With "Risk Off" Trades Waning, U.S. Stocks Could Be Ready to Reverse Course

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There are new signs that institutional traders are preparing for a change in direction of the U.S. dollar and European euro that may have big implications for U.S. stocks.

For months, the winning trade was to short stocks, the euro, and commodities, while buying gold, bonds and the dollar. Commentators labeled this the "risk off" trade since gold and bonds were seen as safe-haven assets. But when crowd mentality is at work, and sentiment – not fundamentals – is driving the bids, there really isn't such a thing as a "safe" trade. It's all speculation.

Take yesterday (Tuesday), for example: After surging 131 points, or 1.4%, out of the gate, the Dow Jones Industrial Average relinquished most of its advance to close just 16 points higher at 9,702.98. Meanwhile the Standard & Poor's 500 Index, which had climbed 1.5% to 1,038 in early trading, ended the day just 0.18% higher.

Indeed, the early jump in stocks and their subsequent decline is further evidence of the ongoing battle royal between the bulls and the bears.

However, there was a watershed moment last Thursday, when stocks found support at the 62% Fibonacci retracement of the move out of the March 2009 low.

The euro, a proxy for risk appetites, gained 2.3% – the biggest one-day gain since March 2009. And gold lost 3.5% in its biggest one-day loss since Feb. 4 (one day before stocks turned and moved higher). Gold prices also suffered in early December before stocks rallied to the January high.

U.S. Treasury bonds hit a wall, with the two-year note stalling near new highs. The dollar plunged 1.8% and fell out of a two-month trading range in the largest one-day loss since last March.

The dollar's slide is notable because its rise since November has coincided with a lack of progress for the overall stock market – unlike the March 2009 to November 2009 period, which saw rising stock prices and a falling dollar. So the greenback's misfortune should be a big positive for stocks if these relationships persist.

The trend continued yesterday, with the euro continuing to rebound as the dollar and gold sank.

Ready for a Reversal
No doubt, volatility has crept up. Large bets are being placed on either side of the ledger. Expect the dramatics to continue. Bulls and bears on the global economy each have a ton of conviction, but they can't both be right. When one side gives way, there will be an explosion that will put Eyjafjallajökull to shame.

This is especially true in the credit markets, which have been the battleground in Europe. According to bond expert Brian Reynolds at WJB Capital Group, an incredible amount of pressure is being put on the credit derivatives market as the bears press their bets. As a result, he sees "tremendous upside and downside risk with the potential for volatile moves" in excess of what we've seen in the past two weeks.

On the economic front, it's becoming increasingly clear that the global economy is transitioning from a high growth rebound phase to a slow-motion expansion. This is typical for the second year of a recovery from recession. Businesses are basically out of the hospital, but they're still rehabilitating. Combined with the slow-burn financial crisis in Europe, evidence of a slowing rate of economic growth has set investors on edge.

Asia was first up with a report that June factory production slowed in South Korea, Taiwan, India, Australia, and China. Oh boy. Still, the overall level of activity in all six countries continues to grow, albeit at a slower rate. China was the exception, with one sub-index for an unofficial survey of purchasing managers by HSBC Holdings PLC (NYSE ADR: HBC) indicating a very small contraction in output. It wasn't all bad though: South Korean exports increased 32% for the eight months of gains, while Japanese manufacturers have turned optimistic for the first time in two years.

Here in the United States, jobless claims crept higher and the ISM Manufacturing Index fell back slightly but continues to indicate month-to-month growth.

"The latest indicator pointing to a modest recovery is the June survey of non-manufacturing firms by the Institute for Supply Management," said Joel L. Naroff, president and chief economist for Naroff Economic Advisors in Holland, Pa. "Its overall index eased back to a level that signals continued growth but not a robust expansion. Orders remained decent but are not rising nearly as rapidly as they had been."

The real shocker was the Pending Home Sales Index, which fell from 111 in April to just 77 in May. That's a huge drop, and really shows how soft the housing market has become in the wake of the expiration of the homebuyer tax credit.

And it's getting worse. In its latest survey of real estate agents, analysts at Credit Suisse Group AG (NYSE ADR: CS) found that buyer traffic has fallen beneath the levels of late 2008.

"Agents noted sellers are beginning to capitulate on home prices in many markets, and we expect further pressure given the combination of the weak traffic and high inventory levels," said Credit Suisse analyst Daniel Oppenheim.

Translation: Another move lower for home prices is all but baked into the pie at this point.

Still, the stock market – as it should be – has been one step ahead of the economic data. And the nearly 16% decline suffered by stocks over the last three months has surely discounted much of the bad news. So what's ahead?

The leading economic indicators I monitor continue to suggest the economy remains on a growth trajectory – albeit one that is slowing down. Interest rates will likely remain near zero for another year and a half. Central banks remain accommodative. And corporate profitability and cash reserves remain at historic levels.

If the "risk off" trend does lose favor, now could be the time to cautiously dip toes back into risky assets for a short-term advance that would be seen as the traditional summer rally.

In the days to come, I think stocks can rebound to around 1,090 on the S&P 500. The strength of the rebound rally, if it materializes, will determine what will happen next. If a rally does not materialize, we will move on swiftly to 'Plan B,' an exciting and potentially very lucrative proposition that will be explained in detail in my next report.

[Editor's Note: Money Morning Contributing Writer Jon D. Markman has a unique view of both the world economy and the global financial markets. With uncertainty the watchword and volatility the norm in today's markets, low-risk/high-profit investments will be tougher than ever to find.

It will take a seasoned guide to uncover those opportunities.

Markman is that guide.

In the face of what's been the toughest market for investors since the Great Depression, it's time to sweep away the uncertainty and eradicate the worry. That's why investors subscribe to Markman's Strategic Advantage newsletter every week: He can see opportunity when other investors are blinded by worry.

Subscribe to Strategic Advantage and hire Markman to be your guide. For more information, please click here.]

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  1. Johan Brusse | July 7, 2010

    Please send me the daily Morning news letter.

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