Are markets ready for a pullback?

It generally pays to follow the money and respect the trend; however sometimes it can also be worth thinking like a contrarian, and getting ahead of the curve.

I will always trade with the trend as long as I can, unless I am seeing clear signs of exhaustion and divergence on the charts. Of course with this in mind you need price to confirm any reversal, but right now I am seeing a number of interesting indicators that suggests thinking like a contrarian.

Everyone is bullish

The weekly American investors bullish sentiment survey (released on Friday) at 46.28 is the highest reading since July and at levels thematic of pullbacks. The S&P 500 is in a strong uptrend and shorting the index has been the pain trade; however the index is now two standard deviations from its 20-day moving average, while also testing trend resistance drawn from 2010. The contrarians will be taking note of the overtly bullish sentiment at a time where markets are slightly overbought and approaching strong resistance.

Perhaps the fiscal ‘agreement’ has provided the necessary spring board for risk assets to appreciate, though it’s interesting to see a comparison of the VIX (volatility index) relative to the S&P. In the last couple of years, whenever the VIX has traded above 21% and subsequently undergone a sharp decline, strong buying has then occurred in the equity market. Of course there is a strong element of ‘climbing the wall of worry’, but it’s then a question of how long the move can be sustained. It also seems that when the VIX gets down to 12% (it’s currently at 13%), the S&P 500 subsequently falls; again this could be another red flag for the contrarians.

If there are signs of an impending reversal then Asia is showing limited concern and markets are doing nicely today, with the Nikkei the outperformer with a gain of 0.8%. Japan’s September trade deficit came out slightly higher than expected at ¥932.1 billion. Exports grew less than forecast at 11.5%, although exports to Europe, China and the US continue to grow at a really positive pace. If anything, the worse-than-forecast trade balance reinforces the market’s view that the BoJ can afford to be more aggressive in in October 31 meeting, thus we have seen the market bid.

The ASX 200 is strong, but overbought

The ASX 200 has once again printed a higher high (currently up 0.7% at 5356), and price action looks bullish and it continues to hone in on 5426 (the 61.8% retracement of the all-time high to GFC low). A breakdown of the sub-sectors show trend breaks in the financial and consumer dictionary spaces, and volumes have been pretty solid today. Similar to the S&P 500, the actual index is over two standard deviations from its short-term average, and at some stage in the next session or two could mean revert and head to 5236; although given the current uptrend would present itself with a healthy buying opportunity.

Again, actually prophesying what will actually cause the change in momentum is yet to be known. China is up 0.3%, despite the  PBOC advisor (Song Guoqing) implying that the Q3 GDP print of 7.8% is pretty much the peak (he expects growth of 7.7% in Q4), and that if CPI stays above 3%, the PBOC may adopt a more neutral or restrictive policy setting. Still, given the high levels of retail participation in China’s equity market (thus making the Shanghai Composite or CSI 300 a really good guide to sentiment), you would expect this market to be lower. What the comments really highlight though is that inflation is now back on the market’s radar after being off it for over a year.

The other big contrarian play is around the USD, where unlike S&P 500 the large majority of market players have a short-term negative bias. The US dollar index is at the lowest levels since February, with EUR/USD (55% of the index) rallying on Friday to seven pips shy of its February high, while price action in NZD/USD, AUD/USD and GBP/USD has also been strong. It’s not just a USD story, but one of traders looking for carry (i.e. selling the low yielding asset and buying a higher yielding asset). The recipe for further carry opportunities is strong right now, with low volatility and positive risk-on themes.

Traders bearish on the USD

Still, what happens with the USD is a different beast, and traders may change their bias on the carry trade to one of solely focusing on using JPY as its preferred funding currency. With consensus expectations pushed out to March for the Fed to taper, and Senate Republicans Mitch McConnell and John McCain saying over the weekend there will not be another government shutdown, what happens if we do get a blowout payrolls number tomorrow? The market expects a print of 180,000, however given all the aforementioned parameters if we see a number above 200,000, it probably won’t alter the view of tapering; however it could alter USD positioning and push EUR/USD, AUD/USD and cable lower. Again, one of the contrarians.

With all this in mind, a stronger open is expected in Europe and it will be interesting to watch the DAX today given the German Finance Ministry has detailed that domestic tax revenues gained 7.8% in September. This could provide support to the EUR as well; however there are some interesting issues playing out in Europe, not to mention a strong possibility of Spain significantly missing its 2013 6.5% deficit target. On the docket today we get US existing home sales. While on the earnings side we hear from McDonalds, Gannett, Halliburton, SAP and Phillips. Price action in Google commands attention and it’s worth highlighting that the extra market cap it gained on Friday, was greater than 404 companies in the S&P 500!

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