DON´T GET LEFT STANDING WHEN THE MUSIC STOPS / BARRON´S MAGAZINE ( A MUST READ )

Getting Technical

 WEDNESDAY, FEBRUARY 15, 2012

Don't Get Left Standing When the Music Stops

By MICHAEL KAHN

The relationship of stocks, bonds and currencies has been a fluid one for the past few years but the most dominant of late has been classified as "risk-on" versus "risk off." Basically, when investors feel aggressive, they buy risk assets such as stocks. And when they feel defensive, they buy the U.S dollar and Treasury securities.



Unless the relationship between markets has changed—and I do not believe it has—one side of this risk trade is now wrong. This week, stocks, bonds and the dollar are all rising at the same time.


Stocks have been in rally mode since late November and over the past eight weeks there has barely been a hiccup in the rising trend. Until Wednesday, the longest losing streak was three days, and so far in February all intraday declines led to strong finishes by the ends of respective days (see Chart 1).
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Chart 1

STANDARD & POOR'S 500

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It has been a relentlessly rising tide, bringing the majority of stocks higher.


Since the start of the year through last week, while stocks moved higher the dollar fell. We can rationalize that a weaker dollar is good for U.S. companies as it makes their products cheaper overseas. The technical angle is that stocks and dollar simply have an inverse relationship, albeit not a perfect one.



In the bond market, the relationship is a bit different thanks to the Federal Reserve's efforts to provide liquidity for the financial markets and drive down long-term interest rates. On a day-to-day basis, as stocks rallied, 30-year Treasuries fell in price. And on the rare occasions when stocks fell, bonds tended to move higher in price. But overall, bonds have held firm for months albeit with a slight downward bias.



Money may be moving into stocks but it is not coming from the bond market, at least not en masse. Investors still seek the safety of U.S. Treasuries where the return of capital is in higher demand than a return on capital.



Again, if the risk-on versus risk-off relationship is still intact, then either bonds and the dollar should not be firm or stocks should not be as strong as they clearly have been. As they say, something's gotta give.



Currently, there is a rather lopsided view that stocks have a long way to run. From sentiment surveys at very high levels of market optimism to the glut of articles in the financial press telling investors they need to own stocks, expectations are very high. Indeed, some say that the European debt crisis is already priced into the market, and it is the resolution, not escalation, of the problem that will surprise the market.



In other words, investors' unabashed optimism should perk up the ears of a contrarian investor.
There are two other factors to consider. The first is Apple (ticker: AAPL). Even a technical analyst can see that the world's premier technology company sports a relatively low trailing price/earnings ratio.



But it seems that analysts are falling over themselves to raise their price targets. And for the market's most valuable stock by market capitalization, a 28% rise in 2012 to date seems quite frothy -- and unsustainable. Indeed, Apple's shares swung from a high of $526 around noon EST to a low of $502 just an hour later and ended the session under $500.



The second is gold. The yellow metal is now holding firm despite the new strength in the dollar.


Typically, gold and the greenback move inversely, but that has not been the case this month. In fact, gold seems to be marking time following a bullish breakout from a six-month correction (see Chart 2).
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Chart 2

GOLD

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It is very difficult, and costly, to fight the stock-market trend. But that does not mean we have to blindly follow it, either. The music is still playing, but investors should dance close to the exit doors.