Reaction to Over-reaction
by David Yu
I guess I should've thrown my caution to the wind. The S&P 500 and the Nasdaq had gained 4.67% and 5.59% respectively last week riding the coattails of IBM, Google, Coca-Cola, and Caterpillar's stellar earnings, which had been attributed largely to the growth of their overseas operations.
For the first time in Google's history, more than half of its revenue came from outside the United States. Without the overseas contribution, Google's sales that excludes revenue passed on to partner sites would've been $200 million below analysts' estimates. Meanwhile, Caterpillar's sales outside the U.S. represents 58% of its total revenue, and more than 60% of IBM's revenue were generated from overseas operations. By all means, these revenue increases were the direct results of favorable foreign exchange rates, due primarily to the dollar's decline. More than 40% of Coca-Cola's revenue increases were attributed to the dollar's decline against other currencies (see Chart 1 below).
The Broad Dollar Index, a weighted average dollar's exchange values against the currencies of a large group of major U.S. trading partners, continued to slide even though the more popular Dollar Index (DX, USDX, or USD) appeared to be moving sideways and building a base since March 26.
Nevertheless, to think that major U.S. corporations can continue to profit from currency exchange rates consistently or the global economy's de-coupling from the U.S. economy is to live in denial. I know the market's not in denial. The market knows the slowdown in the U.S. could slow everyone else down, overseas or not. And, the market knows relying on favorable currency exchange rates aren't always reliable. Therefore, last week's rally could not have possibly come from the earnings reports that were aided by foreign operations and foreign currency exchange rates. It's more likely just a reaction to the market's prior over-reaction. Simply, a reversion to the mean.
Chart 1
For the past 2-3 months, I've been (tirelessly) providing technical evidence showing that the selloff since January had been excessive. Last week's rally that brought the major indices back to the mid January level essentially nullified what had happened after mid January (see Chart 2 below) and validated what the technical evidence had been telling us all along. Now that the market's back to where it's supposed to be, what's next?
Chart 2
The market's next move will depend largely on its breadth. Last week's rally, or the process of reverting to the mean, had recalibrated some of my market breadth indicators. My CMB (Composite Market Breadth) Volatility Index, for example, had dropped precipitously from its March 26 new high to the normal distribution range below 0.50 (see Chart 3 below). As the market's internals stabilized, the market started feeling comfortable again to move on up. However, the descend of the CMB Volatility appeared to be stalling once again right at around 0.45 (black circle), just as it did from late December to March. The upticks over the last few sessions, in particular, bothers me.
Chart 3
With the price volatility dropping to a new low since the beginning of March, the stalling and the subsequent upticks of the market breadth volatility may serve as an early warning of a probable trend reversal. Institutional investors appear to have taken notice as well.
While the Nasdaq 100 had advanced more than 6% last week, the volume of the Ultra Long QQQQ ProShares had surged passed its January 2 high (see Chart 4 below). The volume of Ultra Long ProShares for the S&P 500 ETF had also been rising quite substantially. Institutional investors use these Ultra ProShares to hedge against their short positions. Accumulation of Ultra Long ProShares means increase in short positions. This indicates the probability that institutional investors had been selling into the rally.
Chart 4
So, on second thought, no, I shouldn't throw my caution to the wind just yet.
email: dyuguard-2@yahoo.com