Euro's SPX Influence

Over the past few years, the fortunes of Europe's euro currency have appeared to significantly influence the US stock markets. This rather-curious relationship has proved vexing at times to American traders, as it doesn't seem logical on the surface. But given the high correlation between the US stock markets and the euro, prudent traders can't ignore its impact. And the euro's state today is very bullish for US stocks.

Ever since this odd composite currency was born in January 1999, the euro has been much maligned. More or less continually over this entire 13-year span, skeptics and naysayers have been calling for the euro's imminent demise. They argue that a currency straddling such a disparate and economically-diverse group of sovereign nations is doomed to fail. But the euro's stunning record begs to differ.

In the brief span in currency terms since its introduction, the euro has achieved vast success beyond what the wildest optimists in the late 1990s could have dreamed. Something like 330m Europeans use this currency daily, along with 175m more people worldwide using currencies pegged to the euro. In November 2011, the total euro banknotes and coins in circulation surpassed the US dollar's! Today the euro is by farthe world's second-largest reserve currency and second-most-traded currency after the US dollar.

You can't argue with such dazzling success, the euro has definitely defied the odds. So today whenever I hear traders and analysts claim Europe's sovereign-debt troubles are going to destroy the euro, I have to laugh. Every single time the euro has traded near lows since 1999, similar euro-to-zero arguments were ubiquitous. Yet the euro still continues to grow in popularity worldwide among central banks, investors, and ordinary people. Rumors of its imminent demise are greatly exaggerated.

Nevertheless, why should any foreign currency exert any material influence over the US stock markets? In 2011, total US exports ran something like $1.5t out of our total economy of $15.1t. And out of that merely 10% of the US economy driven by exports, none of our top four trading partners (44% of total exports) are European countries. So at absolute best, Europe accounts for less than half of US exports and therefore less than 5% of total US GDP. Realistically, European trade is closer to 3% of our GDP.

But though Europe and the euro shouldn't be material enough to influence US economic fundamentals underlying our stock markets, the trading action implies otherwise. This post-panic chart superimposes the benchmark US S&P 500 stock index (SPX) over the euro. Note that when the euro is rallying strongly in major uplegs, the SPX tends to mirror it with major uplegs of its own. And the biggest SPX selloffs of recent years nearly all happened when the euro itself was correcting, often sharply.

Emerging out of those brutal secondary stock-panic lows in early 2009, the massive SPX upleg mirrored a huge advance in the euro. The SPX rallied strongly until the euro topped out in late 2009, and then the US stock markets generally stalled out in the face of strong euro-plunging headwinds. The SPX was finally able to surge again in early 2010, but only after the euro stopped falling. And the moment the euro started plunging again, the SPX suffered a sharp selloff that snowballed into its cyclical bull's first correction.

The euro plummeted in spring 2010 because, are you ready for this, Greece had debt problems! Yes, Greece is nothing new. We've been dealing with this Greek "crisis" foralmost 2 years now. At the dawn of May 2010, the European Union and IMF agreed to a mammoth €110b bailout for Greece. Why anyone cared was beyond me. The entire Greek economy accounted for less than 1.9% of the EU's GDP then, and has shrunk considerably since. So if the profligate Greeks stupidly refuse to live within their means, kick them out of the eurozone and move on. No one will miss their drama.

I highlighted the major euro selloffs in red, to better understand their apparent impact on the US stock markets. After plummeting in a full-blown euro panic, which I took a hardcore contrarian stance on near its lows and correctly declared it a huge euro buying opportunity, the euro ultimately lost 21.3% by June 2010. Over that same span, the SPX lost 5.4%. And this comparison actually understates things considerably, as the euro panic ignited the first full-on correction of this stock-market cyclical bull.

Of course the euro surged sharply out of those incredibly-irrational euro-to-zero panic lows. Extreme fear is never sustainable in any market. Soon the SPX joined in, with a major surge of its own. But once the euro started retreating sharply again in the summer of 2010, the US stock markets followed. In several weeks the euro plunged 4.8%, and the SPX actually fared worse with a sharp 5.9% loss of its own.

This happened again in late 2010, when an 8.7% euro plunge over several weeks totally arrested an in-progress strong SPX upleg. The US stock markets pulled back 3.3% over this span despite having serious momentum going into that particular euro selloff. The euro was clearly seemingly influencing the fortunes of US stocks, even though our country's European trade is trivial relative to our total economy.

Then just as it had in late 2010, when the euro started surging sharply again in early 2011 the US stock markets mirrored its fast ascent. It is rather amazing that the SPX topped just a few trading days before the euro itself did in the spring of 2011. Then as the euro started selling off again from its highs, the SPX ground sideways to lower. The weak euro was a major headwind for the American stock markets last summer as they headed for an overdue correction.

Provocatively the lion's share of this SPX bull's second correction wasn't ignited by the euro, but by the profligate Obama Administration spending like the Greek government to force the first downgrade of America's vaunted credit rating in history. But the subsequent plunge in the euro dragged the SPX down to its secondary correction low in early October, when the SPX and euro bottomed on the very same day. Over that ugly span where the euro fell 11.1%, the SPX lost a staggering 18.4%.

And then just as the euro started soaring in October, the SPX mirrored it with the biggest monthly rally it had seen since December 1991 and the best October since 1982's! Then in late October the euro topped the day before the SPX did, and as the euro sold off again on more sovereign-debt fears the SPX struggled to grind sideways. Thankfully late in this last euro selloff, US stocks started to decouple from the euro's influence. But still the SPX was only 0.4% higher over a span where the euro fell 10.7%.

This chart is pretty powerful, you have to admit. Though I have known about this relationship for a couple years, I hadn't bothered to formally chart it until this week. The euro appears to have a significant to major impact on the American stock markets the majority of the time since the panic. Whether it seems logical or not, this relationship is inarguably there. So prudent American speculators and investors have little choice but to pay careful attention to the state of the euro in this post-panic environment.

With the euro apparently influencing the fortunes of the American stock markets, it behooves us to carefully consider the euro's own technicals and sentiment. This next chart looks at the euro and its Relativity-trading indicator, the rEuro. The rEuro divides this currency's daily closes by its own 200-day moving average, and the resulting multiple forms a horizontal trading range. The euro itself actually looks very bullish today!

Since the stock panic, the beleaguered euro has enjoyed a few massive uplegs and subsequently weathered some major corrections. But given the flaring intensity of the European sovereign-debt fears from time to time over much of this span, this performance is very impressive for the much-maligned euro. Back during that spring 2010 euro panic, most analysts predicted the euro would soon fall under parity with the US dollar. Instead it rocketed higher to nearly regain its pre-Greece-crisis highs by spring 2011!

Like every other major asset, the euro's price flows and ebbs based on sentiment. After major uplegs this currency grows way too overbought and greed reigns supreme. In rEuro terms, the past 5 calendar years of data have led us to define this overbought danger zone at 1.08x the euro's 200dma. All three times the rEuro hit this resistance zone since the panic, major corrections were soon born to eradicate the excessive greed and euphoria to rebalance sentiment.

Conversely after these big corrections, the euro becomes way too oversold and fear dominates. In Relativity terms this support zone is now defined at 0.93x the euro's 200dma. Though the incredibly-irrational euro panic dragged the euro far below normal support as panics always do, out of those hyper-oversold conditions a massive new upleg was born. And it didn't stop running until the rEuro once again hit greedy overbought territory last spring, the euro itself at major highs.

The resulting necessary and healthy correction pummeled the euro back down to its relative support late last year, and just last month the euro was very oversold again. Traders around the world were very scared of this currency, fearing the same old things we heard about during the spring-2010 euro panic. Europe's sovereign-debt woes and Greece's intransigency were going to soon fracture the euro, so it is doomed to fall below parity with the US dollar. Sound familiar?

The last time the euro was so low, and euro fears were so popular, the euro soon surged in a couple massive uplegs that coincided with a major upleg in the US stock markets. Seeing the euro so oversold again today, by the objective rEuro measure, is very bullish. After having just weathered a major 14.5% correction over 8.4 months, the euro is not only due for a major upleg but one appears to have already started!

Emerging from such oversold levels below 0.93x its 200dma, the euro remains super-low in relative and absolute terms and has lots of room to run higher. It ought to once again hit 1.08x its 200dma before this new upleg fully runs its course. And not even accounting for the fact that its 200dma will start to rise again later in this upleg, at this point 1.08x the euro's 200dma is $1.49 or 8.0% higher than this week's levels!

American stock speculators and investors ought to be very excited about this given the euro's seeming strong influence on the US equity markets since the panic. During all of the previous post-panic euro uplegs, the SPX rallied sharply to achieve major new cyclical-bull highs each time. Once again a strong euro, very likely after this second Greek bailout deal is resolved soon, is a very-bullish US-stock omen.

Now that you made it this far, it is important to clarify the relationship between the euro and US stock markets. While this analysis is certainly valid, an oversold euro near lows is very bullish for the SPX in the near term, the causality is backwards. I've done much published research in recent years showing that it is not the euro that drives the SPX, but the SPX that drives the US dollar that drives the euro! The true directionality of this relationship is crucial for traders to understand.

Psychology is the key, as is nearly always the case in short-term market action. Ever since late 2008's epic once-in-a-century stock panic, major SPX selloffs have ignited rallies in the US dollar. I've written essays exploring this critical relationship in depth if you need to get up to speed. Basically falling US stock markets frighten traders around the world, so they sell stocks and seek refuge in the two dominant global safe havens of the US dollar (cash) and US Treasuries.

And of course when the US dollar surges, the euro has no choice but to plunge. As the world's second-most-important currency by far, the euro dominates the flagship benchmark for measuring the US dollar. The euro accounts for 58.6% of the US Dollar Index's weight! So an up dollar necessarily means a down euro. And whenever the euro falls, the tired old euro-to-zero fears resurface in an attempt to justify it.

But these feeble rationalizations are wrong. The fortunes of the US stock markets dominate global trader psychology, without any doubt. So when a weaker euro is the result of a US dollar rally driven by a major US stock-market selloff, Europe woes are simply an excuse rather than the cause. Europe's bloated big-government model Obama so foolishly idolizes has had problems for decades and will have problems for decades to come. Europe's woes don't suddenly blink into existence only when the SPX is selling off.

But regardless of the causality between the euro's fortunes and those of the US stock markets, today's technicals are very bullish for both. As I discussed in depth last week, the SPX's newest upleg still has lots of room left to run technically even in the context of the ongoing secular stock bear. And the US dollar has recently been very overbought, driven higher by scared stock traders hiding out in safe havens. This has led to a very-oversold euro that looks like it recently started a major new upleg.

These young reversals in the euro and US dollar are not only bullish for the stock markets, but even more so for commodities. Commodities were utterly crushed late last year on the outsized dollar strength driven by the SPX correcting. So a rallying euro (and therefore falling dollar) is super-bullish for the oversold commodities as well. Gold in particular is a huge beneficiary of dollar weakness, as I discussed in depth in a recent essay. Bullish euro technicals are bullish for everything else but the US dollar!

So don't fall into the same mainstream trap the thundering herd did during the spring-2010 euro panic, blindly believing all the euro-to-zero gloom and doom we've been hearing. The euro flows and ebbs like everything else, and following its latest major ebbing we are due for some serious upside action. The major euro upleg now getting underway will help reignite the entire global risk trade, leading to major capital inflows into the stock markets, commodities, and commodities stocks.

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The bottom line is the euro currency has shared a very-high positive correlation with the US stock markets in recent years. When the euro is strong, the US stock markets tend to be strong. And vice versa. Though the actual causality starts with the SPX and flows through the US dollar to influence the euro, the resulting conclusion is the same. A rallying euro is definitely a bullish omen for US stocks.

And the euro just weathered a major correction, falling to very-oversold levels last month. Naturally this correction spawned hyper-bearish sentiment typical of a major bottoming. If you can put on your contrarian cap and transcend the herd's crippling groupthink, the euro looks super-bullish. As the second Greek bailout deal gets resolved soon, psychology will turn favorable too. And everything but the US dollar will surge.

Adam Hamilton, CPA

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