From Dominic Frisby, in London

Dear Money Morning Reader,

A lot of people, including me, have been waiting a long time for the next move down in sterling. We know it’s coming, we’re just not sure when.

Well, I think the turn may now be upon us. A number of simple, yet reliable technical indicators are suggesting that now is the time to get out of sterling.

And that could also mean that the rally is nearly over for UK stocks...

The charts are saying it’s time to sell the pound. I’ll get to those in a minute. But, first, I want to look at the bigger picture and see, in general terms, the relationship between stock markets and currencies.

Owning US dollars is like betting the stock market will fall

Largely speaking, over the last seven or eight years, as stocks and commodities have risen, the US dollar has fallen. When the dollar rallies, stocks and commodities tend to fall. Our first chart shows the US dollar against the S&P 500, and you can clearly see this pattern. Apart from in 2005 when both rallied, one has been the inverse of the other. The red line shows the trade-weighted dollar index, the black the US stock market.

Owning US dollars is almost like betting the US stock market will fall.

What’s interesting, however, is that on Monday, even as the stock market rallied, the dollar stayed firm. In fact, it actually rallied at a few points, so we have a divergence. That signals a reversal.

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Why a fall in sterling is bad news for the FTSE

The relationship between our own stock market and the pound is very different. In recent years at least, they have risen and fallen together. I suspect this is because, largely, the pound is levered to banking. In this next chart the red line shows the FTSE 100, and the blue shows the pound in dollar terms.

What is worth noting in this relationship is that the FTSE has tended to lead the pound. In other words, if the FTSE has risen the pound will follow it up; and when it falls, the pound will follow it down. In the summer of 2008, the FTSE was in freefall several months before the pound capitulated.

However, in recent days, there has also been a divergence here. The FTSE has continued its rise, but the pound has turned down. Now it could be that the pound turns back up and follows the FTSE higher, as it has done before. But my instinct is telling me that won’t happen this time, or at least not for long.

Sell sterling now

You don’t need lecturing as to the fundamentals of why the pound is a sell. A quick look at the balance sheet of UK plc followed by a glance at our policy-makers at their conference on the south coast will tell you all you need to know. But the timing of that sell is all important. And a number of chart patterns are suggesting that the time could be now. I’ll just discuss two simple ones: the head-and-shoulders top and the moving averages.

Let’s start with the latter. Moving averages show the average price of the previous period. So the 20-day moving average (20 dma) shows the average price of the last 20 days, the 50-day moving average (50 dma) shows the last 50 days and so on. Different traders like to use different moving averages, but I find the 21-day and 55-day to be pretty reliable. When the 21 dma crosses up through the 55 dma, it’s known as a ‘Golden Cross’ and you have your buy signal. When the 55 dma crosses down through the 21 dma, it’s known as a ‘Death Cross’ and you have your sell signal. Against the US dollar, the pound has just made a Death Cross.

In the chart below, the black line shows the pound vs the US dollar over the last year. The red line shows the 21 dma and the blue line the 55 dma. I have marked the crosses.

When a chart traces out a ‘head-and-shoulders pattern’ that can be indicative of a reversal, especially when the ‘neckline’ breaks. Identification of a head-and-shoulders can be a little arbitrary. Even so, it’s surprising how often they work. On our next chart, which shows the pound since late 2006, you can see the massive head-and-shoulders pattern that the pound mapped out against the dollar over 18 months before capitulating in mid-2008.

I have also marked, for academic interest, another chart pattern, the ‘double bottom’ it made in early 2009. What is of concern just now is that the pound has mapped out another head-and-shoulders pattern over the summer and the neckline has just broken. Here it is in close-up.

The pound may rally back up to that neckline at 160 and retest it, but all in all it looks a sell here. We could be back at 140 before you know it.

The longer this stock market rally continues, the more painful any correction will be when it comes. But, given that they've been trading in tandem, it’s not unreasonable to expect that if the pound goes, so too will stocks.

Until tomorrow,

Dominic Frisby

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Turning to the markets...

The JSE all share index closed rose 0.22% yesterday. The gold mining index climbed 2.05%. Resources fell 0.11%. Banks and financials gained 0.55% and 0.59% respectively. Industrials added 0.38% and the platinum mining index tumbled 1.62%.

London’s FTSE100 closed down 0.50%. The Dow Jones lost 0.31% and the Nasdaq dropped 0.08%.

Tokyo’s Nikkei 1.57% down. Hong Kong’s Hang Seng shed 0.28%.

Brent crude is currently trading at $65.44 per barrel.

Spot gold’s trading at $1,006.15 and platinum was last quoted at $1,291.00

And here’s how the rand is performing against the major currencies:
R/$7.56
R/£12.06
R/€11.06

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