The Week Ahead (by BBFinance)

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After the surreal week when equities defied all logic and reasoning only to gain 15 SPX points, the hangover from the party may be due next week. In the process, all trading parameters have been trashed to the extreme and if there is anything called super overbought, it is here and now. But we all know that markets can remain irrational longer than we can remain solvent or sane. So we see die-hard bears throwing in towels. When such a thing happens, you know that the reversal is round the corner.

The situation is not a cut and dry one. I expect a higher high in February before weakness returns with a vengeance. By May of 2012, the bulls will forget that they were ever so ecstatic. The mood will swing from euphoria to eternal gloom. But we have some unfinished business before that.  For now let us take a short term view of only the next week and see what is possibly in store.

Given that indexes are due for a decent pull back, question is when is that going to happen. For answer let us look at AUD which has the highest correlation with SPX. AUD has reached 100% of FIB extension on Friday, January 20th, and the coming week we may see a sell off. The following is from David Song, currency analyst.

The Australian dollar advanced to a fresh monthly high of 1.0480 following the rise in risk-taking behavior, but the high-yielding currency may come under pressure next week as the fundamental outlook for the region deteriorates. Indeed, the 4Q Consumer Price report highlights the biggest event risk for the Aussie, and the development may trigger a selloff in the AUD/USD as the headline reading for inflation is expected to expand at a slower pace during the last three-months of 2011.

In turn, the Reserve Bank of Australia is widely expected to further reduce borrowing costs this year, and we will maintain a bearish outlook for the high-yielding currency as interest rate expectations remain weak. According to Credit Suisse overnight index swaps, market participants see the RBA lowering the cash rate by another 100bp over the next 12-months, and the weakening outlook for growth and inflation is likely to heighten speculation for additional monetary support as the central bank tries to balance the risks surrounding the economy. At the same time, the slowing recovery in China – Australia’s largest trading partner – fosters a bearish outlook for the AUD/USD as the world’s second largest economy faces an increased risk for a ‘hard-landing,’ and we may see the RBA aggressively scale back the slew of rate hikes from 2009 as the region faces a protracted recovery.

As the rally in the AUD/USD tapers off ahead of 1.0500, the weakening outlook for growth and inflation is expected to drag on the exchange rate, and we expect to see a short-term reversal next week as long as the relative strength index holds below 70.”

Yesterday I posted about the RSI divergence in AUD, ( ) and the before that I have posted that AUD has reached the top of the triangle ( ) . It seems that AUD is running out of steam short term and may now test the lower trendline of the triangle. And the AUD cycle tops early next week.

 The following chart shows the daily correlation between AUD and SPX. You will note that from time to time, SPX diverges from AUD but eventually comes back closer. 

AUD SPX correlation
If now is the time for correction for both AUD and SPX, we may see some violent movement in SPX in the next week. Of course nobody knows what will be the extent of the correction because many other factors are in play and given that an uptrend is due in February, the correction this time may not be for long either. It will be an opportunity for trapped short holders to get out of the position with the skin intact. A bigger and better opportunity to short is coming by Mid-February.  

The year 2012 is going to be more like 2011. No one can afford to be perma- bull or perma-bear and investors will find it hard as ever. While we may see SPX 1000 being tested by May 2012, we may also see SPX 1500 being probed in October 2012. So let us not get carried over by end of the world stories. Nor let us believe the buy hype because fundamentals do not justify. It will be a liquidity driven market, run by the TBTF banks, for the TBTF banks.  That is the only way they will be able to make profit and write off the toxic assets in their balance sheet. Otherwise they are all dead men walking. The Fed, ECB, Governments and TPTB (the powers that be) know this and encourage this with their printing press.

So let us ride the BS when we can. Let us run with the hare and hunt with the hound and keep the holding period short.  

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