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posted on 29 March 2016

Is That All There Is?

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Weekly Technical View 28 March 2016

Last week I thought the market was near a short term top, but end of quarter pressure on money managers to be fully invested was likely to help the stock market hold up a bit longer. The S&P peaked the next day at 2056, declined to 2022 on Thursday March 24, before rebounding to 2042 today.

Seasonality is still supportive until early next week, and as the S&P was pulling back last week, traders bought more puts than calls on the three days the S&P dipped. Based on seasonality and very short term sentiment, a rally above 2056.60 is possible. If the S&P does manage to exceed last week's high, it would be an opportunity to become more defensive by lowering exposure to the market. For aggressive investors, a new recovery high would be an opportunity to establish a modest short position - 25% to 33%. A decline to 1950 - 1970 is likely to unfold in coming weeks, especially after mid April when first quarter earnings will be reported.

In order for the stock market to decline, there has to be a reason for investors to sell since the investment business is long only biased. As noted last week, since the low on February 11, global investors have been provided a host of reasons to expect better economic growth and higher equity prices. The finishing touch was provided by the Fed on March 16 when it lowered the number of times it expected to increase rates in 2016 from four to two hikes.

In addition, a number of prominent strategists in recent months have noted that the annual rate of change in the dollar index has dropped from a peak in March 2015 of more than +25%, to less than -3% now. The dollar index has fallen from 100.00 in March 2015 to 96.00, so the annual rate of change has indeed turned negative.

Strategists have concluded that since the annual rate of change in the dollar index has turned negative, the headwind for revenue growth has abated for U.S. companies that derive 40% or more of their revenue from international sales. They expect revenue growth to improve due to the lower dollar and result in higher earnings. Investors are thus going to be surprised by the good news as revenue and earnings growth exceeds expectations, which is why these strategists expect equity prices to rise.

While it's factually true that the annual rate of change has fallen below 0%, this 'fact' is meaningless in the real world for U.S. companies selling products in the European Union. Since June 2014, the dollar is still almost 20% higher versus the Euro. When a U.S. sales person tries to sell their products to an EU based customer, they can tout all the great features of their product, but the annual rate of change in the dollar index is not one of them. At the end of the day, the EU customer will point out that the U.S. products still cost 15% to 20% more than the comparable EU products. Unless the U.S. sales person is willing to cut prices, there will be fewer sales due to the strength in the dollar. This reality is being repeated in many countries whose currency has lost value versus the dollar.

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Nike, Inc. is the world's largest supplier and manufacturer of athletic shoes, apparel and other sports equipment. Nike is a well managed and is the dominant company in its sector, and gets more than 50% of its revenues from overseas. Last week Nike reported its results for its third quarter which ended on February 29, 2016. Revenue was up 8% which is impressive given global GDP is only growing 3%, and U.S GDP is barely growing more than 2.0%. However, excluding currency changes, revenue growth would have been up 14% or 75% faster than the 8% reported increase. This suggests than the increase in the dollar since June 2014 is still a significant headwind for companies that derive a large portion of their revenue from international sales. If there is going to be a surprise as companies report first quarter earnings en masse after mid April, it is likely to be a negative surprise, as numerous companies continue to cite the strength in the dollar for their weak revenue growth.

Intermediate Sentiment

The net percent of bulls minus bears in the Investors Intelligence weekly survey rose to 19.6% as of March 22, modestly higher than the high in early November of 18.8%. Sentiment can certainly become more bullish, as it did during 2013 and 2014. However, central banks have done much in recent weeks through actions and words to lift equity prices, and further moves aren't likely for months. As I said last week, the stock market will have to stand on its own two feet, a balancing act that could prove challenging without further support from central banks. The stock market won't find much solace from upcoming earnings reports if I'm correct about the dollar's negative impact on revenue and earnings.

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Intermediate Participation

Many technicians use the 200 day average of the S&P or other major market averages as a timing tool. When the S&P is above the 200 day average, the S&P's trend is considered up, and down if it is below. I don't find the 200 day average particularly useful as a 'timing' tool. For instance, in 2009 the S&P didn't cross above its 200 day average until June 1, when the S&P closed at 943. In contrast, the Major Trend Indicator (MTI) turned positive on March 17 when the S&P closed at 778. A technician using the 200 day average would have missed out on a 21% gain compared to the MTI.

Whipsaws are another problem with the 200 day average. In October, November, and December last year, the S&P closed above and below its 200 day average 9 times. How can anyone determine which crossing is worth following? And if anyone followed each crossing religiously, their head would have been spinning like Linda Blair's head in the Exorcist. In contrast, the MTI only generated one buy signal on October 8.

The percent of stocks above their 200 day average is a valuable indicator since it provides a good assessment of how many stocks are participating in a rally or decline. During 2012, 2013, and 2014, more than 50% percent of stocks held above their 200 day average, which showed that the majority of stocks were participating as the S&P 500 ETF (SPY) was rising. In late April last year, and just before the S&P peaked on May 20, only 62% of stocks were above their 200 day average. This was much lower than the 78% in July 2014. By late May last year, less than 50% of stocks were above their 200 day average, foreshadowing the coming weakness in August.

As impressive as the rally from the February 11 low has been, only 49% percent of stocks were above their 200 day average on March 21, and 45% on March 24. This is more indicative of a bear market rally, rather than the beginning of a new bull market.

In addition, between the low on February 11 and March 17, the stocks of companies with the lowest returns on equity gained 41% versus a gain of 12% for the S&P. These stocks have the weakest profit growth and balance sheets, but were the most oversold and the most shorted stocks. This suggests short covering played a huge role in the rally. Despite this, there are still more stocks under their 200 day average than above it.

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Intermediate Momentum

The Relative Strength Index (RSI) on the S&P reached 70.7 on March 21, which is identical to the level it reached on November 3 last year as the S&P was topping out. The S&P is in the major resistance zone between 2040 and 2080 and is overbought, which suggests the odds favor a pullback.

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The 21 day average of net advances minus declines registered a divergence on Friday March 11 as the NYSE was posting a new high, and again on March 18. As of March 24, it had slipped even more. If the S&P does manage to better 2056, it is likely the 21 day average of net advances minus declines is likely to register another negative divergence. This would further reinforce the expectation of a decline to 1950 -1970 in coming weeks. So far, the resistance in the NYSE as indicated by the red horizontal line has stopped the rally as expected.

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The Dollar and Oil

Last week, I thought the dollar was likely to rally to 98.0 to 99.0 in coming weeks, since

"the RSI on the dollar index fell to 29.0 on March 17 after the dollar index closed at 94.80, compared to 27.3 on March 10 when the dollar index closed at 96.06."

The dollar rallied for 5 days and reached 96.42 before pulling back today. As long as the dollar holds above 93.80 the rally is intact.

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As noted last week, the pattern from the February low looked like oil had completed as a 5 wave rally. Even if oil had bottomed, it looked vulnerable to a decline of $6 to $8 a barrel in coming weeks and a rout if OPEC fails to agree on any meaningful freeze or reduction in output when it meets on April 17.

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I will be surprised if Saudi Arabia agrees to a freeze and allows Iran to continue to boost its production at the April 17 meeting. Oil peaked on March 18 at $42.29 on the May contract, and quickly dropped to $37.71. A close below $37.71 should be followed by a test of $34.00. If correct, fears about energy firm defaults, bad bank loans, bankruptcies, and high yield bonds should reemerge, and weigh on equity prices.

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 (XLU) at $47.28, and a 25% long position in the Consumer Staples ETF (XLP) at $51.65. These positions were liquidated on March 15 for a gain of .92%. Past performance is no guarantee of future results.

The Tactical Sector Rotation program is 100% in cash.


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