Credit: Shutterstock photoIf you have been reading “Market Musings” over the last few days you will be aware that I am, somewhat uncharacteristically, a little nervous and bearish with regard to stocks in the near future. As yesterday’s action showed, however, we are still in a recovery and the default direction for the market is upward. Even when dark clouds can be seen on the horizon stocks will often default to rising until a storm actually breaks.
This tendency creates a problem for investors; caution is fine, but nobody wants to miss out on significant gains. As always, success in trading and investing depends largely on timing. If only there was some foolproof indicator that things were about to turn around. If we could deduce that if “A” happens, “B” will inevitably follow, we would all be rich. The belief that there is such a relationship somewhere has spawned countless hours of research and is the basis of most technical analysis.
The reality though, as most successful traders will tell you, is not that simple. There is no one thing that you can reliably track that gives you an indication of market direction to come; rather there are a lot of things that need to be followed. In addition, different things are useful at different times, depending on where the concern or optimism regarding stocks lies.
Right now, for example, there are five things that should be on investors’ radars. No one of these alone is a reliable indicator, but if they all move together it is about as reliable an indicator as can be expected.
- The Dollar: My background in forex may result in some bias, but I was always taught that currencies lead financial markets. Logically, the case is simple. If you are going to invest in a country’s assets, you must first buy the currency. That is, however, complicated in the case of the U.S. dollar due to its role as a “safe haven” when the outlook is questionable. In this case, if investors are looking for signs of upcoming volatility they should be looking for a jump in the dollar index (DXY) that is otherwise unexplained; not as the result of the Fed indicating a return to rate hikes, for example.
- Treasuries: On the same basis of looking for signs of fear, U.S. treasuries are also seen as a place to hide if stocks are considered to be about to turn downwards. A sudden jump in price, which equates to a drop in yields, should be taken as a possible warning sign.
- Oil: Under normal circumstances a drop in oil prices would be good for the broader U.S. economy, but these are not normal circumstances. The exposure of banks to the shale boom and the extent to which whole regions of America are dependent upon it mean that a severe drop in oil prices could be problematic. Add in the potential damaging effect of much lower oil on several emerging market economies and the black stuff bears watching.
- China: It seems that traders have forgotten that just a few short months ago concern about the rate of growth in China was driving a bearish sentiment. The emerging giant may be out of the headlines for now, but the slowdown is still happening and simply a return to a focus on that fact will act as a warning sign.
- Emerging Market Bonds: The fate of emerging market bonds, just about the riskiest of fixed income investments, has recently been a good indicator of overall sentiment towards risk and therefore of future stock market moves.
The comparative chart above shows that the iShares Emerging Market Bond ETF (EMB) started to drop in early December and bottomed out at the end of January, in each case leading the S&P 500 by a couple of weeks. If EMB starts to reverse recent gains, therefore, it should be taken as a warning.
Based on recent history, EMB is probably the best direct indicator of trouble to come, but nothing is foolproof. If however, several of the above start to show signs of turning around investors would be well advised to reduce exposure to stocks for a while.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
