of risk appetite based on the current global environment.  If it's trending higher, the stock market tends to come under pressure.  And if it's trending lower, stocks and risk assets tend to rise.

So if the US Dollar index breaks below 79.00, that would likely represent a significant technical breakdown and provide a huge bullish catalyst to the stock market.  However, a rising dollar from here should help ease your anxieties and reinforce your patience to wait for the opportunity to buy a pullback.

US Dollar Index (DXY)

click to view full size image

Then, I told him to pay attention to the long-end of the US treasury curve, notably the yield on the ten-year treasury bond (TNX).  The Fed has been aggressively buying long dated treasury bonds as part of its QE stimulus program in an attempt to pressure interest rates artificially lower.

But even though they're applying influential downward pressure on yields, interest rates still generally move on economic growth and inflation expectations.  And as the stock market has been rallying, so has the yield on the ten-year bond.  This is a bullish sign under this scenario, because that means that there's a natural rotation out of low-yielding securities of safety occurring, and the proceeds are finding their way into riskier assets like stocks.

So, I told him to watch the ten-year yield and, if it significantly breaks above 2.10%, that would likely represent a technical breakout and a very bullish sign that money is aggressively funneling out of fixed-income and rotating into equities.  However, if you see yields recede from here and firmly fall back below 2.00%, that should also help you maintain your patience looking for that pullback.

click to view full size image

So I summed it for him that this market still seems too risky to put fresh money to work right now, with short-term conditions remaining so overbought.

And the upcoming negotiation process over the spending sequester and government funding resolution should provide some level of market uncertainty and hold any additional significant upside in check while you await your pullback.

But if the market still continues to defy the odds and you see the US Dollar index break down while the ten-year treasury yield breaks out... well, then, I told him that it might be time to finally drink the Kool-Aid and capitulate.

Just remember to use a very tight stop.



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