Feb 5 Update | Overbought + The Correlation Advantage | Daily Market Updates

Monday started the week with a broad market decline, which was not unexpected. The broad market advance has been underway for well over a year, with the month of January being relentless in terms of pushing into extreme overbought levels. I don’t think I’m the only one who finds it interesting that investors wouldn’t touch a stock such as Netflix at $53 last October, but flooded the market to pay $150 last month after the company reported earnings of a mere $8 million. On the other hand Apple posted record quarterly revenue of $54.5 billion and a record net profit of $13.1 billion and the market “jumped ship” with the stock dropping over $60 in the process. There doesn’t seem to be any correlation – right?

Correlation within the financial markets tends to be a measure of strength and direction of the relationship between two variables. Correlation is measured by a “coefficient”, which is a number ranging between -1 to +1. The closer “A” is correlated to “B” (+1) suggests that they will move at the same rate on a percentage basis and conversely (-1) suggest they will move at the same magnitude but in the opposite directions.

So it is fair to ask how accurate correlations are and how do they change over time. To name a few notables over the past few years – the S&P (SPX) for a period of time traded almost tick for tick with the bond market on inverse basis, (SPX up, bonds down or bonds up – SPX down). Oil and gold seem to march to the same beat and until very recently the NDX traded in lockstep with AAPL. What is important to bear in mind is that during these periods’ correlation moves sharply toward 1 or -1 and this also happens when the market(s) fall quickly.

Understanding correlation gives valuable information to traders during strong rallies or steep declines. Making note of changes is important as well. For example, Apple and the QQQ in the past were very closely correlated at almost 95%. Over the past year though, that correlation has decreased by 40%. CAT and the SPX have completed “decoupled” moving from 85% to -1% over the last year. Goldman Sachs and the SPX on the other hand have seen a strong increase in correlation rising by 58%.

So it isn’t very surprising that on Monday GS dropped in step with the SPX (on a percentage basis) and then rose on Tuesday in line with the strong gains seen in the SPX.

Back to the markets – the overbought readings remain intact across the broader markets. Yesterday’s declines registered little to nothing after today’s bounce back up. The market is not going to just roll over and go down without a fight. That much is certain. On a longer term basis the advance has more to go before all is said and done. However, the near term picture continues to point to a pullback. So, while yesterday looks to have been swept under the carpet I believe the nature of the decline points towards more to come before the sustained advance takes over again.

Expectations for Wednesday (2/6/2013) watch the US$/Euro for signs – weakness there will likely lead to lower equity prices as well as lower gold and silver prices. The overbought nature of the market suggests an additional decline is likely and with the stubborn nature of the bulls to jump ship I would suspect the move could be sharp and quick. The bears believe the “head fake” was today’s rally and not yesterday’s decline so any move in their direction may pick up momentum as a result of profit taking. Also, any strong downside should switch HFT traders to flip the switch to accelerate the move.

Support and resistance zones (daily) to watch for:

DJIA: support at 13,800 and resistance at 14,200
SPX: support at 1490 to 1480 and resistance at 1515 to 1525

Treasuries:

30yr – support at 142 to 141’16 and resistance at 143’29 to 144’12
10yr – support at 130’23 to 13’16 and resistance at 131’22 to 131’27

Stocks:

AAPL: support at 439 and resistance at 469
GS: support at 146 to 143 and resistance at 151 to 152

I will begin to add additional indexes and stocks over the coming days.

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