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posted on 03 May 2016

What Did The Fed Say To The Markets?

Written by

Weekly Technical Review 02 May 2016

In last week's WTR and in anticipation of the FOMC's meeting on April 27, I asked the question, "What Will the Fed Say"? My answer was simple.

"No matter what, I think the odds favor at least a slightly less dovish message in the FOMC statement than in March."

dove.365x240

My main point was that the hawks on the Fed board would make the case for a rate hike in June. We won't know what was discussed at last week's meeting for another 2 weeks, but I suspect there was a lengthy discussion spurred by the 3 hawks on the Fed about the risk of the Fed falling behind the inflation curve.

One of the hawks (Esther George) voted against the FOMC's policy position. In an April 7 speech Esther George made the flowing comments. "Years of experience, evidence and research remind us that monetary policy is most effective when used as a counter-cyclical tool. That means providing policy accommodation when deteriorating economic conditions threaten price stability and employment. Conversely, it means unwinding accommodation as we see economic conditions improve. In other words, the Fed should cut rates when the economy stumbles or contracts, and raise rates as the economy recovers and grows. In the long run, a failure to keep interest rate policy in line with improving fundamentals can distort the allocation of capital toward less fruitful - or perhaps excessively risky - endeavors. Within the last two decades we have faced episodes of accelerating equity prices, housing prices and, most recently, commodity prices. Currently, commercial real estate markets, where prices have continued to drift higher, bear watching. When these types of imbalances tip, the entire economy can face the consequences of their fallout, with some sectors and populations more impacted than others. My concern for some time has been that extending monetary policy too far beyond its scope of capability risks undesirable financial, economic and political distortions. Some argue that we have the ability to make more rapid adjustments later if inflation moves higher than currently projected. From a technical standpoint, it is true that the Fed has the ability to steer short-term rates and could raise them quickly if needed. But such actions are likely to be costly, inducing financial market volatility and slowing economic activity. Historically, rapid increases in interest rates end poorly, resulting in economic recessions."

The most notable change in last week's statement was the change in wording regarding the global economy. In March the statement noted 'global economic and financial developments continue to pose risks', while last week the statement said 'The Committee continues to closely monitor global and financial developments'.

Mohamid El-Erian, chief economic advisor for Allianz, assessed the FOMC as somewhat more hawkish:

"The Federal Reserve acted as expected Wednesday: It left interest rates unchanged and used language that was somewhat more hawkish, increasing the probability of a rate increase in June. The Fed downplayed the risks posed by "global economic and financial developments" to the U.S. economy, though it said it would "closely monitor" these. Seen as a whole, the Fed's message suggests that the data-dependent central bank is amplifying its signal that the June meeting is "live."

His assessment was what I concluded in last week's WTR. This slightly more hawkish tilt was over shadowed by the Bank of Japan's decision to leave interest rates unchanged and not push rates further into negative territory below 0%.

Gold and the Dollar

The BoJ decision caused the Yen to rally 5.3% against the dollar in a matter of hours. The dollar has declined for 6 consecutive days since April 22, losing a total of -2.79%, with -2.15% of the loss coming in the wake of the BOJ's decision.

On Wednesday April 27, the dollar lost -0.17% after the Fed released the FOMC statement. However, the 2 sharp declines in the dollar has led many strategists to conclude that the foreign currency market viewed the Fed's statement as dovish, and maybe they will be proven correct.

Recent data points have been weak, culminating with first quarter GDP growing just 0.5%. The Atlanta Fed's GDP Now indicator has second quarter GDP pegged at 1.8% as of today. This figure will obviously change weekly since less than 1/3 of second quarter economic data has been released. However, if incoming data firms a bit, the debate on whether the Fed will move in June will be revived.

The next important data point is the employment report for April which will be released this Friday. If more than 175,000 jobs are reported and prior month's figures are not revised down, the 'discussion' of will they or won't they could begin in earnest. The total number of private jobs is around 140,000,000, so a miss of 0.1% represents 140,000 jobs, which is why the payroll number is one of the most revised data series. My guess is that the number will be strong enough is kick-off the debate, not because I have any insight, but due to how the dollar and gold are currently positioned.

On second thought this may be more hazardous than trying to guess the actual number!

I think the dollar will make a bottom between 92.00 and 93.00 in the first half of May, and gold will top out. The dollar appears close to ending the correction that began in March 2015 when the dollar traded up to 100.39. It then dropped to 92.62 on August 24, before rebounding to 100.51 on December 2. The dollar fell to 92.54 today, marginally undercutting the August 24 low. The price pattern has, or is close to, the completion of a big A, B, C correction of the dollar's 21 point move up from its low of 79.00 in May 2014. My original assessment had been that the dollar would hold above 93.80 on a closing basis. This was the case until after the BOJ's decision, when the dollar close at 93.72 last Thursday.

Click on any chart for larger image.

welsh.fig.1.2016.may.2.600x400

The other similarity is the amount of time the dollar fell in wave A which was just over 5 months. A similar amount of time since the high on December 2 suggests a turn is possible in the first half of May. Finally, since last May the dollar has rallied every time the RSI has dropped to near 30, as noted by the green arrows.

Even if the dollar is destined for much lower prices, it is due a rally to work off how oversold it has become. 3 I think the dollar is one of the keys to how a number of markets are likely to perform in the reminder of 2016. If the pattern analysis is correct, and the dollar is completing the correction that started in March 2015, the dollar has the potential to rally comfortably above 100 before the end of 2016. All the markets that have enjoyed big rallies since the February 11 low would likely come under pressure if the dollar strengthens that much. On March 6, I sent an email entitled 'The Coming Correction in Gold and Gold Stocks'. While the analysis on gold was OK, gold stocks have rallied far more than I expected given how flat gold has been since March 6. On March 7, gold traded between $1259 and $1275. Before the BOJ made its announcement on April 28, gold traded at $1240, and then leapt to $1271.70 in the following hours.

This morning gold traded up to $1306. I thought gold had finished a 5 wave rally from its low in December on March 11, when it traded above $1287. Based on how it has traded since last Thursday, gold is either beginning the next big move to the upside, or completing wave 5 now, after wave 4 followed the March 11 high. I favor the latter since the smart money has continued to increase short positions while the trend followers have established a record long position. The potential for a low in the dollar also supports this view.

If I'm wrong about the dollar, gold very well may be at the threshold of the next big move higher.

welsh.fig.2.2016.may.2.600x600

Stocks

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 needs to make a lower low and then a lower high, before the uptrend can be considered at risk. I thought 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. On Friday the S&P did close below 2073, but it was able to recapture that level again today. The decline from 2111 is only 3 waves, which is a corrective pattern, rather than an impulsive decline. Since selling didn't accelerate after closing below 2073, the potential for the S&P to rally above 2111 still exists. A rally above 2111 would not change my view that the S&P will experience a correction down to 2033 at a minimum in coming weeks.

welsh.fig.3.2016.may.2.600x400

The technical negatives I have cited in the last two Technical Reviews are still in play. The negative RSI divergence in the S&P would likely be more pronounced if the S&P is able to rally above 2111.

welsh.fig.4.2016.may.2.600x400

Upside momentum, as measured by the 21 day average of net advances minus declines, has been posting lower peaks since early March. The gradual erosion has continued, even as the averages hold up near the recent high.

welsh.fig.5.2016.may.2.600x400

The net bulls in the Investors Intelligence weekly survey jumped last week to 23.7, which is the highest level of bullishness since August 7. Although the 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 of 3% to 6%. As always the depth of any correction will depend on how much negative news materializes in coming weeks. The prospect of a Fed rate increase in June and a stronger dollar might be enough to get the ball rolling.

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.

welsh.fig.6.2016.may.2.600x400

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 0.92%. (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. 7 Since early April the top three sectors, Consumer Staples (XLP), Utilities (XLU), and Technology (XLK) have experienced a pullback, while economically sensitive sectors have been the leaders. The problem at this point is that Energy (XLE), Basic Materials (XLB), Industrials (XLI), and Financials (XLF) are over bought, while the former leaders are vulnerable to a deeper correction. This is why the market as a whole usually experiences a correction when a change in leadership unfolds. If Staples, Utilities, and Technology fail to strengthen during the coming decline I expect in the market, it would support the observation that a lasting change in leadership is developing. This would be further confirmed, if the new leaders hold up reasonably well during a correction, and indicate that allocating to these sectors might provide a measure of outperformance if the S&P manages to rally to 2360 in wave 5 from the 2009 low in coming months.welsh.tactical.rot.2016.may.02

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