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posted on 27 April 2016

What Will The Fed Say?

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Weekly Technical Review 26 April 2016

At its March 16 meeting the Fed surprised many (including me) when it lowered the number of expected rate increases in 2016 from 4 to 2. This dovish shift was reinforced when Chairperson Yellen followed with a speech on March 29 at the Economic Club of New York. In response to her speech, the S&P jumped more than 2% from its low on March 29 before she began speaking to a high on March 30.


When the minutes of the March 16 meeting were published on April 6, the committee referenced international or global risks more than 20 times as one of the reasons why the FOMC's rate expectations for 2016 were cut in half. In addition to the Fed's dovish tilt, every other major central bank has reassured global investors that they will or are willing to do more since February 11. As global investors have been trained to do since the financial crisis, they bought stocks, even though the IMF has in the last four months lowered its growth estimates twice for the global economy in 2016 and 2017.

The Fed will not raise rates at this week's FOMC meeting. However, with international financial markets stabilized and well off their February low, unemployment claims at their lowest level since 1973, the dollar lower by 4%, the CPI for services up to 2.7% in March, and oil prices up sharply, the hawks on the Fed board will make the case for a rate hike in June. The hawks are concerned that the Fed might fall behind the inflation curve and be forced to raise rates more aggressively in 2017. They will also argue that if there is a chance for a rate hike in June, the Fed will need to 'communicate' this potential to markets.

I don't know whether the FOMC will word its post-meeting statement on Wednesday to convey this possibility. They may choose instead to allow Fed watchers to see how much discussion was devoted to a potential June hike when the minutes are published in 3 weeks.

No matter what, I think the odds favor at least a slightly less dovish message in the FOMC statement than in March. If correct, the bond market and gold could be vulnerable to a selloff. Stocks may try to rally, since a possible rate increase shows that the Fed is confident enough in the economy's strength to raise rates. I would look to get more defensive or short if the S&P does rally above last week's high of 2111, since I still think the rally from the low on February 11 has either ended or will with one more push.


In last's weeks WTV entitled 'Short Term High At Hand', I noted there were reasons why a short term high was likely soon. The DJIA had closed above 18,000 last Monday for the first time since last July, the S&P was less than 6 points from 2100, and the Nasdaq Composite was less than 1% from 5,000. Round numbers often provide investors a reason to take profits. After the strong rally from the February 11 lows, taking some money off the table would seem prudent. The chart of the S&P could also be counted as a complete 5 wave advance from the February 11 low, which suggested the S&P was near at least a short term high.

The S&P did manage to trade up to 2111 last Wednesday before closing at 2102.40. Despite the close above 2100, the negative RSI divergence I noted last week was maintained. (68.5 vs. 71.4 when the S&P closed at 2072.78 on April 1) The modest decline in the S&P from 2102.40 to 2087.79 today has caused the RSI to drop to 61.4. Should the S&P manage to climb above 2111 and close modestly above 2102.40, the RSI would likely post a larger negative divergence by failing to exceed the 68.5 from last Wednesday. (Chart top of next page) In addition, despite the higher high in the S&P, the upside momentum of market breadth, as measured by the 21 day average of net advances minus declines, has been posting lower peaks for several weeks. (Second chart below.)

Click on any chart in this article for larger image.

Sentiment has become more bullish with the DJIA closing above 18,000 and the S&P over 2100. The Call/Put ratio, although not excessive, has risen to levels that marked the high last November and a pause in the market's rally off the February low this year. The net bulls in the Investors Intelligence weekly survey jumped last week to 19.6, which matches the high last November and in late March. Although the Call/Put ratio and Investors Intelligence numbers are not as high as they have been at other important tops, they do reflect enough optimism to leave the market vulnerable to a correction.

The S&P rallied from 1810 on February 11 to 2111 on April 20, a gain of 301 points. At a minimum, a decline to at least 2033 is likely. A 38.2% retracement of the 301 point rally would bring the S&P down to 1996, which is near the December low of 1993. After it was broken on January 6, a sharp decline followed so it is a pivot point.

As noted last week, since the February low, the S&P has posted higher highs and higher lows, so the trend is up. At a minimum, the S&P will need to make a lower low and then a lower high, before the uptrend can be considered at risk. A close below the last short term trading low on April 18 at 2073 would likely confirm that the short term top was in place.

Has the S&P's Long Term Pattern Changed?

Maybe. The NYSE advance / Decline exceeded its high from April 2015 last week. While not perfect, the A/D line is one of the better indicators, and suggests that the pattern in the S&P may be more positive than I have previously considered. When the strength of the A/D line is combined with the long term level of sentiment, as measured by the weekly Investors Intelligence survey, the low in February may have been significant.

When the S&P bottomed in March 2009, the percent of bears in the weekly Investors Intelligence (II) survey outnumbered bulls by 20.8%. This extreme level showed just how negative investors had become. The S&P then rallied for more than a year, until it topped out in April 2010. This high marked wave 1 of the new bull market.

At the low in October 2011, the net percent of bears exceed bulls by 11.9%. The lopsided number of bears resulted in the wave 2 low. The S&P subsequently rallied almost without interruption until August 2014, which is typical of a wave 3 advance. The S&P dropped sharply into a low in October 2014, which resulted in a big increase in bearishness. The percent of bears in the II survey swamped bulls by 10.9%, the most since the October 2011 low and ideal to establish a wave 4 low. This is why I thought the high in May 2015 was wave 5 and the high for the 2009 bull market.

The end of the 2009 bull market was seemingly confirmed, when the Russell 2000 fell apart after peaking in June and the A/D line performed so poorly during the rally after the September 2015 low. This was classic bear market action, with the broad market acting terrible, while the DJIA and S&P lingered near the all-time spring highs in November and December.

At the low in February, the percent of bears in the II survey swamped bulls by 14.5%, reflecting even more bearishness than at the low in October 2011. This was why I expected a multi-week rally that I expected to fail, with the S&P and the A/D line posting lower highs. This would set the stage for another decline in coming months to potentially below 1800. While that is still possible, the probability of that outcome has diminished, since the A/D line has been much stronger than I expected and sentiment has not become wildly bullish. This new information has forced me to consider that the high in May of last year was not wave 5, but wave 3. If so, the low in February represents wave 4 and not the first wave of a large bear market as I originally thought. If this is correct, the question is whether the rally since the low in February is all of wave 5 or just wave 1 of 5. Since wave 1 off the March 2009 low lasted 13 months, it is unlikely that wave 5 would last less than 3 months. This suggests that the high that has either just been made at 2111, or will soon be made, is far more likely to be wave 1 of 5.

In the short run, it doesn't matter since the odds favor a correction. If the market does pullback as expected, the level of selling pressure and the strength or weakness of market breadth will be informative. If selling pressure is relatively muted, the A/D line holds up, and bearishness jumps, it will increase the probability that the S&P will march to a new high in coming months, after completing wave 2 of 5 in coming weeks. Since wave 1 off the March 2009 low traveled 550 S&P points (667-1217 April 2010), the potential for wave 5 is a rally to 2360 (550+1810).

It is hard to imagine how the S&P could trade up to 2360, but until reasons to sell materialize, the lack of selling pressure, combined with corporate stock buybacks can continue to inflate the market. As we have seen in recent years, central banks have strived to create a wealth affect through higher equity and housing prices. The coordination and intensity of central banks efforts to stem the selloff in February and then nurse stock prices higher since the February low is testimony to their fears of a deflationary debt collapse. Valuations may be at the third highest since 1900, but that doesn't mean they can't be stretched further at the behest of central bank manipulation.

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.

The MTI confirmed a new bull market on March 30. 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.

For the first quarter, the Tactical U.S. Sector Rotation program was up 6.1%. I also recommended via email on December 31 a 10% position in the gold ETF (GLD) and a 10% position in the gold stocks ETF (GDX). These positions were closed during February with a gain of 1.0% for GLD and 1.8% for GDX. The total return for the first quarter was 8.9%, which does not include management fees. Past performance is no guarantee of future results. The total return for the S&P 500 in the first quarter was 1.4%.

The Tactical Sector Rotation program is 100% in cash as I await a pull back to below 2033 and potentially lower.

The Consumer Staples sector (XLP) has been in the top four sectors since September 4, 2015, so it has been one of the leading sectors for more than 7 months. The Utility sector has also been strong and in the top four sectors since December 18, 2015. These sectors offer good dividend yields and are seen as safe sectors during periods of market tumult.

Since early April, there has been a rotation out of 'safe' high yielding stocks and into other sectors more dependent on improved economic growth. Over the last three weeks, Consumer Staples fell -4.1%, Utilities -6.3%, while Industrials rose 3.5%, Basic Materials were up 7.0%, and Energy jumped 8.9% on the back of the rally in oil.

Historically, the stock market has experienced a correction whenever a change in leadership takes place, so this is another reason to expect a pullback in coming weeks. If Staples and Utilities fail to strengthen during a decline in the market, it would support the rotation that has occurred since early April, and suggest that once wave 2 of 5 is finished, these sectors are likely to lag the market during wave 3.

If Industrials, Materials, and Energy fall less than the S&P during the expected wave 2 decline, it would suggest that these sectors are likely to outperform the S&P during the wave 3 of 5 rally in the S&P.


Jim Welsh

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