Back in May 2011, I introduced Chart In Focus readers to the leading indication that I get from looking at Commitment of Traders (COT) data on eurodollar futures.  Since then (and also before) readers of our twice monthly McClellan Market Report newsletter and Daily Edition have appreciated getting to see this relationship on a more frequent basis.

For almost a year, we have known that a top was due to arrive in February 2012.  And sure enough, stock prices have been rising nicely in recent weeks as fulfillment of that expectation.

Now this leading indication says that things are going to get less fun for investors for a while.  The next 3 months show a sideways to downward structure in the eurodollar COT data, and the implication is that the steep price advance that we have been seeing should transition to a more sideways market.  That's great if one can be a swing trader, buying oversold opportunities and selling when prices get overbought, and then repeating.  But it is a lousy time to be a buy and hold investor.  How to play that chop is something that we will be sharing with our subscribers. 

The next major inflection point is due in early June, when this leading indication says that a big multi-month rally is due to begin.  By then, all of the bullishness that investors are expressing now in the various sentiment indications should have turned to frustration and pessimism, creating the right setup for a big new uptrend.  The hard task will be to remain patient until then, waiting for conditions to be right again. 

Some sentiment indicators work by analyzing what people say, such as polls and sentiment surveys.  Others work by analyzing what people actually do, and I tend to like those more. 

This week's chart looks at investments into QQQ, the ETF designed to track the movements of the Nasdaq 100 Index.  The lower line in that chart is the total number of shares outstanding of the QQQ.  It fluctuates each day as fewer or more people feel like owning shares.  Because of that waxing and waning of interest, the sponsoring firm (Power-Shares) issues or redeems shares to keep the share price close to the NAV. 

When the firm issues new shares, it goes out and buys the shares of the NDX component issues to back those ETF shares.  Not surprisingly, interest in owning these shares rises and falls along with the overall stock market.  When the overall market goes up, that makes more people want to participate. 

To help track where “high” and “low” levels are, I added 50-day 1-sigma Bollinger Bands to the chart.  That means that the upper and lower bands are drawn one standard deviation above and below the 50-day simple moving average, which is not shown.  Other settings for drawing Bollinger Bands could also be used for the same purpose; I just like these because they look about right, and give good insights about an overzealous or disinterested investing public when the shares outstanding number goes outside these bands. 

The current number of shares outstanding is not at an all time high, but it is the highest we have seen since all the way back in 2006.  And it is way above the upper 50-1 Bollinger Band, indicating that traders and investors are getting a little bit too interested in being invested in the QQQ.  That overly bullish sentiment condition begs for at least a short term pullback, to reintroduce people to the idea that stock prices actually CAN go down.

The QQQ and the Nasdaq 100 Index are just now breaking out slightly above their 2011 highs, but interest in owning the QQQ is well ahead of its corresponding highs in 2011.  That means that traders have been drawn in to owning this ETF to a degree even greater than what the raw price advance itself would suggest should have happened. 

In a September 2010 Chart In Focus article, I showed this same 3-decade rising trend channel in T-Bond prices.  The message then was that bond prices were getting up toward the "expensive" side of things, and afterward bond prices sure enough came back down to touch the bottom of that channel by the end of 2010.

Now the message is similar, except that all of the worries over European debt problems have pushed T-Bond prices up even higher toward "expensive" territory.  And now with a deal reportedly getting worked out between Greece and its creditors over the size of the "haircut", traders are concluding that the supposed safety of T-Bonds does not merit as much premium as it used to.

At the same time, commercial traders of both T-Bond and T-Note futures are getting to a point of being net short in the biggest way that they have been in years.  Commitment Of Traders (COT) Report data is something that I address every Friday in the Daily Edition.  And commercial traders are also net long the euro in the biggest way in the history of that future contract.  So the big smart-money traders are betting on a euro rebound and a T-Bond selloff. 

You can sign up to get the Daily Edition as well as our twice monthly McClellan Market Report by visiting our Market Reports page.  And new subscribers to our Daily Edition can get the first two weeks free. 

The Ratio Adjusted Summation Index (RASI) is back up above +500, and that is a bullish piece of news.  It takes a sustained period of positive breadth numbers to achieve this, and I like to say that gobs of positive breadth is almost always a good thing. 

The Ratio Adjusted Summation Index is much like the classic version, with one difference.  We factor out the changing number of issues on the NYSE in order to make long term historical comparisons more meaningful.  You can see the whole calculation method here.

Like the classic Summation Index, the RASI moves up and down with the trend of the market, and it gives important information about the state of the trend when it gets to very high or very low levels.  But the factor I like the most about the RASI is what it tells us based on how it behaves around the +500 level.  That is an important threshold for telling us whether there is strength to continue both an uptrend and a bull market. 

If you see a nice deep selloff that takes the RASI down below zero, then on the subsequent advance it is important for the RASI to be able to get back up above +500.  Failing to surpass that level is a sign that the uptrend cannot achieve "escape velocity", and prices are likely to roll over and head back down to the prior low, or lower.  From late 2007 to early 2009, there were several attempts but all rolled over short of that +500 level.

That is why it was important in October 2011 to see the RASI climb up well above +500 following the August 2011 selloff.  That action said that a new strong uptrend was being initiated. This was the point I was making back in the Oct. 14, 2011 Chart In Focus article titled, The Key To Watch For In November.

The other way that the +500 level is important lies in marking the end of an important uptrend.  Usually the initial rally of a brand new uptrend is where you will see the highest RASI readings, and so every subsequent RASI peak will be lower than that highest one, even though prices make higher highs.  These divergent conditions show a waning amount of upward impetus, but the strength of the market can still be enough to carry on even if it is not as strong as the initial upward impulse.  It is similar to how I'm not as fast of a runner as I was in my 20s, but I can still run. 

But at the end of a long uptrend, what is often seen is a failing RASI up move after several divergent lower tops, and that final RASI push reaches a peak at a level below +500.  A couple of examples are highlighted in the chart. 

So all of this leads us to the current RASI reading, which at +618.2 is above the +500 level but still below the peak of +763 seen on Nov. 15, 2011.  So it is a divergent lower high, but it is still high enough to say that the uptrend which started in October 2011 is not over.  There can be ordinary pullbacks along the way, but the message of the RASI is that the final highs of this current new uptrend have not yet been seen. 

In this week's chart, I take a look at an indicator which is featured in every issue of our Daily Edition.  It looks at each of the 30 stocks which make up the Dow Jones Industrial Average (DJIA), and checks to see what percentage of them have a rising Price Oscillator.

A Price Oscillator is calculated similarly to the McClellan A-D Oscillator, except that instead of using the daily difference between Advances and Declines, we look at the closing price.  See Calculating the McClellan Oscillator, and Calculating Indicators in Daily Edition Table.  To get this composite indicator, I do 30 different Price Oscillator calculations, one for each of the 30 DJIA component stocks.  Then I count how many of those Price Oscillators are rising. 

Those 30 stocks which make up the DJIA are generally well correlated with each other, but there will be slight differences at times which can give us important information.  That is what this indicator is designed to detect.  If all of the DJIA stocks are trending higher, then most or all of them will see their Price Oscillators rise.  Similarly, during a downtrending market, you can see a condition when most or all of them have a falling Price Oscillator, which takes this indicator down toward zero.  Interestingly, by the time the market gets all of them moving together in either direction, the short term move is likely done, because a large amount of energy must be expended just to get the herd all moving together.  So extreme readings above 80 or below 20 can show an overbought or oversold condition. 

The interesting indication we are seeing right now in the chart is that the DJIA has been making higher price highs as 2012 begins, but the DJI Oscillator Rising Index is making a pattern of lower highs.  This sort of divergence can be problematic, because it says that a smaller number of component issues are doing the work of pushing the index to a higher high.

Caution is warranted, however, because not every divergence like this turns immediately into a reversal for the stock market.  It is merely describing a condition, and there is no guarantee that prices will roll over right away just because the participation in the rally is waning.  Sometimes divergences like this can persist for several weeks before they finally matter.  You can see a great example of that at the left end of the chart, when the DJIA kept on trending upward in spite of a divergent condition lasting several weeks.  Eventually, though, that divergence did matter. 

So right now, we cannot leap to any conclusions about the market's direction just because we see a divergence in this one indicator.  But with other divergences already in place right now between stock prices and copper, and with the middle part of January normally a period of minor seasonal weakness, it is a concern to see this particular sign of waning participation in the advance. 

Turning such warnings into more concrete guidance about trend changes is what we do in every issue of our Daily Edition.  You can see samples, and sign up for a subscription at our Market Reports page.  New subscribers can take advantage of a 14-day trial offer.  If you have already been a subscriber or had the trial in the past, you can still take advantage of our normal pricing of $160/quarter, or $600/year, which is the same pricing that we started at in 1998 when it debuted as the "Daily Fax Edition".  It has been a while since we sent our last fax issue.

If you are in the Houston, TX area, you may be interested to know that I will be coming to town for a pair of speaking engagements. On Friday, Jan. 13 at 10:00 AM, I’ll be speaking to the computer investing special interest group of HAL-PC, which is the Houston Area League of PC Users. HAL-PC’s web site, www.hal-pc.org, has location and other information. 

On Saturday, Jan. 14 at 10:30 AM, I’ll be addressing the Houston Investors Association, http://houstoninvestors.com/wp/.  They meet at the University Center on the University of Houston campus. Small special interest groups meet at 8:30 and 9:30, and my talk will begin at 10:30.  Attendance is free for 1st time visitors.

Back in January 2011, I pointed out that copper prices had in recent years started to track very closely with whatever the stock market was doing.  But the key point about that relationship then was that when disagreements appear, it is usually copper that knows what the real story is.

That relationship continues to work to this day, with the two price plots mostly doing the same things, but with divergences usually working out the way that copper says that they should.  By that I mean that if the SP500 makes a higher high but copper makes a lower high, that is a bearish divergence with bearish implications for both of them. 

It is worth noting that there was a big "oops!" back in July 2011, when copper prices made a higher high as the SP500 made a lower high.  In that instance, it turned out that the stock market was right, but copper worked extra hard in the weeks that followed to make up for lost time and to plunge to a lower value.  Nothing works all the time. 

The higher high for the SP500 going into the end of the year has not yet been matched by a higher high in spot copper prices, and that is a troubling development.  But the problem with converting this observation into an actionable and tradable signal is that we never know exactly when such a divergence is actually going to start to matter.  Sometimes it happens after just a few days of divergent behavior.  Other times, the divergence persists over several weeks before it finally matters.

One other worry is a phenomenon I just shared with readers of our Daily Edition, which is the realization that a lot of currencies seem to undergo reversals around New Year's Day.  The end of 2011 arrives with commercial currency futures traders holding a huge net short position against the dollar.  Commercial euro futures traders have the biggest net long position in the euro in the entire 12 year history of the reporting of euro futures positions in the Commitment of Traders (COT) Report.  Commercial traders are also long the Swiss franc in a big way.  Analysis of COT data is something that is featured every Friday in our Daily Edition.

So what this all means is that we have a situation where an upward move for the euro (downward for the dollar) is likely because of what the COT data say, and because of the year end reversal tendency.  A big drop in the dollar would be bullish for copper prices, because a cheaper dollar would mean that you would need more dollars to buy a pound of copper.  So a potential big currency reversal could push copper prices upward, removing this current divergence between copper prices and the SP500.  Accordingly, this relationship will bear watching closely as we move into 2012. 

As you head off into the long holiday weekend (and I hope that yours is a joyous one), I thought I would give you something a little bit more fanciful to chew on.

This week's chart shows an interesting correlation, or perhaps I should say that it is a troubling correlation.  We have all been told by the financial media lately that the wild up and down movements of the stock market this year stemmed from investors' reactions to the various plans and announcements coming out of Europe, focusing on its debt problems.  But here we are seeing that the ups and downs of the DJIA seem to match the rise and fall of solar radio flux.

Flux is a measure of the energy output of the sun, and is an excellent indicator of overall solar activity levels.  It is associated with the 11-year sunspot cycle, but it varies a whole lot on a daily basis, as the chart illustrates. 

So why could it be that rising solar flux would lead to rising stock prices, and vice versa?   That is the deep and possibly troubling question.  Some people have theorized that the fluctuations in the amounts of charged particles hitting the wiring in our brains can affect collective moods, just as they can affect electrical power grids and microcircuitry.  That's as good of an explanation as any.  I usually operate on the philosophy that if the correlation is good enough, no explanation of the root cause is necessary. 

Here is something more to chew on: Perhaps it is not the radio flux that is really doing the job of affecting our brains' wiring, but rather the spikes in solar flares that seem to arise out of the low points in radio flux.  This next chart looks at the counts of "S Class" solar flares.



You can see that the biggest spikes in the numbers of these flares tend to coincide with meaningful bottoms for stock prices.  Those spikes also happen to arrive at minimum points for total radio flux, as if the surge in solar flares kicks off the next rising phase for that measure of solar activity.  The DJIA's rise up out of the minor price bottom on Dec. 19, 2011 coincided with an upward surge in the number of these S-Class flares.  Other spikes in flares in 2011 have also coincided with important lows, although not all price lows have flare spikes to explain them.

One trouble with identifying this relationship is that it is not much good for those of us in the forecasting business.  The relationship between solar activity and stock price activity seems to be a coincident one.  We know that it is related to the 11-year sunspot cycle, but even that cycle can vary from 9 years to 14 years.  Forecasting solar weather on a daily basis has proven to be very difficult. 

You can access the historical data at NOAA's web site and play with the numbers yourself if you are curious enough to delve into this.  You can also get daily updates at http://www.spaceweather.com/. 

I am certain that a lot of readers will have trouble accepting the idea that stock prices could in any way be driven by changes in solar activity.  I have some trouble accepting it myself.  But every once in a while, it can be worthwhile to take a look at a wild idea just to see if there is any merit to it.  The evidence here seems to be strong enough to demonstrate that there is something going on there, even if it is not good enough to figure out how to make money off of it.  One possibility is that if you see a big solar flare that is bigger enough than what has been happening around that time, then it is an invitation to a stock price rally in the days that follow.  But putting that effect into quantifiable terms and actionable information is more elusive. 

There is a growing chorus of analyst voices calling for an economic collapse in China.  This is based in part on how poorly Chinese stocks have done this year, and it sets up all sorts of worries about what an economic slowdown in China might do to prices of commodities, and to other world financial markets.

I have a different view, and it is based on the comparison we see in this week's chart.  The Baltic Dry Index (Source: bloomberg.com BDIY:IND) is an index of dry shipping lease rates.  In other words, it reflects how much it costs to rent a freighter for hauling non-liquid stuff.  The Baltic Exchange also tracks lease rates on oil tankers, and on specialized ships like Panamax ships designed to transit the Panama Canal, and Capesize ships that are too big to fit through the Suez Canal and which thus must go around Cape Horn.  The Baltic Dry Index includes pricing for Handymax, Supramax, Panamax, and Capesize dry bulk containers. 

Economists and analysts like to watch the Baltic Dry Index because its pricing reflects demand for shipping stuff across the ocean.  Because the supply of such ships is fairly inelastic, changes in demand will flow through very quickly into lease rate pricing.  It takes a while to build new freighters in response to high lease rates, and that is part of the explanation for why BDIY crashed in late 2008.  A lot of shipyards had ramped up production earlier that year, and then those new freighters flooded a collapsing freight market during the 2008 financial meltdown.  This is a classic case of what's know as the Avocado Effect, or the Hog Cycle.

It is not surprising to see a correlation between Chinese stock prices and some indicator of world economic activity.  China is a mercantilist country which seeks to export a large amount of what it produces.  So when there is a change in world demand for "stuff", that is going to affect the country producing the stuff.  And because stock price movements can often precede changes in GDP, the big drop in Chinese stock prices during 2011 has people understandably concerned.

But the Baltic Dry Index is not confirming that drop.  BDIY bottomed in January 2011 and has been trending higher, in direct disagreement with the Shanghai B Stock Index.  When the two disagree, I have found that it is worth listening to what BDIY is saying. 

BDIY did not confirm the higher highs in the Shanghai B Index in late 2010 and early 2011.  Now, as Chinese stocks are unwinding that big top, BDIY is saying that things are actually not as bad as the stock price decline seems to imply. 

Here is a riddle for you to ponder.  I'd like you to consider a hypothetical situation, with these economic parameters:  US unemployment is above 9%.  The federal government is running large deficits.  A summer decline has investors worried.  And this comes after several years of sideways price movement for stocks.

Now, into that environment, imagine that a populous country and important trading partner of the US announces that it is going to default on foreign debt equivalent to about half the size of its GDP.  And imagine that this default soon spreads to several other countries. 

So given all of these conditions, what happens to the stock market?  For the answer, see this week's chart.  The scenario I described was the default of Mexico in August 1982, which soon spread to defaults by 26 other countries.  See http://www.fdic.gov/bank/historical/history/191_210.pdf for the longer version of that story. 

The fascinating point about this comparison is that the current stock market price behavior matches quite nicely with what we saw after the bottom in 1982, a bottom which coincided with Mexico's debt default.  The current version of debt default is a "haircut" for Greek debt holders, unfortunately including customers of MF Global who did not even know that their "cash" positions were actually invested in troubled European debt instruments.  That whole episode is a story worthy of a book-length description that is beyond the scope of this brief article.

Why it could be that the default of Mexico could be good news in 1982, and Greece in 2011, could be good for the stock market is an interesting mystery.  But the correlation is there in the stock price patterns, or at least it has been ever since July.  Prior to July, when the Fed's QE2 program of bond purchases was in effect, the correlation between these two price patterns was not that good.  In fact, at times the patterns seemed to have a loose inverse correlation.  But the end of QE2 on June 30 resulted in a liquidity vacuum which seems to have jolted the current market price pattern into sync with that of 1982. 

The December 2011 price action does not match the 1982 pattern of higher highs, but the timing of the turns does match up, and that is the important point for watchers of analogs like this.  It is the turns that matters more than the price levels suggested by the slope of the prior pattern.  And the turns in the 1982 pattern suggest that we should see a big rally into the end of December, followed by some time to think about things. 

You can see a video of the discussion of this pattern and other topics that I had in an appearance before the Seattle Securities Traders Association.  Click on THIS LINK to watch the 72 minute video.

We'll be watching how it actually plays out in our twice monthly newsletter and Daily Edition, and invite you to join in by subscribing here. 

As gold prices push out toward the apex of a symmetrical triangle structure, gold ETF investors seem to be betting as a group on a big upside breakout for gold prices.  But that very uniformity of opinion may be what dooms the rally attempt. 

The two big gold bullion ETFs are GLD and IAU.  GLD got a jump by coming to market in November 2004, just two months prior to the launch of IAU. But that two month head start gave GLD a big advantage in terms of attracting investors.  IAU has been trying to catch up ever since, and it got a big boost in investor interest when it cut its fees to below those of GLD.  But GLD is still the assets leader.

I combine the two ETFs assets into a single indicator in this week's chart. The units are the total tonnes (1000kg) held by the two ETFs. The number of tonnes goes up and down with investor interest in being invested in gold, and the sponsoring firms issue or redeem shares as needed to keep the ETFs' share price close to the net asset value.  When they issue more shares, they immediately turn around and buy more gold bullion with the proceeds. 

So when you see the total assets rise, it means that more people are investing money into these ETFs.  Not surprisingly, rising gold prices tend to be what gets people more interested in investing in gold, and falling prices provide an incentive to cash out.  The key insight comes from being able to notice when that tendency has gone too far one way or the other. 

In the chart, we can see that total assets are all the way back up to where they were in August, when gold was building a big top ahead of its 16% decline.  And this surge in investor interest comes even though gold prices are still well below that August high, meaning that sentiment has swung farther toward the bullish side that the price movement might have justified.

At the same time we are seeing bullish sentiment reflected in the ETFs, there is another sign of a problem.  We recently featured a chart in our Daily Edition on Dec. 1 (subscription available here) showing that gold lease rates are climbing in London in a way similar to what we saw in September 2011, just before the plunge.  It appears that gold investors are getting bullish just as a squeeze is mounting in the gold lease market, which is a setup for a big drop like September's.  It is not a sign that such a decline has to start right away, just that the conditions are ripe. 

In the spot SP500 Index chart right now, there are a lot of things going on simultaneously.  On the way down from the Oct. 27 top, the SP500 stopped briefly at the 0.382 retracement level, and paused there for an extra day.  Then it dropped through and made its next stop at the 0.500 retracement level, again pausing there for a day.

The big drop on the day before Thanksgiving made it almost to the 0.618.  That precise level is at 1158.00, and the intraday low on Nov. 25 was 1158.66 .  So is Black Friday's small range just another manifestation of the "pause for a day" Fibonacci effect?

Probably not.  Also going on right now is that we are seeing a completion of the "rainbow convergence" shown in this chart.  That name comes from all of the pretty colors of the moving average type lines.  A rainbow convergence is a similar event to Dave Landry's "bowtie crossover", and other moving average crossover events that others have written about. 

This week's chart uses our own preferred mix of moving average type lines, and this style of chart is featured frequently in our Daily Edition.  You can read about the definitions and calculations of each of those four lines here, but the focus today is on making an interpretation of their meaning rather than in getting bogged down discussing the math.

In our understanding of rainbow convergences, the meaning of a particular convergence event depends on how prices are behaving when the convergence takes place.  When prices make a short term accelerated move which brings the four lines together, then the moment of the convergence usually marks the end of that move.  What follows next is a pause for a few days, as prices decide whether to resume the move or reverse it for good.  Usually that decision process involves a test of the Price Oscillator Unchanged line, which represents the level at which a close would turn our Price Oscillator precisely sideways. 

A good example of this is the July 2011 top.  A sharp up move ended when the four lines converged.  In the days that followed that top, the SP500 was not able to successfully find support at the Price Oscillator Unchanged line, and the market eventually broke down in a big way. 

If, on the other hand, prices retrace back toward the price-time point of an impending convergence before it is done, then what usually follows is a resumption of the preceding trend.  We saw an example of that type of behavior in mid-October, when the new uptrend interrupted itself briefly to dip back toward the convergence, and then the uptrend resumed. 

So now here in November 2011, we are seeing the Thanksgiving week selloff take the SP500 down to its 0.618 retracement level, and simultaneously completing a rainbow convergence with this accelerated short term move.  Because we have seen no retracement back toward this convergence, that means that we should expect to see at least a pause in the down move, while prices decide what to do next.  In the days ahead, if we see prices rally up to the Price Oscillator Unchanged line and fail to move above it, then we can expect more downward movement.  But if the SP500 can instead get up above that line, and turn the Price Oscillator up in the process, then we'll know that this rainbow convergence will have marked a bottom for the down move, and the strength we saw in October can have a chance to reassert itself.

For those who are new to seeing our work, this sort of analysis is regularly featured in our Daily Edition.  Check out the samples posted here, and see if it is something you would be interested in reading on a daily basis.

I invite you to also check out the 72-minute video of a recent presentation I did before the Seattle Securities Traders Association.

Gold has a couple more years to outperform the stock market before the end of this leg, if history is any guide.

This week's chart looks at the Dow Jones Industrial Average expressed in terms of the number of ounces of gold it would take to "buy" the DJIA's index value.  This is a popular comparison that a lot of chartists like to show, especially when it gets up to a really high level like it did back in 1999-2000, at the end of the tech bubble.

It has been falling since then, as gold prices have gone higher.  Having an ounce of gold become more valuable means that it takes less of it to buy something else.  And the (violently) sideways movement of the stock market over the past decade has allowed gold's price rise to pull this ratio back down toward "normal" levels seen over the past century.

Based on this way of looking at the DJIA, there have been 3 big bubble tops in the DJIA as expressed in ounces of gold.  What I find interesting and relevant just now is that the declines out of those first two took 13 and 14 years respectively.  So if the current decline follows the same course, then we can expect this ratio to bottom out about 13-14 years from the most recent top.

Doing the math on that is a little bit problematic, since the last top was actually 2 tops, in August 1999 and October 2000.  So if we take 13 years from 1999, and 14 years from 2000, that gives us a date range of 2012-2014 for when to expect a bottom for this ratio. 

That tells us about the "when", but it does not tell us about the "how far".  The bottoms for this ratio in the 1930s and 1940s were down below 3.0, and it got all the way down to 1.3 at the low in January 1980 (based on monthly closes).  If the DJIA were to stay around 12,000 for the next few years, then a ratio of 2-3 would mean gold at around $4000 to $6000 an ounce.  Or the ratio could get down below 3 by having gold stay where it is, and the DJIA get cut in half, or some other combination of movements.  That's how the math works. 

It is risky to forecast both the timing and the price for the end of a trend, so I'll refrain from endorsing those numbers.  I just offer them as food for thought.  Nothing mandates that this ratio reach any particular level. 

The more important conclusion to take from this is that the decline in this ratio does not seem to be done, and is not due to be done for a little while longer.  But the end to this decline in the DJIA/gold ratio is going to come someday, probably when the Fed decides to wake up and start fighting inflation again via higher interest rates.  That does not appear to be on their agenda any time soon. 

Among our favorite types of data to follow are the unique sentiment insights we get from the weekly Commitment of Traders (COT) Report.  We highlight key pieces of that information every Friday in our Daily Edition.

The basic idea is to look at the net position held by the "commercial" traders of the various contracts, because those traders are the big money, and thus presumably the smart money.  But not every futures contract in the COT Report offers us useful insights.

This week's chart is a great case in point.  It shows the commercial traders' net position in crude oil futures.  Ideally, you would like to see this indicator get up to a high reading (large net short position) at important price tops, and a deep negative reading (large net long position) at price bottoms.  But it just does not work that way, at least not very well.

One of the problems with looking at the COT data for crude oil is that some of the "commercial" traders are actually oil producers, who are using the futures market to lock in pricing for their future production.  Other entities like airlines and rail carriers use the futures markets to hedge their fuel costs, so it is not so much of a matter of the smart money versus the dumb money.

There are times when this indicator gives us great indications of a top or a bottom for crude oil prices.  And then there are other times when listening to it would be a horrible idea.  It is just not consistent enough to be reliable.  So what should we do to get an insight about where crude oil prices are headed?

The answer is to borrow a related indicator from another market.  Below is the same indicator for the Canadian dollar futures.  It is well known that the exchange rate of Canadian dollars versus US dollars is very closely correlated to oil prices.  And so if you could know where the Canadian dollar was going, then presumably you would have a pretty good idea about where the price of crude oil was going.  



The COT Report data for Canadian dollar futures offers us a much more reliable indication for both that currency, and for oil prices.  One reason for the greater reliability is that there are no "producers" of Canadian dollars like there are oil producers.  So it is a much purer bet on the direction of exchange rates.  Interestingly, the Mexican peso also correlates very well to crude oil prices, and so I find that its COT data also makes a nice surrogate indicator for oil prices.

Right now, in November 2011, commercial traders of Canadian dollar futures are back to being net long, after having shown us a big net short position earlier in 2011 when oil prices and the Canadian dollar were topping.  The message from this net long position is that crude oil prices should be expected to head upward from here.  How long they head upward is something that this indicator does not tell us now, but we will be watching and reporting on it in future issues of our Daily Edition as more data come in. 

Back in early 2008, before the real ugliness in the stock market unfolded, commodities funds became the "hot thing" as hedge funds and other investors chased returns in more exotic places.  The argument then was that one should use investments in commodities to diversify away from the risks of stock market investments.

The problem with this idea, then and now, is that a diversified portfolio should invest in non-correlated assets.  That way if one asset class falls, the others won't go down with it.  And the assumption that commodities are non-correlated to stock prices is one that does not survive contact with the data. 

This week's chart shows that commodities prices are very closely correlated with the movements of the stock market.  So if one invests in a basket of commodities prices in an effort to get a non-correlated asset, one is making a big mistake.  The reality is that their movements are very strongly correlated. 

The chart above uses the old CRB Index for comparison to the SP500. That old version is now called the Continuous Commodity Index (CCI, not to be confused with an indicator called the Commodity Channel Index, also CCI). The redesignation followed the 2005 reconfiguration of the CRB Index to more heavily favor energy related futures contracts.  That new version actually goes by the full name of "Thomson Reuters/Jefferies CRB Index", but almost no one refers to it by that long version.  



The strong correlation between commodities prices and the SP500 is there regardless of which commodities index one uses.  Here we see that the CCI and the new CRB Index may be moving apart in the long run, but their daily and weekly dance steps are almost identical.  This is because the components are still largely the same, and just the weightings have been changed. 

Perhaps even more interesting than the insight that commodities and stocks are mostly well correlated is the idea that the subtle differences in their behavior may contain useful information.  This next chart looks at the 1-month correlation coefficient between the CCI and the SP500.



You can see that most of the time it remains well above zero, indicating a strong positive correlation.  But every once in a while, the correlation seems to break temporarily, sometimes even plunging below zero.  That can be a useful sign that the stock market is trouble, and that volatility is about to pick up due to a temporary illiquidity condition. 

In late 2010, the two showed a consistently strong correlation.  That lasted all the way until March 2011, when the stock market's advance had slowed and began running into liquidity troubles.  Even more significant dips in correlation preceded the big plunge in the stock market during August 2011.

Now in November 2011, the two appear to have returned to a strong positive correlation, implying that liquidity has returned to the financial markets.

I hear more and more analysts talking about how negative real interest rates are a bullish factor for gold.  That is a true statement, and it is something I addressed here back in January 2010.  The circles in the chart highlight instances of negative real T-Bill yields, and they are generally associated with rising gold prices.  I do get worried, though, when everybody starts to recognize a bullish factor for anything. 

We are seeing negative real interest rates right now because of a conscious choice that the FOMC is making.  Congress gave the Fed a dual mandate--maximum employment and stable prices.  Since 2008, the Fed has been ignoring the mandate for stable prices in favor of keeping short term interest rates effectively at zero, in hopes that it will help to stimulate economic activity and therefore restore jobs growth.

Jobs have not yet come back as fast as everybody would like, but consumer prices have been rising.  The CPI-U is up 3.9% from a year ago, and PPI is up 6.9%.  Having higher inflation while interest rates remain low means that the negative real interest rate on T-Bills goes to an even more negative level.  And while that is a bullish factor for gold prices, it may be too much of a good thing.

What I would like you to notice in this week's chart is that when the real yield gets down below -3%, that tends to mark a terminal point for an uptrend in gold prices.  I don't mean exactly today or tomorrow, but in the really long term a condition like this tends to mark important tops for gold prices.  The reason it works this way is that at some point this sort of condition gets so big that somebody decides to do something about it. 

Back in 1981, that somebody was Fed Chairman Paul Volcker, who finally took short term rates up above the inflation rate and thereby helped to snuff out the runaway inflation we were seeing back then.  Those higher rates made it more expensive to speculate in gold, because investors would miss out on the chance to earn big yields by investing elsewhere.  So money came back out of the gold market to chase those higher yields, and the price of gold fell. 

In 2008, the real yield on T-Bills got down to -4.0%, as a reflection of the wealth destruction that was going on everywhere that year.  Gold prices finally fell in sympathy because investors turned to their gold holdings as a "source of funds" to cover other losses.

Now we are once again seeing real yields well below that -3% threshold, and while it is still a bullish factor for gold prices, it also may be the sign that the good times for the gold bulls may be nearing an end.  At some point, the FOMC is going to remember that it has a DUAL mandate, and that the stable prices part of that mandate has been ignored for too long. 

Exceeding the -3% threshold does not mean that the Fed has to wake up and start doing its job right at this moment.  It just says that they are increasingly likely to do so.  Gold investors should take heed, and understand the negative implications (for gold prices) of the Fed actually deciding to do its job, whenever that might happen.

Exceeding the -3% threshold also does not specifically mean that the top is in for gold prices.  When the top might come in is something that we address for subscribers of our twice monthly McClellan Market Report and our Daily Edition. Why not take a look?

My chart this week is the same one that is featured every day on our Market Breadth Data page, and it is particularly noteworthy because of the multiple signs of confirmation that it is giving us about this new uptrend. 

The first sign that something was brewing was the divergent higher low that the Oscillator made when the major stock market averages were making lower price lows on Oct. 3, 2011.  Coming off of that divergent bottom, the Oscillator broke its own downtrend line, which is something that quite often precedes the breaking of the equivalent trend line drawn on prices.  Trend lines like these on the Oscillator chart do not always appear, but when they do they are worth paying attention to.

The second sign of bullish power was that the Oscillator was able to rise up above +200 and stay there for a while.  The Oscillator tends to shown an overbought condition up at around +150, but when it goes well above that level it shows that there is unusually strong liquidity.

The problem in making that interpretation is that a high Oscillator reading can also appear during snapback moves during a downtrend, as short covering leads a majority of issues to close higher for a few days.  So this possibility should be kept in mind as technicians read all of the signs that the charts have to offer.

Here is an historical example of what I am talking about.  During the 1998 double bottom, there was an initial Oscillator surge up to +230, which showed that there was some liquidity available to push prices higher.  But that rally could not be sustained, and prices fell back down to make a double bottom at a much less negative Oscillator reading.



Coming out of that double bottom, there was an even more powerful Oscillator surge, which said that there really was a lot of money wanting to get itself into the market.  That is a condition which usually takes a long time to exhaust itself, and meanwhile prices trend higher as liquidity is gradually absorbed by the stock market. 

Turning back to 2011 again, a third sign of bullish confirmation is that the Oscillator is forming a complex structure above zero.  When we write about complex structures in the Oscillator, we are referring to choppy up and down movements without a crossing of the zero line.  Complex structures imply strength for the side of zero on which they form, either bullish strength or bearish strength.  


During the August 2011 decline, there was a complex Oscillator structure below zero, which told us that the bears were in charge.  At the bottom on August 8, 2011, the McClellan Oscillator was at an all time record low, and so complex structure or not, it was time for a reflex rally.  From mid-August through early October 2011, there were a series of simple structures above and below zero, which said that neither side was in charge. 

At the right end of the chart, the complex structure with repeated surges to above +200 is saying that the bulls are in charge, and that they have some power.  That is a condition that tends to last for a while. 

Through August and September 2011, the stock market has gone through a meaningful correction.  That resulted in a nice low reading for the McClellan A-D Summation Index.  It was not as low of a reading as we saw during the ugliness of the 2008 selloff, but it was still low enough to mark a nice intermediate term oversold condition.

Now the question coming out of this oversold reading is over whether we will see enough strength to signal initiation of a strong new uptrend. 

This week's chart shows the Ratio-Adjusted Summation Index (RASI).  It is calculated using the same math that is used for the classic version of the Summation Index, except that for the data input we divide the daily Advance-Decline (A-D) difference by the sum of Advances plus Declines.  We also then multiply that ratio by 1000 just to take the product back up into the realm of real numbers.  In effect, we are mathematically pretending that there are always exactly 1000 stocks traded every day, which factors out changes in the numbers of issues traded, and makes for better long term comparisons. 

Coming out of an intermediate or long term correction, the key indication to look for is whether or not the RASI can climb back up above +500.  It is kind of like when a rocket takes off to get up into earth orbit.  It has to achieve a certain speed, referred to as escape velocity, or else it will fall back down to earth.  Market rebounds work similarly, in that there needs to be a certain amount of strength showing up in the A-D numbers at the beginning of an uptrend, or else prices roll over and head back down to the level of the prior low, or even lower. 

So what we will want to see in the weeks ahead is a RASI move back up above the +500 level, which equates to around +2500 on the classic version of the Summation Index.  That is something that we will be watching for and discussing in the upcoming issues of our twice monthly newsletter and Daily Edition.

If it fails to get up above +500, and instead rolls back over and heads downward at or below the +500 threshold, that will be a sign that there is not sufficient liquidity to keep the rally going, and the August to October 2011 lows will get revisited or exceeded. 

Copper used to be said to be the metal with "a PhD in economics".  But lately, copper is just a doppelganger for whatever stock prices do.  Now, the commodity that really tells us about the economy is lumber. 

Lumber is unique among industrial commodities in terms of the balance that its prices portray about the conflict between supply and demand.  Ups and downs in the housing market affect demand for lumber.  But the input costs also vary according to the availability of raw timber, labor costs, electricity to run the mills, fuel to transport it, and space to store it.  It lies at the crossroads of a complex set of economic forces.

I believe that is what makes it such a great economic indicator, as detailed in the articles referenced below.  And that makes the recent decline in lumber prices a bad omen for the near term future of the economy.  But within that decline, there is deeper information about what lies ahead in the more distant future.

The near month contract as of Oct. 7, 2011 is the November contract, which as I write this stands at 226.60.  If we go out almost a year to the Sep. 2012 contract, it stands at 280.10.  That is a pretty big spread, as shown in this week's chart.

When the near month contract is well below that of several months out, it is a condition known as "contango".  A higher price in the distant month futures contracts is a sign that spot and near month contract prices are likely to rise.  It is also a positive development for the economy overall. 

Whenever the far out months are much higher than the near month, the indicator shown in this week's chart goes to a high level.  Getting it above 30% is a sign that the near month contract price is far too low, and the market's viewpoint about the current economic condition is overly pessimistic.  Saying it more plainly, current lumber prices are too low, and are likely to rise.  That is a positive development for the economy, and is suggestive that the Fed's efforts to keep short term rates at zero are misplaced.  The economy is about to rebound, whether anyone thinks so or not. 

How much of a rebound we get, and for how long, is not something revealed in this current lumber contango.  All it says is that lumber prices are too cheap right now, and they are likely to rise.  And that is a positive development for the economy going forward.

Looking only at the near month lumber price, we see an apparent break below the rising bottoms line.  That would ordinarily be a bearish sign.  But with the contango already so large, that additional evidence suggests that the breakdown is not likely to be sustained, and is instead a "false" breakdown.  The upward pressure from the out months should pull the near month price higher. 

As the stock market closes out the ugly month of September, a lot of people are looking ahead to the bullish tendency for the first day of the month. 

First days have a bullish bias, and since 2003 the SP500 has closed higher 65.7% of the time on the first day of the month, versus only 54.8% when we look at all days.  This week's chart reveals that if a person had been invested only on the first day of the month, he would have beaten buy and hold.  The two plots are hypothetical equity curves based solely on the SP500 Index, and discounting dividends, interest, transaction costs, and other factors which would matter for real investing.  The point in doing this is not to calculate real performance, but rather to demonstrate the phenomenon. 

There are even some hedge funds who have built their trading strategies around just this sort of month-based "seasonality".  But before you go and start trading based solely on this one factor, there is a really big caveat to understand.  The bullish bias on first days of the month really only works when the stock market is in an uptrend.  From August 2008 through March 2009, first days went through a string of 7 down closes out of those 8 months, including a whopper of a 8.9% drop on Dec. 1, 2008.  So this is far from being a surefire strategy.

Interestingly, this bullish bias on first days is a relatively recent phenomenon in market history.  From 1976-1992, the 53.6% of up closes on first days was statistically indistinguishable from the 52.2% of up closes on all days.  Then starting in the 1990s, as automatic investments became more of a widely used practice, first days started seeing higher closes much more often, as those fund flows helped to push up prices more. 

2011 has not been such a good year for this phenomenon.  With 9 months gone by, only 4 of them have seen a higher close for the SP500 on the first day of the month.  This is part of that same story of how first days have a bullish bias only during uptrends. 

At the point when the market finally starts trending higher again overall, then we can start expecting first days to show that historic bullish bias once again.  But it is not an expectation we can apply during corrective periods for the stock market. 

I love price pattern analogs, because I love just about anything that can tell me in advance what is going to happen to stock prices.  If the current price behavior is similar to that of another period in history, then sometimes it can give us insights about what lies ahead.

Subscribers to our Daily Edition and our twice monthly McClellan Market Report newsletter have enjoyed getting to see this week's chart on a regular basis.  It compares the ugly decline of the summer of 2011 to a very similar decline in the summer of 1946. 

We first took a look at this comparison back in August 2011 because of a common factor in each period: there was no divergence in the A-D Line.  Most of the time when there is a price decline as big as we have just seen, the A-D Line gives us warning of liquidity problems by making a divergent lower high as prices make a higher high.  We did not get that A-D Line signal in the summer of 2011, although other divergences did tell us (and thus our subscribers) that there was trouble brewing.

1946 similarly did not have an A-D Line divergence, and so that made it worth taking a look at as a comparison model.  When lining up the price patterns in a single chart, the correlation of price movements then and now became obvious. 

1946 also shares other similarities with the current time frame.  The U.S. was in the midst of dismantling the stimulative effects of a war-time economy, and unemployment shot up in a big way.  There were also concerns about rebuilding post-war Europe, and whether or not loans would be repaid like the Lend-Lease Program.  Now we have an economy with high unemployment, and the expiration of stimulative efforts like TARP and QE1 & 2.  There was great labor union unrest in 1946, which led to the 1947 passage of restrictions on union activity in the Taft-Hartley Act, which passed over President Truman's veto.  2011 saw a big push back against unions in states like Wisconsin and New Jersey. 

Zooming in closer, we can see that even the manner in which each of the steep declines unfolded was very similar.  There was a rapid one-day drop, a slight hesitation, and then the final plunge in both cases.



Rather than continuing the decline after the steep plunge, the 1946 market saw a long series of retests, with the DJIA seemingly bouncing along against a price floor for several months.  The last of those came on Nov. 22, 1946, and with the price pattern alignment shown in these charts, that equates to a bottom due Oct. 21, 2011. 

One point to understand about using price pattern analogs is that eventually the correlation breaks up and stops working.  Often that point will arrive at the moment when one is most counting on the correlation to continue working.  So one should never give these pattern analogs complete trust, no matter how good they look.  But for the moment, the 1946 pattern does seem to be telling us the correct answers about how the current market's corrective period will play out. 

Sentiment could not be much worse for the U.S. housing market than it is right now.  And why shouldn't people be pessimistic?  All of the governmental efforts to stimulate a housing rebound, so people start thinking that if the government cannot fix it, what can?

Meanwhile, most people are unaware of a major rebound brewing for the home building stocks.  That is because most people are not readers of our publications. 

This week, I'm revisiting a topic addressed here before, concerning the way that housing stocks tend to follow in the same footsteps as lumber futures prices.  The price plot of lumber futures has been shifted forward in the chart by a year to reveal how the same patterns tend to show up in the PHLX Housing Sector Index HGX about a year later.  It is not a perfect correlation; it is merely very good. 

A year ago, lumber prices were finishing the bottoming process after pulling back to test the top side of a broken declining tops line.  Lumber prices then surged into early 2011, which means that we should expect the HGX to see a similar surge into early 2012. 

This next chart looks at the same relationship, but zooms in closer.



One important point to notice is that the lumber price top a year and a half ago was a lot sharper of a blowoff move than what ended up being seen in the HGX's own topping structure.  There is a very good reason for this.  At the end of an ordinary up move in lumber prices, the Maule earthquake struck Chile on Feb. 27, 2010.  That earthquake shut down lumber operations in that country, disrupting supplies and sending lumber buyers scrambling for alternate sources. 

Once the lumber and other markets had a chance to recover, prices normalized and came back down from that sharp blowoff top.  The HGX decline in 2011 matched the timing of the lumber decline in 2010, but not the magnitude.

The lesson here is that lumber tends to respond a year ahead of time to the economic forces which will strike the housing market a year later.  I liken this to a wave passing under the end of a long pier.  The same wave eventually strikes the beach, and so if you know the length of the pier and the speed of the wave, you can know when the wave will hit the beach. 

The same economic wave which caused a decline in housing stocks in 2011 had caused a decline in lumber prices a year earlier.  Lumber's price pattern also reflected a temporary anomaly from the Chile earthquake, which was not a factor that affected housing stocks.  That's the hard part with using a leading indication like this, or any of our other Liquidity Wave relationships: one has to figure out which movements are due to economic forces, and which are due to something putting a thumb on the scale.

Lumber's price rally in late 2010 was not due to any one-time factors like earthquakes, and so it seems much more likely to have its full echo observed in the prices of home builder stocks.

That headline is nothing new to most people, but you may never have seen such a long term view of gold prices before.  This week's chart looks all the way back to 1792 at the value of gold expressed in dollars per ounce.  If we assume that gold's real value stays constant over time, and that its price is a statement about the value of the dollar, then this chart is a good representation of the debasement of the dollar by virtue of how many more dollars it takes to buy an ounce of gold. 

It is called "debasement" because when it happens, 'de value of 'de dollar goes down to 'de basement.

We have been going through a financial crisis since 2007 when the real estate bubble collapsed, and the Fed's efforts to resuscitate the economy have tripled the price of gold from its early 2007 levels.  But the rise in gold prices was going on since 2001, long before anyone ever heard of "quantitative easing".

Looking at this long term chart also allows us to make a visual comparison of this current round of debasement, and other periods in history when the dollar's value changed dramatically.  The scaling is logarithmic, which means that each increment of vertical chart space represents the same percentage move for prices.  Calculating the logarithm of a number means that you are expressing that number as the exponent by which a base number (10 in this case) has to be raised to produce that number.  So 2 on the Y-axis equates to $100/oz, 3 equates to $1000/oz, etc. 

Being able to see gold prices in this way puts into perspective the modern round of dollar debasement, compared to other events in U.S. history.  We might think we have it bad now, with unemployment north of 9%, but that pales in comparison to the estimated 37% unemployment rate in 1933, and also to the economic difficulties during the U.S. Civil War. 

When talking about the price of gold, people typically use pricing units of dollars per troy ounce.  But that convention is not the only way to look at the comparative value of gold versus the dollar.  This next chart flips that relationship upside down, and looks at gold's price measured in ounces per $100.  I could have used ounces per $1, but then there would just be longer decimal numbers in the Y-axis.  I did not use logarithmic scaling on this one.  



After the founding of the U.S., a hundred dollars would buy you 5.16 ounces of gold.  Now, it buys you just 0.05405 ounces.  Pushing this line down all the way to the basement is great for owners of gold, but lousy for owners of dollars. 

I'll bet you did not know that housing makes up 42% of the Consumer Price Index (CPI).  All the rest of it, food, energy, clothing, recreation, education, transportation, toys, cosmetics, etc. makes up the other 58%.  So whatever housing prices are doing has a big effect on the headline CPI number. 

The softness of housing prices continues to artificially supress the growth of the CPI inflation rate.  Some Fed officials are even saying that they need to strive for higher inflation to help the economy rebound, in spite of the Fed's mandate to promote "stable prices". 

Most people have heard about the CPI variant that excludes food and energy.  But not many people outside the economics community know that the Bureau of Labor Statistics also publishes a long list of alternate permutations of CPI calculations, including or excluding various components.  This week's chart shows a comparison of the CPI-Housing growth rate versus "all items less shelter", which is that other 58% of the CPI calculation I mentioned above.  When we exclude the contribution of the housing price data, we can see that the inflation rate for everything else is already up to 4.68%. 

And this high inflation rate is occurring at a time when the yield on the 30-year T-Bond is just 3.51%, and 10-year T-Notes are yielding just 2.15%!

The chart also reveals that the CPI-Housing growth rate is already working on catching up to where the inflation rate has gone for everything else.  And if the next chart is correct, the future should bring even higher housing costs.



This chart shows that the CPI-Housing growth rate follows the movements of lumber prices, with a lag time of about 18 months.  So the bottom for housing prices in 2010 was just the echo of the bottom in lumber prices in early 2009.  The current uptrend for the growth rate of CPI-Housing is following the path of an up move in lumber prices that occurred 18 months before.  Lumber prices peaked in December 2010, which suggests that the CPI-Housing numbers should continue rising until around June 2012.

If so, that is going to take away the depressing effects of low housing prices on the headline CPI data.  And a higher input from housing prices joining with the already 4%+ inflation everywhere else is going to make it really hard for the Fed to live up to its promise to keep interest rates low until 2013. 

With the sharp price drop in August 2011 came the side effect of large magnitude numbers for the daily breadth, meaning Advances minus Declines.  Looking at that daily A-D difference is the basis for calculating the McClellan Oscillator and Summation Index, but others have used that data in many different ways.

Norman Fosback is a legendary technical analyst, who developed several tools and indicators over the years.  One of them is in this week's chart, which looks at the absolute value of the daily breadth numbers.  That means it ignores whether the A-D difference is positive or negative, and looks only at how large the number is.  Fosback found years ago that bigger absolute breadth numbers seemed to occur around bottoms, whereas quieter numbers tended to be a sign of a top.  That's still true today.

The indicator in this week's chart smoothes the daily absolute breadth numbers with a 21-day simple moving average (SMA).  It is worth noting that the range of values in the last few years has gotten a lot bigger than what it was before the elimination of the uptick rule in 2007.  Greater daily volatility also shows up in other ways, such as the number of 10 to 1 up or down volume days.

When the market is operating in an illiquid environment, prices have to travel farther to find where the remaining liquidity is hiding.  This leads to bigger negative days for daily breadth, and then the snapback up moves tend to get most of the stocks going up together as well.  So you see bigger A-D numbers on both down days and up days, which drives up the value of this indicator. 

At some point, those bigger numbers take this indicator to an extreme value like the one we see at the right end of the chart.  Those high indicator readings are reliably associated with important bottoms for the major stock market indices, so it is important to note that we are seeing such a condition in late August 2011.  It is also important to note, however, that the highest readings for this indicator do not always mark the bottom for stock prices. 

So we can note the message about a bottoming condition that this indicator conveys, but we have to switch to other tools for knowing more precisely when the bottom has arrived.  That is the sort of information we convey to subscribers in our twice monthly McClellan Market Report and our Daily Edition.