posted on 15 March 2016
by Jim Welsh
Weekly Technical View 14 March 2016
Pause or Top?
In the February 29 Weekly Technical Review, when the S&P was at 1932, my guess was that the S&P could rally up to 1999, which was the 61.8% retracement of the November to February decline, and possibly as high as 2040, which was where the S&P broke down from last August. With the S&P reaching 2024 Monday, it seems appropriate to review how much more upside remains.
Note: In this article click on any chart for larger image.
During the last two weeks, the market has been lifted by a number of fundamental news items that mollified the fears that caused the S&P to get off to the worst start of any year in history. The U.S. February employment report alleviated concerns that the U.S. was edging toward a recession. The ECB announced additional stimulus measures that convinced investors that central banks were still able to adjust monetary policy to lift economic growth. The Peoples Bank of China cut the reserve ratio for banks, freeing up more money to make more loans, and China announced plans to eliminate some of the excess capacity that is causing banks loan loss reserves to increase. Saudia Arabia and Russia announced plans to freeze production at 35 year highs, but that was enough to shift sentiment in the oil market and incite a dynamic short covering rally that eased worries that the high yield bond market would be swamped by defaults in coming months.
In order for the stock market to roll over and test the January and February lows (1812-1810), each of the concerns that caused selling pressure to accelerate in January and early February will have to reemerge sufficiently to make investors very nervous. That is likely to take some amount of time, and would start with some consolidation and a modest correction, since additional good news in coming days and weeks is likely to be less exciting. This fundamental backdrop suggests that a pause in the rally is very likely, especially if the U.S. economy shows signs of slowing in the second quarter as I expect.
Oil is also likely to suffer a setback after its big rally, since supply will continue to exceed demand as refineries are shut for maintenance during the next 4-6 weeks. Producers continue to hold the largest short position of the past year, and commercial speculators have increased their short position on February 18 from -169,000 contracts to -241,000 contracts, an increase of 42.6% in just three weeks. Chart wise the $40 a barrel level is important, since oil bounced from a low of $40 in August to over $50 in October, and then experienced a failed rally off that level in late November before it fell apart. The 38.6% retracement in the cash price for oil from the high in June 2015 and the low in February is $39.60. Even if oil has indeed bottomed, a 50% retracement of the $12.75 rally since the February low would bring oil back down to $32 - $33. Given the negative underlying fundamentals, a 50% retracement may prove optimistic. If oil does drop to under $33 a barrel, it is likely to result in some selling in the stock market.
A review of the major market averages suggests that the upside is limited in the short term since the market has rallied up to over head supply. The NYSE Composite is approaching its long term down trend, which begins from the high in June 2015. For the first time since the rally kicked off, the 21 day average of net advances minus declines registered a divergence on Friday March 11 as the NYSE was posting a new high. This is the first concrete sign that the market is losing some internal strength. The lower peak is still fairly overbought which is a sign of strength and supportive of the market holding up for awhile.
The Russell 2000 is also running into over head resistance, which is significant enough to rebuff the first attempt to break through to higher prices. Market breadth has been quite strong during the rally as measured by the NYSE advance/decline line (A/D Line). The A/D Line has recovered all of the ground it lost after the S&P topped in early November when the S&P was trading above 2100, or 4% below its current level. The A/D Line consistently underperformed after it topped in late April last year until the low on February 11. If healthy market breadth is maintained during a pullback, it would be a positive worth paying attention to. However, now that it has recovered back to its high in November and December, the A/D Line is also at resistance, just like the NYSE Composite and Russell 2000.
As of February 12, the net percent of bulls minus bears in the Investors Intelligence weekly survey fell to its lowest level since October 2011 at -14.5%, which supported the potential of a multi-week rally. In the wake of the employment report on March 4, I thought the percent of net bulls would jump to 10% in the March 10 report. Although the percent of bulls did increase, the amount of improvement was less than what I expected. The net percent of bulls rose from 2.1% to only 4.0%. In the wake of the ECB's announcement and the market's positive response, the net percent of bulls probably increased more. At the high last November, the percent of bulls exceeded bears by 18.8%. Until the net percent of bulls approaches that plurality, sentiment is still too cautious to expect an intermediate high in the market just yet.
Short Term Pattern
As I noted last week, the pattern in the S&P would look better if the S&P rallied above the high of 2009.13 on Friday March 4. The initial rally from the low of 1810 on February 20 carried the S&P to 1931, a gain of 121 points. An equal rally from the low at 1891 on February 24 would target 2012, which has been modestly exceeded. From the low of 1891 on February 24, the S&P rallied to 1963, or 72 points (wave 1). After pulling back to 1934 on February 29, the S&P rallied 75 points before topping on March 4 at 2009 (wave 3). As observed last week, if investor's psychology had shifted as I expected due to the market's rally and employment report, the buy the dip mentality would bring in buying as the S&P approaches 1960. The S&P dipped to 1969 before dip buying commenced. If wave 5 is equal to wave 1 (72 points), the S&P could reach 2041, before this move up is over.
Like other major averages, the S&P is approaching what should be significant over head supply between 2040 and 2060. It is unlikely that the S&P will be able to punch through this resistance in the short term. This suggests that a pullback in the S&P is coming. The most obvious target is near 1950, which represents the initial resistance (horizontal black line) the S&P encountered.
Major Trend Indicator
Although the MTI crossed above its moving average on February 25, generating a bear market rally buy signal, the MTI is still in bear market territory. This bear market rally signal will remain in place as long as the MTI is above its moving average and the S&P does not violate important chart support. The first warning sign will come if the S&P closes below 1930, and especially if it closes below 1915, which represents the 50% retracement level of the rally from 1810-2024. The S&P shouldn't give back more than half of its recent gain, if all the worries that have dissipated since the February low are indeed passe.
Conversely, if sentiment becomes negative on a pullback into support above 1940, it would increase the odds of the S&P holding up for a longer period, and potentially increase the odds of a breakout above 2060. I remain skeptical since I don't think the fundamentals in the U.S. or global economy are going to improve much, and are more likely to soften in coming months. A pause in the rally is coming, but more evidence is needed to confirm a top. In the short term I'll let the charts to the talking
Tactical S&P Sector Rotation Portfolio Model: Relative Strength Ranking
The Sector Relative Strength Ranking is based on weekly data and used in conjunction with the Major Trend Indicator. As long as the MTI indicates a bull market is in force, the Tactical Sector Rotation program is 100% invested, with 25% in the top four sectors. When a bear market signal is generated, the Tactical Sector Rotation program is either 100% in cash or 100% short the S&P 500.
The Major Trend Indicator generated a bear market signal on January 6, when the S&P closed below 1993, and was confirmed on January 14. The Tactical Sector Rotation program went 100% short when the S&P closed at 1990.26 on January 6. The short position was reduced to 50% on February 8 when the S&P closed at 1853, further lowered to 25% early on February 24 as the S&P traded under 1895, and closed on February 25 when the S&P was 1942. The S&P's average 'cover' price on the short trade was 1885.75. The short trade earned 5.2%. Past performance is no guarantee of future results.
The MTI crossed above its moving average on February 25, generating a bear market rally buy signal. As noted in the Weekly Technical Review on February 25, I allocated a 25% long position in the Utilities ETF (NYSE:XLU) at $47.28, and a 25% long position in the Consumer Staples ETF (NYSE:XLP) at $51.65. The balance (50.0%) is in cash.
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