Forward Markets: Macro Strategy Review

July 14th, 2015
in contributors

Macro Strategy Report, July 2015

by Jim Welsh with David Martin, Forward Markets

U.S. Economy

After the U.S. Department of Commerce revised its second estimate of first quarter gross domestic product (GDP), it reported that it contracted -0.2% rather than a decline of -0.7%. As forecast, the economy is rebounding in the second quarter after slipping in the first quarter.

Follow up:

The May employment and retail sales reports provided solid evidence that the economy was warming up after the tenth most severe winter since 1960.

The U.S. Department of Labor reported that the economy created 280,000 new jobs in May, up from 223,000 in April. It was also encouraging that 397,000 unemployed people were motivated enough to begin actively looking for work, which actually caused the unemployment rate to rise from 5.4% to 5.5%. As we have discussed before, the Labor Department determines the unemployment rate based on the number of people who are unemployed and actively looking for a job. Perversely, if every unemployed worker told the Labor Department they did not look for a job in the last month, the unemployment rate would drop to 0%.

The opposite occurs when more unemployed people join the labor market by actively looking for a job. For example, since the pool of unemployed workers increased in May, the unemployment rate rose. In the twisted methodology of the Labor Department, the labor market improved in May even though more unemployed workers were drawn off the sidelines and the unemployment rate ticked higher. As the saying popularized by Mark Twain goes:

"There are three kinds of lies: lies, damned lies, and statistics."

The U-6 unemployment rate (U6), which includes workers who are working part time but would prefer a full-time job, was unchanged in May at 10.8%. Therefore, the spread between the U6 and the U-3 official unemployment rate (U3) narrowed to 5.3% from 5.4% in April. Average hourly earnings grew 2.3%, the highest growth rate since August 2013. The increase in average hourly earnings was heralded by some economists as a sign that wage growth was finally accelerating.

We think it is more likely a statistical fluke since average hourly earnings have been stuck for five years in a very narrow range above and below 2.0%. We wouldn't expect a consistent acceleration in wage growth until the spread between the U3 and U6 begins to trend below 5.0%. Historically, annual wage growth above 3.3% has occurred when the U3-U6 spread was below 3.85%. The spread of 5.3% suggests there is still too much slack in the labor market to expect a consistent increase in wages during the next few months.

According to the recently released annual survey by the Federal Reserve (Fed) on families' financial well-being, too many families have not measurably benefited from the current recovery. About two-thirds of Americans surveyed about their finances said they were either "doing okay" or "living comfortably." The remaining one-third said they were "just getting by" or "finding it difficult to get by."

The most alarming response was that nearly half of the respondents said they lacked the resources to cover an unexpected emergency that cost $400. Almost one-third said they had skipped some form of medical care last year because they couldn't afford it. This helps explain why so many Americans spent so little of their energy windfall after gasoline dropped by more than $1.00 per gallon. They needed the extra $10-$15 a week and couldn't afford to spend it as most economists had forecast.

In April, real median household income was $54,578, 4.7% lower than in January 2008, according to Sentier Research. Since most economists earn far more than median income, it is a challenge for them to appreciate the mindset that results from less purchasing power after more than seven years of hard work. We suspect that even should wage growth improve in coming months, many consumers will not embark on a spending binge and will hoard most of the gain, just as they did with their gasoline savings.

Retail sales rose a seasonally adjusted 1.2% in May, according to the Commerce Department. Based on headlines, one might have thought Christmas had arrived in May. One touted, "Retail Sales Jump as MIA Consumer Is Back in Action," while another garnered style points for alliteration, "Shoppers Splurge in Spring Spree." As usual, we dug a little deeper to see if we could really find Rudolf or any other reindeer buried in the government statistics.

After adjusting for auto and gas sales, the spending spree shrunk. Excluding autos, sales rose 1.0% and after adjusting for the 3.7% increase in gasoline sales due to higher gas prices, retail sales were up 0.7%. This is a decent number, but hardly worth the giddy headlines. Aggregate retail sales, which include auto and gas sales, were up 2.7% from a year ago, which doesn't impress us as a real splurge.

Much of the increase in aggregate retail sales was the result of an 8.2% rise in auto sales over the past year. The adjusted annual selling rate in May pegged vehicle sales at 17.8 million vehicles, the highest since July 2005, according to research firm Autodata. And it's not due to consumers becoming more environmentally aware-hybrids and electric vehicles comprised just 2.8% of total sales down from the peak of 3.7% in 2013. The average sticker price of a new vehicle topped $33,000, about 4% higher than a year ago, according to Kelly Blue Book. There are a number of factors driving the pickup in vehicle sales.

According to Edmunds, the average age of vehicles on the road in the U.S. has reached a record 11.4 years. This is due in part to improved quality, so vehicles today require less maintenance and simply last longer. But eventually, everyone gets the new car bug- how many car and truck commercials can a person watch during the NBA and hockey playoffs and not fall prey to the siren song of a brand new car!

The challenge facing the majority of consumers, who have experienced a reduction in the purchasing power of their income since 2008, is how to buy a car within the limits of their monthly income. In the first quarter, the average car loan was 67 months for a new car and 62 months for a used car. Experian Automotive also reported that 29.5% of new car loans had terms of 73-84 months, up 19% from the first quarter of 2014. The average new car loan required a monthly payment of $488 on a balance of $28,711.

If a consumer's goal is to lower the monthly payment so a new car can be affordable, the significant increase in leasing in recent years is understandable. According to Experian Automotive, the percentage of leased new cars has jumped from 22.0% in 2012 to 31.4% in the first quarter of 2015. The average monthly payment for a leased vehicle was $405 in the first quarter, almost $1,000 per year less than financing the purchase of a new car with a loan. According to Equifax, subprime auto loans have doubled since 2009, totaling $129.5 billion as of November 2014, or 14.8% of total auto loans.

However, subprime loans made up 34% of all loans in the last 12 months, which indicates that lending standards have been coming down overall. Equifax defines subprime borrowers as those with a credit score below 640. The delinquency rate is low- only 3.3% over the past year-but the increase in subprime loans is never a problem when the economy is growing. The problem of repaying loans only emerges after the economy has slowed and the unemployment rate rises.

Reconciling the fact that consumers were only willing to spend about 25% of the $15 per week saved from lower gas prices when vehicle sales are at their highest level in almost a decade presents a contradictory conundrum. On the surface it suggests that consumers are back in a spending mode since they are willing to commit to such a large purchase-the view being touted by the majority of economists. We have a different take. Rather than being a sign that happy days are here again, it shows that consumers are doing whatever it takes to minimize the monthly payment as a result of weak wage growth. This priority is forcing many consumers to make choices that are questionable from a longer-term perspective.

According to Experian Automotive, the average interest rate on a new car was 4.71%, which means the average car buyer will pay roughly $3,800 in interest expense on the average loan of $28,711 over the 67-month average loan term. Almost 30% of purchasers are stretching out payments over six or seven years and likely paying a higher rate of interest than the average. Over the life of a seven-year loan, interest expense will total about $4,750 (assuming a 4.71% loan rate) and increase the cost of the new car by about 16%. Many of these new car buyers likely own a smartphone that allows them to compare prices so they can save a few bucks on a $50 purchase, but when it comes to a $33,000 purchase they're doing whatever is necessary to finance their purchase, even if the terms are not the most favorable.

With the average car loan now 67 months in length, many buyers may unknowingly be creating a future problem. This problem is even more likely for those with six- or seven-year loans. Since interest expense is front-loaded, not much of the monthly payments in the first few years goes to lower their loan balance.

The average car depreciates about 13% a year, according to CU Direct, which provides car loan technology to credit unions. After years of making on-time monthly payments, a prospective new car buyer in three or four years may be shocked when the value of their car is worth less than their loan balance, which means they won't be able to use their older car as a down payment. The reality of negative equity could hurt vehicle sales four to six years from now as prospective buyers are forced to keep making payments on their old car until they have paid off the loan they took out in 2015. We suspect the 42% increase in the leasing of new vehicles since 2012 is an attempt to avoid the negative equity trap. It is also a way to lower the cost of monthly payments since the average monthly leasing payment was $405 compared to $488 for the average monthly car loan.

According to the Federal Reserve Bank of New York, the total amount of auto loans increased from $875 billion, as of March 31, 2014, to $968 billion, as of March 31, 2015, an increase of 10.6%. Consumers would not be taking on this additional debt load unless they were feeling more comfortable about their current financial situation. However, over the same period, wages only grew 2.3%, so the average consumer is not rolling in newfound wealth. We suspect many consumers decided, after delaying a new car for more than 11 years, to find a way to squeeze a monthly new car payment into their already tight budget. If we're right, consumer spending on everything else will be less until income growth truly accelerates. As noted previously, based on the U3-U6 unemployment spread, wage growth is likely to be modest for the balance of 2015.

Another indication that the psychology underpinning consumer spending has not suddenly become more optimistic is evident in the personal savings rate. Even as vehicle sales have improved, the personal savings rate rose from 4.4% in December 2014 to 5.6% in April. This supports our view that consumers have not become the spendthrifts of old and are likely to maintain a level of discipline in their overall spending in coming months.

Federal Reserve

Last month we wrote that we detected a subtle shift in outlook among a number of Fed governors. After leaning toward not initiating a rate increase in 2015 unless data improved, the bias of several Fed members seemed to tilt toward raising interest rates before year-end unless the economy proved weaker than forecast. We thought this shift was noteworthy since it followed a weak first quarter and suggested that the concern of maintaining their zero interest rate policy (ZIRP) outweighed the potential fallout from a rate increase. A rate increase before year-end would represent one small step toward creating some maneuvering room before the next economic slowdown. It would also lessen investors' fixation on the first rate increase and take some wind out of the sails of those who have criticized the Fed for not raising rates sooner and fomenting a foundation for hyperinflation in coming years. Of course, the inflation agitators have been hyperventilating about an inflation tsunami since 2011, but have only increased global warming with their exhortations. We admit to a certain level of disdain for those warning about inflation since it reveals a lack of understanding of the obvious. The Fed has expanded its balance sheet from $900 billion in 2007 to $4.451 trillion in June 2015, but $2.6 trillion of that increase is sitting at the Fed in the form of excess reserves. Until that money finds its way into the economy, the risk of there being too much money chasing too few goods is low. As we have noted repeatedly, the world is suffering from a lack of demand and excess capacity. Combined with excessive debt, the risk has been and remains deflation, not inflation.

After its Federal Open Market Committee (FOMC) meeting on June 17, the Fed released its interest rate outlook. Despite the first quarter slowdown, 15 of the 17 members at the meeting said they expected to start raising short-term interest rates before year- end, which confirmed the shift in bias we suspected. Of the 15 members in favor of a rate rise, 10 were in favor of two increases before year-end. If economic data comes in stronger than we expect in the third quarter, a second increase is certainly possible since the Fed continues to emphasize that it is data dependent.

In her press conference after the FOMC meeting, Fed chair Janet Yellen noted, "My colleagues and I would like to see more decisive evidence that moderate pace of economic activity can be sustained." Yellen also attempted to quell the ridiculous concern that the Fed will be anything but gradual. Beginning in June 2004, the Fed increased the federal funds rate at 17 consecutive meetings. As we noted in the May Macro Strategy Review (MSR), nothing close to that will happen in this cycle. The economic landscape today is very different than in 2004 and it's surprising that anyone would be unable to understand what should be obvious. Nonetheless, Yellen tried to dispel the notion that the Fed would not be gradual. "What should matter to market participants is the entire expected trajectory of policy...Economic conditions are currently anticipated to evolve in a manner that will warrant only gradual increases in the target federal-funds rate." We'll wager that within an hour after the first rate increase is announced, the TV talking heads and a handful of economists will begin the guessing game of when the second increase will occur. According to a study by Microsoft on the effects of the digital world, the attention span of the average human shortened from 12 seconds in 2000 to eight seconds in 2013. To put that in perspective, we've now slipped below a goldfish, which has an attention span of nine seconds.

Quantitative Easing, ZIRP and Unintended Consequences

In recent months we have discussed a number of unintended consequences due to ZIRP. Corporations have overindulged in stock buybacks at the expense of business investment. Record numbers of buybacks have boosted earnings in the short run, but the lack of investment has lowered productivity and is likely to result in less innovation and economic growth over the next five years. By directing a greater share of cash flow toward paying dividends and less to higher wages, economic growth has been mediocre, with GDP growth averaging 2.36% in the current expansion versus a historical average of 5.36% since World War II. By maintaining ZIRP since 2008, savers have received $470 billion less in interest income. This has led to a big increase in recent years in the percentage of those over 65 years old who continue to work to replace the loss of interest income.

In recent months, another unintended consequence of the Fed’squantitative easing (QE) program has emerged and it has the potential of becoming even more consequential. Total Federal debt is $18.152 trillion, with 72%, or $13.076 trillion, in public debt and $5.079 trillion, or 28%, in intragovernment debt. Social Securitydebt is the primary form of intragovernment debt and represents 54.8% of debt that is owed to the government. About $924 billion(18.2%) of intra-agency debt is owed to retirees of the Office ofPersonnel Management (OPM), $483 billion to retired militarypersonnel and $270 billion to Medicare.

Most of the $13.076 trillion in public debt is held by entities forthe long term and only a small percentage of their Treasury issues would likely be traded in the course of any given year. Foreign governments own $6.013 trillion of the debt with Japan holding $1.224 trillion and China holding $1.224 trillion. Neither Japan nor China have made significant changes in their holdings over a short period of time, so their “trading” only adds a minimal amount to the overall level of liquidity in the Treasury market. Caribbean Banking Centers hold $350.6 billion of Treasury paper and Belgium holds $345 billion. The Bank for International Settlements believes the Caribbean Banking Centers and Belgium are conduits for sovereign wealth funds and hedge funds that prefer not to reveal their positions. We suspect the sovereign wealth funds are also not active traders, but hedge funds certainly are far more active. Oil exporting countries have $297 billion in Treasurys and are probably more in the buy-and-hold camp, especially when oil prices are high and rising. State and local governments, private pensions and insurance companies own $1.593 trillion of Treasury issues and China have made significant changes in their holdings over a short period of time, so their “trading” only adds a minimal amount to the overall level of liquidity in the Treasury market. Caribbean Banking Centers hold $350.6 billion of Treasury paper and Belgium holds $345 billion. The Bank for International Settlements believes the Caribbean Banking Centers and Belgium are conduits for sovereign wealth funds and hedge funds that prefer not to reveal their positions. We suspect the sovereign wealth funds are also not active traders, but hedge funds certainly are far more active. Oil exporting countries have $297 billion in Treasurys and are probably more in the buy-and-hold camp, especially when oil prices are high and rising. State and local governments, private pensions and insurance companies own $1.593 trillion of Treasury issues and very little is traded since pension funds and insurance companies are holding them to meet long-term actuarial goals. U.S. banks own $407 billion, but most of their holdings are likely static since they are specifically holding them to satisfy higher capital ratios under the Dodd-Frank Act.

We have no way to accurately estimate how much of the $13.076 trillion of Treasury paper truly adds to the daily liquidity in the Treasury market, but after this cursory review of entities holding Treasury paper, it is clearly far less than expected. The only meaningful source of daily liquidity is mutual funds and their holdings, which represent less than 10% of total public debt. Although mutual funds are managed by professionals, outflows could rise dramatically if financial advisors or individual investors become spooked by the pace of Fed rate increases or higher volatility. As the yield on the 10-year Treasury bond rose smartly in the first half June, more than $10 billion flowed out of bond funds in the week ending June 19. That isn’t a lot of money, but if liquidity in the bond market is poor it could have an outsized impact, especially if outflows increase when the Fed does raise the federal funds rate.

As mentioned earlier, the Fed has expanded its balance sheet from $900 billion in 2007 to $4.451 trillion, as of June 15, 2015. It holds $2.461 trillion in Treasurys and $1.742 trillion in mortgage-backed securities. The Fed’s $2.461 trillion in Treasury holdings represents 18.9% of the $13.076 trillion of public debt. However, if the $13.076 trillion in public debt is reduced by 50% or more based on the entities that hold most of the illiquid paper, the impact of the Fed’s holdings could easily be double the 18.9% figure. The largest risk from the increase in the Fed’s balance sheet isn’t potential inflation but a reduction of liquidity in the bond market that may have already contributed to an increased level of volatility.

After a jump in volatility in response to the taper tantrum in May and June 2013, the 13-day rate of change in the yield of the 10-year Treasury bond significantly subsided and remained low throughout most of 2014. A period of higher volatility began on October 15, 2014, when the 10-year Treasury posted a range of 22 basis points, or 15%. A comparable move in the Dow Jones Industrial Average would be 2,700 basis points—a jump that would have made the evening news. Since February 2, the 10-year Treasury yield has soared from 1.650% to 2.489% on June 10. Most of the increase occurred after the yield fell to 1.850% on April 20. Ironically, the increase was not the result of much stronger economic data or an imminent increase in rates by the Fed but a large increase in yields in Europe. Between April 20 and June 10, the yield on the 10-year German bund exploded from 0.07% to 0.98%. Those dates should sound familiar since they are the same reversal dates for the U.S. 10-year Treasury bond. Whether the increase in volatility is due to rate fluctuations in Germany or the prospect of the first Fed rate increase since 2006, the reduction in liquidity due to Treasury bond purchases by the Fed is not likely going away anytime soon and suggests the Treasury market will be susceptible to selling squalls as investors ponder future actions by the Fed.

Bonds - Technical

Last month we discussed the importance of the 2.300%-2.400% range on the 10-year Treasury bond since a number of trend lines intersected in this tight range. We also suggested that the yield might spike up to 2.451% from the low of 1.843% on April 6 if the initial 0.608% run up from 1.651% on January 30 to 2.259% on March 6 was repeated. We expected the yield to then decline if that rise occurred. One June 10, the yield spiked up to 2.489% before falling to 2.260% on June 19. As this is being written on June 24, we think the yield can drop to 2.190% and possibly fall as low as 2.100%. Sentiment has become very bearish, which from a contrarian point of view supports a decline in yields. In early June, only 9% of bond market investors polled by J.P. Morgan expected bond prices to rise (lower yields), but 41% thought bond prices would fall further (higher yields). The 32% spread was the widest since May 2006 when the yield on the 10-year Treasury bond was 5.200%. By December 4, 2006, the yield had fallen to 4.450%.

We suspect investors are overestimating how aggressive the Fed will be in raising rates through 2016. As we said in May, the pace of rate increases is likely to make a tortoise look like the Road Runner and, if correct, should limit how fast and how far bond yields rise. However, the rise in volatility is worrisome longer term. A close above 2.58% would be a longer-term negative and increase the possibility that the yield on the 10-year Treasury bond could exceed the December 2013 high of 3.04%. As noted, the correlation between the U.S. 10-year Treasury bond and German bund has been extraordinarily tight, holding near 1.50%. There is a chance that the bund yield could spike up to 0.98%-1.08% (as we will discuss subsequently), which suggests the 10-year Treasury bond could pop to 2.58% if the bund does trade up to 1.08%.


In April and May of 2014, we thought the European Central Bank (ECB) had only one policy option if it was going to reverse the downward spiral in inflation and also boost economic growth. By lowering the value of the euro, the ECB would gradually lift inflation since imports would cost more and a devalued euro would boost exports and growth. Since April 2014, the 20% decline in the euro has spurred exports, which were 9% higher in April 2015. Imports fell -1.1% in April and were up only 3.0% higher than in April 2014, as their higher cost curbed demand. Unlike the Fed, the ECB does not differentiate between the overall Consumer Price Index (CPI) and the core rate of inflation, which subtracts the impact of energy and food prices. The net result is that measured inflation in the eurozone is more volatile when there are large swings in the price of oil. The plunge in oil prices pushed the eurozone CPI down to -0.8% in January and the rebound in oil lifted the CPI to a 0.3% increase in May. Although the ECB does not base policy on the core CPI, it is hard to imagine that ECB president Mario Draghi doesn't pay attention to it when oil has been so volatile. In May, the core CPI was up 0.9% from a year ago while in April it was up 0.6% from the year before. Both inflation measures are well below the ECB's 2% target, which supports the continuation of the ECB QE program for the foreseeable future.

We expected eurozone GDP growth to improve to 1.5% in 2015 and it has. However, we don't expect growth to strengthen much in the second half of 2015, even though bank lending has finally turned positive. While this will be supportive of growth in coming months, the level of lending is still far below where it was in early 2008 and even in 2011. The eurozone is a net importer of oil, so the stimulus from cheap oil has diminished somewhat with oil at $60 a barrel rather than under $50 a barrel. The euro has also rebounded about 7% since mid-April, so the tailwind that boosted exports has modestly weakened.

Interest rates throughout the eurozone have risen but are still historically low. The unemployment rate was 11.1% in April and is not likely to drop appreciably before year-end. A recent survey by international accounting firm Deloitte of 1,300 chief financial officers in 14 countries found that the vast majority listed cost control as either their first or second concern. They listed geopolitical risks, the state of the eurozone economy and fear of regulation as the primary drivers behind wanting to keep costs down. This suggests that hiring and business investment is likely to remain muted for the balance of 2015. A total of 93% of respondents said additional national structural reforms would be effective or very effective in supporting growth. This response echoes our discussions over the last couple of years that rigid labor laws and smothering regulation were significant headwinds to improved growth, particularly in France and Italy. We thought the regulatory environment was unlikely to change much since politicians lacked the courage to make changes and too many people throughout Europe have come to view government programs as entitlements. We expect the ECB to maintain its QE program at least through its stated goal of September 2016.

Euro and German Bund - Technical

Between April 20 and June 10, the yield on the 10-year German bund exploded from 0.07% to 0.98%, an unprecedented increase following an unprecedented decline in yields. We expect the extreme volatility of the past six months to subside as investors realize GDP growth is still relatively weak and that the ECB will most likely maintain its QE program until September 2016. Technically, the 1.0% level should incentivize buying and act as a ceiling, although a brief spurt above 1.0% is possible. In coming months, a decline in the 10-year bund yield to 0.50%-0.62% seems likely.

In the May MSR, we suggested covering a portion of the short position established in May 2014 (when the euro was above 1.38) when the euro traded under 1.065. We expected a rally to 1.110-1.150 and on May 15 the euro peaked at 1.1472 before dropping below 1.090 on May 27. As we noted in the June MSR, any rally above 1.1472 would not alter our longer-term negative outlook. Now the odds of a rally above 1.1472 have increased. As this is being written on June 24, a rally to 1.170-1.185 is possible, based on the chart pattern. If the euro does rally into this price zone, we would suggest using the portion of the short trade that was covered to short the euro again. A rally to 1.170-1.185 would likely complete the countertrend rally from the mid-March low. Longer term, we expect the euro to make new lows and possibly drop below 1.000.

Dollar - Technical

As discussed in the May MSR, we expected the dollar to pullback to 92.60-94.77 before another rally would take hold. The dollar bottomed on May 14 at 93.44 (September futures contract) and then rallied to 98.29 on May 27. As this is being written on June 24, the dollar has the potential of declining to 90.20-93.30 (based on the dollar and euro charts), before the entire correction from the mid-March high of 100.38 is complete. Longer term, we expect the dollar to rally comfortably above 100.00.


There has been elevated volatility in a number of important markets in the first five plus months of this year, but little has spilled over into the stock market. Despite the above-average volatility in oil, the foreign currency market and global bond markets, the stock market has been almost serene. Here is an extraordinary factoid: in the first 120 trading days through June 24, the S&P 500 Index has not been up more than 3.5% or down more than 3.2%. That has never happened before, according to Bespoke Investment Group, and only in 1952, 1993 and 2004 was the S&P 500 not up or down more than 5% through the first 120 trading days.

There are a number of reasons for such a tight trading range despite the volatility in other markets. Economic growth has been okay, so earnings continue to grind higher. There have been no real reasons to sell stocks, so selling pressure has been virtually nonexistent. This is an underappreciated dynamic since it takes far less buying pressure to keep the market up and making new highs when selling pressure is low. Corporate stock buybacks have reached historic highs in recent months, so there is a constant bid under the market, which is why pullbacks have been so shallow. Bond yields are low and, with the looming prospect of a rise interest rates, not an attractive stock alternative.

However, the stock market is expensive and the technical underpinnings continue to weaken. This combination suggests that risk levels are high and the market is vulnerable to at least a 4%-7% correction and potentially a 10%-15% correction if reasons to sell materialize.

The S&P 500 has continued to make higher highs and higher lows, so by definition the trend is up until it breaks below a prior low. Despite the higher highs, our proprietary Major Trend Indicator is at a low level, which indicates that upside momentum has dissipated in recent months. With upside momentum waning, the market is vulnerable should selling pressure increase.

As discussed last month, the advance-decline (A/D) line is one of the better technical indicators since it measures whether the majority of stocks are participating in a rally or not. The A/D line has usually weakened before an intermediate or major market top is recorded, as it did in 2007 and numerous other instances going back to 1928. Although the potential of a Dow Theory sell signal has garnered a lot of attention over the past month, what has not received much attention is the divergence between the S&P 500 and the A/D line. In our view, this is more important and more reliable than the Dow Theory, which is good, but far from perfect.

In May 2008, the Dow Theory actually gave a buy signal, which was written about in a Barron's article by Richard Russell, the dean of the Dow Theory. To say it wasn't a good signal would be an understatement.

The A/D line remains below its peak made on April 24, so it has been almost two months since it last made a new high. As this is being written on June 24, the A/D line is below the low it made on May 6 when the S&P 500 made its intraday low at 2,067. The A/D line often leads the way, and since April 24 it has now made a lower high and a lower low and completed what looks like a top.

Should the S&P 500 rally to a new high and the A/D line fail to make a new high, it would provide further evidence that the market is making an important top. The next few weeks are fairly important for the intermediate outlook for the market. The last three trading lows have been 2,067, 2,072 and 2,072. A close below these levels would likely confirm that an intermediate high in the market is in place. Until the S&P 500 confirms a top, the potential for one more rally to our cited range of 2,140-2,160 remains intact and would provide an opportunity to lower exposure to equities.

  1. Joe Millis, "US Federal Reserve: Chair Janet Yellen signals a gradual rise in interest rates," International Business Times, June 18, 2015.
  2. Ibid.

Definition of Terms

10-year U.S. Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year but not more than 10 years.

Advance-decline (A/D) line is a technical indicator that plots changes in the value of the advance-decline index over a certain time period.

Basis point (bps) is a unit of measure that is equal to 1/100th of 1% and used to denote a change in the value or rate of a financial instrument.

A bund is a German federal government bond issued with maturities of up to 30 years.

Cash flow is a revenue or expense stream that changes a cash account over a given period.

Consumer Price Index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation.

Correlation is a statistical measure of how two securities move in relation to each other.

Dodd-Frank Wall Street Reform and Consumer Protection Act increases government oversight of trading in complex financial instruments such as derivatives and restricts the types of proprietary trading activities that financial institutions are allowed to practice.

Dow Jones Industrial Average (DIJA) is a price-weighted average of 30 blue- chip stocks that are generally the leaders in their industry and are listed on the New York Stock Exchange.

Dow Theory is a theory developed by Charles Dow, Robert Rhea and others that uses the Dow Jones Industrial Average and the Dow Jones Transportation Average to determine the health of a particular market trend.

Federal funds rate is the interest rate at which a depository institution lends immediately available funds to another depository institution overnight.

Federal Open Market Committee (FOMC) is a branch of the Federal Reserve Board that determines the direction of monetary policy.

Futures are financial contracts that obligate the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its economy.

Major Trend Indicator is a proprietary technical tool that measures the strength or weakness of the market and helps identify bull and bear phases. During bull markets it helps indicate when the market may be vulnerable to a correction, and during bear markets it helps identify a potential rally.

Mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.

Quantitative easing refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.

Short selling is the practice of selling a financial instrument that a seller does not own at the time of the sale with the intention of later purchasing the financial instrument at a lower price to make a profit.

U-3 unemployment rate (U3) measures the total number of unemployed people as a percentage of the civilian labor force. It is considered the official unemployment rate.

U-6 unemployment rate (U6) measures the total number of people unemployed and those marginally attached to the labor force, plus the total number of people employed part time for economic reasons.

U.S. Dollar Index is a measure of the value of the U.S. dollar relative to six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc.

Valuation is the process of determining the value of an asset or company based on earnings and the market value of assets.

Volatility is a statistical measure of the dispersion of returns for a given security or market index.

Zero interest rate program (ZIRP) is a policy instituted by the Federal Reserve in 2008 to keep the federal funds rate between zero and 0.25% in order to stimulate economic activity during times of slow economic growth.

One cannot invest directly in an index.


Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

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