I Want to Be Bullish. But Here Are 3 Charts That Worry Me …

In recent weeks I’ve laid out my expectations for a buying opportunity in late October. (And I’ve been keeping my Master Trader members aware of what to play in the meantime.)

It very much looks like we were handed that buying opportunity on a silver platter this past week.

Now the next question is, what should you do with it?

One of the best moves you can make right now is to look toward key emerging markets for potential upside through year-end. Additionally, you should look toward key sectors of the U.S. economy for new opportunities.

But before I recommend any specific new trades, I want to make you aware of some signs that the recent downside in risk appetite is not yet over.

Specifically, here are three charts that worry me. You’ll see why I am waiting to see price action next week before making any trading decisions … and why you should exercise some caution as well.

Chart No. 1 —
West Texas Intermediate (Crude Oil Futures)

You may have heard the term “Doctor Copper.” It simply implies that copper prices offer a good diagnosis of the global economy’s health.

Lately, however, copper seems to be better-suited as a China indicator. And crude oil is now perhaps a better gauge of the health of global demand.

The price of crude oil has the potential to increase (or dampen) risk appetite. If traders see crude oil falling in value, they question their other positions in risk assets that may be exposed to global growth trends.

Crude oil is falling now. And it’s broken clear support levels.

But does that make it a buy right now?

I can certainly make the case for a buying opportunity in crude, after another couple dollars of downside. (Outlined as “Scenario B” in the chart below.)

But crude can move fast … and it can extend a lot further than you may think (Scenario C).

In fact, I was a victim of that back in late May of this year. I tried to catch a falling knife — bad idea. Crude continued to plunge through the end of June.

This time around, I can see support coming into play soon (Scenario A).

But if fundamentals don’t improve for some reason — increased demand, geopolitical supply threats, etc. — then maybe crude extends much lower.

My take: I don’t see fundamentals improving to any notable degree in the near future. Potential upside will depend upon broader risk appetite across all markets.

Chart No. 2 —
S&P 500 Index vs. SPDR Utilities Select Sector ETF

It is common knowledge that utilities represent a relatively conservative play. And investors typically rotate money into utilities when the risk of holding speculative plays increases.

Both the broader S&P 500 Index and the utilities sector have suffered together in the recent market downside.

As the Weiss legal team insists: Past performance is not indicative of future results. But look back to earlier this year, you’ll and see how both the S&P 500 and utilities behaved when risk increased.

Above is a chart of two ETFs: The SPDR S&P 500 Trust (SPY) and the SPDR Utilities ETF (XLU).

This is not to say XLU is a perfect ETF to use as protection. (Since it has had a quite-dramatic move this week in line with risk appetite.) But it does show a similar period of uncertainty that preceded the notable market decline earlier this year.

Chart No. 3 —
Chinese Yuan

It seems that has been a sentiment change as it pertains to Chinese growth.

Even though third-quarter GDP was at its lowest point since 2009 … even though manufacturing is still in a contraction mode … even though natural-resource companies are losing pricing power as commodity values lurch lower … investors are taking an optimistic tone of late.

It sounds like this:

The hard-landing has been avoided. The growth slowdown has bottomed out. China is rebalancing toward the consumer.

It’s the last part that worries me.

Yes, there have been indications China is trying to rebalance its economy toward domestic consumption since export growth is, and will remain, sluggish … and investment growth is reaching limits.

But China has a long way to go to rebalance.

And that rebalancing act is going to require a shift in the financial system that favors households and workers while pressuring manufacturing and borrowers.

This means hurting an already-injured manufacturing sector and potentially restricting the borrowers looking to invest in whatever.

There are many ways and combinations under which a rebalancing can take place. One of them is through the currency.

I think everyone knows that China has in the past manipulated its currency in order to bolster its preferred growth model. (Republican presidential nominee Mitt Romney has declared he will designate China a currency manipulator. Stupid, for many reasons. But I digress. …)

If China does allow its currency to trade freely, and likely appreciate substantially — which is already happening — the competitiveness of manufacturers will be reduced as the purchasing power of the Chinese consumer increases.

I think the near-term negative on the manufacturing sector could outweigh the long-term positive on Chinese consumer, as far as growth expectations are concerned.

So when I look at a chart of the Chinese yuan’s recent appreciation, I have to wonder about these newly optimistic growth expectations for China.

In the last 14 weeks, the yuan has appreciated at about twice the average rate over the 87 weeks of appreciation after China de-pegged it.

In fact, the last 14 weeks have been just as fast as any other 14-week period since the de-pegging.

China’s stock market has tended to lag the change in the currency. For example, after periods of appreciation, Chinese shares fell into a downtrend. They have only come out of it after the yuan depreciated for a few months earlier this year.

But now that the yuan is running higher fast, Chinese stocks may feel the pressure again.

Of course, China alone isn’t enough to drive all risk appetite. We saw China severely underperform through most of the last 12 months as U.S. stocks ran higher. But in the near term, should the new Chinese optimism sour, it may lead to more downside.

Fed Up? More Like Fed Down …

I’m getting antsy. I want to jump in on some select Exchange-Traded Fund ideas. But I must acknowledge the risks, as always. Above are just a couple to consider.

Here is a bonus thought …

The market entered this corrective period almost immediately after the Federal Reserve announced QE III. Oops.

Now, downside price action could be due to technical levels. But you have to wonder if something has changed. Has the appetite for monetary accommodation changed?

The Fed’s track record throughout all its QE and twisting has not been good, save the appreciation in stock markets. Even there, the marginal impact has declined with each consecutive measure.

If investors have grown tired of the asset-reflation theme, then Fed Chairman Ben Bernanke better hope it’s because the real economy is actually putting money to work in productive ventures.

I saw some analysis last week comparing the price action in 2012 with comparable years past — years that paralleled the economics and politics of 2012 and also boasted high price correlations.

If memory serves, the two highest-correlated years did not end in a crash. But there were quite a few years, still quite highly correlated with 2012, which did.

Bottom line, a buying opportunity looks to be on the horizon. But it pays to be a bit cautious right now.

Investors who are early to the party might miss out on some attractive deals. But if you arrive fashionably late, you can get in before the bulk of the upswing has taken place.

Best,

JR