Euro Holds Key for Stock Rally

Wed, Dec 28, 2011 - 1:38pm

The best way to monitor the sustainability of the current push higher in stocks (SPY) is to keep an eye on the euro and U.S. dollar. The correlation between stocks and the euro has been strong in recent months. In the current environment, when the euro strengthens, stocks tend to come along for the ride.

On Wednesday morning, the euro made a new low (see below). If the euro fails to recapture 129.87 in the coming days, it may signal another round of weakness for stocks and commodities.

The weekly chart of the euro is telling us to keep an open mind about the possibility of a snap back in the euro. The euro has clearly made a lower low (see downward sloping red line below), but the technical indicators (ULT and MACD histogram) have made higher lows (see green lines top and bottom). The divergences between price and the indicators may be indicative of a weakening desire to sell the euro (emphasis on may).

Since ETFs are a little easier for the average investor to follow, we will focus on the euro and U.S. dollar ETFs below. If the euro ETF (FXE) fails to recapture 129.34 in the coming days and weeks, it will lean bearish for stocks and commodities.

Looking at ETF volume, we see above average interest in the U.S. dollar. Since volumes are light this week, we will use the S&P 500 ETF (SPY) as the baseline. SPY has traded 46 million shares as of 11:30 a.m. ET on Wednesday, or roughly 19% of a typical full trading day. UUP has traded 77% of a typical day’s volume; FXE 45%.

As outlined on December 18, we do not believe the European Central Bank’s (ECB) three-year loan facility represents a long-term solution to unsustainable levels of debt in Europe. With ten-year Italian yields still hovering around 7%, the bond market is skeptical of the ECB’s “back-door bazooka” as well. Since the December 19 low, stocks have turned a blind eye toward Italian yields. If the U.S. dollar ETF (UUP) can retake, and hold above, 22.62, it would add to our concerns about the sustainability of the recent push higher in stocks. Conversely, if UUP drops significantly below 22.62, it will increase the odds of stocks pushing higher over the next few weeks.

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