Where is the Stock Market and the U.S. Economy Heading?

One of the questions I received last week was about the possible non-confirmation between gold at new highs and both silver and stocks lagging well beneath their old highs. The question is if such a non-confirmation becomes a source of worry at some point because these three sectors traditionally move together.

The answer is one that every economist likes to give when being asked just about any question: it depends. In the long run, fundamentals drive prices of assets and the precious metals market isn't an exception from this rule. As long as fundamentals are in place, the bull market in the precious metals will continue. There are several signs that will tell us that this is indeed the ultimate top -- I don't see them yet.

What a difference a month makes.

Roughly four weeks ago, the Dow (INDU) was at an 18-month high, Wall Street's fear gauge, the VIX (VIX), was at a three-year low and the yield on the 10-year Treasury note was flirting with 4% as investors poured money into stocks.

Meanwhile, the euro was still falling apart on worries about Greece and the European debt crisis. Gold and other commodity prices were still rising. But investors weren't panicked. Strong corporate earnings and signs that the recovery was underway tempered worries about global markets, currencies and commodities.

One month later and investors have done a complete 180. A $1 trillion European aid package failed to assuage worries about Greece and other struggling European nations. Those fears sent the euro spiraling to a four-year low and set off all kinds of alarms for market participants.

Now, the yield on the benchmark 10-year note is closer to 3% than 4%. "Investors are flocking to bonds because they're scared," said Madeline Schnapp, Director of Macroeconomic research at mutual fund tracker Trim Tabs. And the recent record run on gold "is a vote of no confidence in the euro."

Iran has announced that it will sell 45 billion euros from its foreign exchange reserves to buy gold and dollars, Reuters says. The process will take place in three stages and the first stage has already begun.

Iran's central bank governor Moahmud Bahmani hinted at a move away from the euro as its value plummeted against the U.S. dollar. Iran's stated policy has been to move away from the U.S. dollar as a hard currency reserve and in payments for its oil exports. The report mentions that the other middle east countries have started converting to gold and US dollars as well.

Pronounced choppiness in major forex pairs and broader financial markets has led to similarly dramatic shifts in FX Options sentiment, making short-term currency moves especially difficult to forecast.

Pronounced choppiness in major forex pairs and broader financial markets has led to similarly dramatic shifts in FX Options sentiment, making short-term currency moves especially difficult to forecast.

A benchmark FX Options risk reversals strategy called for going short EURUSD, GBPUSD, USDJPY, AUDUSD, and NZDUSD through last week’s trade leading to significant drawdowns as markets quickly retraced earlier moves. Our DailyFX volatility indices remain near their highest levels in over a year, and we urge caution against excessive leverage through such choppy market conditions

EURUSD – Euro Forecast to Fall Further against US Dollar
GBPUSD – British Pound Outlook Remains Strongly Bearish
USDJPY – Japanese Yen Forecast to Rally Against US Dollar
USDCHF – Swiss Franc Short-term Bias Turns Bearish
USDCAD – Canadian Dollar Outlook Calls for Gains
GBPJPY – British Pound Forecast Bearish versus Japanese Yen

Impressive Euro declines and US Dollar rallies have been met with aggressive forex crowd buying and selling, giving us strong contrarian signal to sell into EURUSD declines. Much the same can be said for other US Dollar based pairs; our sentiment-based trading systems are mostly long the USD against the Euro, British Pound, Australian Dollar, and New Zealand Dollar. A noteworthy exception is the Japanese Yen, and indeed several of our SSI-based trading strategies have bought into recent JPY advances against the USD and British Pound. Current sentiment extremes suggest short-term trends will continue and give us a decidedly bearish outlook for the Euro and British Pound.

A significant US Dollar bounce has unsurprisingly coincided with a jump in forex options volatility expectations, and it seems that FX markets are reaching an important juncture. The overbought US currency was, in our opinion, at clear risk for short-term corrections against the Euro on extremely one-sided sentiment.