Bank Of America Sees First Signs That The Rally Could Reverse

The S&P 500 has been grinding steadily higher in 2013 as no real bearish catalyst has yet given investors reason enough to sell stocks.

For weeks, while Wall Street strategists have mused that this may be the beginning of a "Great Rotation" out of bonds and into equities, they've also warned that a correction is near.

Though we haven't seen much in the way of selling in the equity market recently, the brief bouts of weakness we have seen in intraday trading have usually been brought about by spikes in the U.S. dollar, which has been mostly weak to start the year.

Today, BofA Merrill Lynch FX strategist Richard Cochinos says his team is seeing "the first signs of a reversal" in a note to the bank's clients.

"Bottom line," Cochinos writes, "Several indicators are calling for a risk correction. USD selling has reached previous reversion levels and greater buy-backs are to come."

Cochinos first points to U.S. dollar selling by "real money" investors (i.e., pension funds, mutual funds, insurance companies, et al.), which has reached extreme levels recently – 1.8 standard deviations from the mean, to be exact.

The chart below shows that historically, 1.8 standard deviations is typically a level where selling reverses, according to Cochinos, which means one big source of dollar weakness, and hence, strength in risk assets, may soon be removed from the market.

Note: the chart above graphs the trade-weighted U.S. dollar index (USD TWI) in orange – as opposed to the standard U.S. dollar index. The standard index gives more weight to the euro – which has been climbing in January – than the USD TWI, which is why the chart above shows a climbing dollar, while the standard dollar index has been weak.

Furthermore, Cochinos says hedge fund positioning has a stronger correlation than any other with changes in the value of the currency – and for the past two weeks, hedge funds have been buying dollars after selling them for the past 5 months.

Finally, with regard to the dollar, Cochinos notes that USD buying by corporates has been running below average recently, writing, "With month-end upon FX markets, greater dollar buying by US corporates could provide a near term trigger."

Meanwhile, flows into equity markets, which have been strong in the past few weeks, are looking stretched, says Cochinos:

The confluence of all these factors suggests to Cochinos that the correction in risk assets everyone has been waiting for may finally be at hand.

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