The second chart clearly shows the hand of intervention while the last chart shows change is in the air.

Cheers - VHF

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Weekly Market Forecast

Graham Summers

October 18, 2010

It’s all thanks to the Fed’s funny money and computers.

Thanks to the world central banks’, particularly the US Federal Reserve’s, constant liquidity injections combined with the automation of almost ALL trading courtesy of the massive rise in high frequency trading programs (HFTPs) and other computerized trading systems, the world financial markets have entered a period of incredible correlations between asset classes.

In plain terms, everything is now moving in near perfect direct correlation or near perfect inverse correlation to everything else on an almost tick-for-tick basis.

The most obvious examples of this were presented in last week’s forecast, namely that the S&P 500 now moves in direct correlation to the Euro/ US Dollar and Aussie/ US Dollar currency pairs.

However, as the below chart reveals, the other critical correlation traders need to note is that of the S&P 500 vs. the US Dollar. As you can see, these two asset classes are now moving in near perfect inverse correlation to one another (one rising when the other falls and vice-versa):

As state before, these are the most critical correlations for traders today. However, we are seeing record or near record correlations between ALL asset classes across the board, including between individual stocks themselves (according to BNY’s Nicolas Cola, the LOWEST correlation between an individual stock sector and the S&P 500 is around 83%).

We’ve seen periods of this kind of intense correlation before, namely from March-November 2009 during the most intense period of the Fed’s QE 1 program. The fact that we’re back to this stage again largely because investors expect a massive QE 2 program to hit in November (and the ongoing weekly POMO cash injections from the Fed) tells us in plain terms that the investment world is completely detached from economic fundamentals and that the most critical items to focus on from a trading perspective are the aforementioned correlations and the days of the Fed’s POMOs actions.

On that note, we have POMOs on Monday, Wednesday and Friday this week. So while the market appears to be showing clear signs of topping (more on this in a moment), we can expect massive intraday ramp jobs to occur on these days between 10AM and 11:30AM.

To show you what I mean, I’ve included a chart illustrating the impact of these POMO actions on the S&P 500 in late September. You’ll note that on four of the five POMOs occasions we saw sharp intraday spikes occur, including reversals that stopped collapses dead in their tracks.

Bearing all of this in mind, from a technical perspective stocks appear to be topping right now, having formed a bearish rising wedge pattern. This is a classic topping pattern which, when broken, usually sees a reversal to its base (in this case 1,040 on the S&P 500).

Indeed, we saw the exact same pattern form during the July stock rally. The collapse that followed its completion was true to form, bringing stocks almost to the base of the pattern (I’ve drawn both wedges on the chart below).

As you can see, we’re right at the breaking point for this current pattern, which means we should see a sharp sell-off begin in the S&P 500 soon. We gain further support for this forecast from the fact that financials and semiconductors (historically, market leading sectors) have been breaking down and failing to confirm this recent rally.

Having said that… the trillion-dollar question is: can the Fed’s POMOs and rampant investor bullishness overcome the significance of this pattern? The answer is: we’ll soon find out (the pattern is SO close to ending). But with stock participation dwindling (fewer and fewer stocks are accounting for the indexes’ gains similar to the action in 2000 and 2007) I wouldn’t want to bet much on it.