The pro-risk trade is very extended / at risk of a correction

My core trading idea for the past month or so has been that the pro-risk trade (long stocks, long commodities, short US Dollar) is very extended and is at risk of a correction. I have been watching for opportunities to fade pro-risk market psychology.

Very strong inter-market relationships

The inter-market relationships between the components of the pro-risk trade have been highly correlated, especially since the Key Turn Date around November 1st, 2020. One of the “reasons” for this strong correlation may be that many people see the “debasement” of the US Dollar by aggressive American fiscal and monetary policy as a driving force behind the rally in stocks and commodities.

In this chart the blue line is the S+P 500, the white line is the inverse of the USDX.

The US Dollar may be turning higher

The storming of the Capitol Building last week may have been a cathartic inflection point for the US Dollar Index which hit a 32-month low that day. I got long the USD the next day by shorting the Euro, the New Zealand Dollar, and the Mexican Peso.

I kept my position size small and my stops tight because I was using a possible daily reversal pattern to trade against a multi-month trend. All three trades moved in my favor and I trailed my stops lower. By mid-week I was stopped out of all three positions with small profits.  

In hindsight I had my stops too tight (al least on the Euro) but at the time it seemed the right thing to do. My trading account is flat going into the long weekend, I will look for new opportunities next week.

Signs that pro-risk psychology is getting tired

This week’s price action across markets makes me think that risk-embracing market psychology is getting tired, which may increase the chance of major reversals. As I wrote last week, “If the USD has indeed hit an inflection point and begins to rally from here, I expect that will hurt stocks and commodities, given the strong negative correlation the USD has had with those markets for the past several months.”

The DJIA, Dow Transports, Russell 2000, and the Vanguard total stock market ETF all hit new All-Time Highs this week. The S+P and Nasdaq 100 did not but came very close.

The CRB commodity index hit new 6-year highs this week as petroleum and Ag products continued their recent strong rallies.

WTI Crude oil has rallied >55% since the November 1st Key Turn Date and now capital is flowing into the energy sector at the highest rate in 12 years. This may be a better time to be a seller, not a buyer!

Best wishes for the Martin Luther King long weekend.

Victor Adair retired from the brokerage business after 44 years this past summer and is no longer licensed to provide investment advice. This blog and everything else on this website is not to be construed as investment advice to anybody about anything.