posted on 10 May 2016
Written by Jim Welsh
As discussed in the May 2 Weekly Technical Review, I thought the dollar would bottom between 92.00 and 93.00 in the first half of May. "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."
Based on how the dollar traded last week, the low may have occurred on Tuesday. The dollar droped from 100.39 in March 2015 to 92.62 on August 24 (Wave A), before rebounding to 100.51 on December 2 (Wave B). The dollar then dropped to 91.88 last Tuesday before reversing and closing at 92.93. This appears to be the end of Wave C.
The dollar has closed higher on the last 5 consecutive trading days, which is quite the change from the prior 6 trading days when it declined each day. Nothing is for certain, but this is the type of trading action one would expect after a correction which lasted for almost 14 months. What makes this even more impressive is that the dollar rallied after selling off after the April jobs number was reported on Friday morning. After closing at 93.78 on Thursday, the dollar spiked down to 93.09 in the minutes after the jobs number was released, and then rallied sharply to close at 93.88. More often than not, how a market responds to the news is more telling than the news itself.
(Click on any chart for larger image.)
Before the final wave of selling commenced on April 19, the dollar tried to climb above 95.20, but failed on April 14 (95.21) and then on April 22 (95.18). I would be very surprised if the dollar would close above this are of resistance on the first attempt. This suggests the dollar will likely run into some selling pressure between 94.80 and 95.21.
In a perfect world I would like to see the dollar hold above 93.62 on any correction. If the dollar does manage to close above 95.21, as I expect, selling pressure on commodities and the stock market will intensify. According to analysis by Morgan Stanley, the negative correlation between the dollar and stocks, emerging markets, and commodities is the highest in 20 years. The Morgan Stanley Global Risk Demand Index reached a negative 86% in early April, and was minus 76% on May 5. The C wave correction shaved 8.63 points off the dollar index. A 50% retracement would bring the dollar up to 96.20. After the trading low on August 24, the dollar rallied to 96.60-96.70 in September and October. This suggests the first leg up is likely to run into stiff resistance between 96.00 and 96.70, and at that point, could be vulnerable to a period of consolidation/correction that could last a number of weeks. Any meaningful pullback could provide commodities i.e., oil, gold, etc. a chance to bounce, and the S&P a window to make a new high.
In the Weekly Technical Review on April 25, I thought the hawks on the Fed board would make the case for a rate hike in June. The hawks are concerned that the Fed could fall behind the inflation curve and be forced to raise rates more aggressively in 2017, which could cause more volatility in the stock market and threaten the economy. I also thought that if there was a chance for a rate hike in June, the hawks on the Fed would suggest that the Fed needed to 'communicate' this potential to markets.
During the week of May 2, three district presidents (Williams San Francisco, Lockhart Atlanta, Dudley New York) gave a speech or an interview in which they supported the Fed's projection of 2 rate hikes in 2016, with John Williams saying 2 or 3 increases were possible. Dudley told the New York Times that it was a "reasonable expectation" that the Fed will raise its benchmark interest rate twice this year. What makes his comments more noteworthy is that they were made after the employment report and, as president of the New York Fed, he is first among Fed district presidents.
As I said last week, "If incoming data firms a bit, the debate on whether the Fed will move in June will be revived." The strength in the dollar suggests currency traders are listening.
Before the BOJ made its announcement that was not taking any additional steps to weaken the Yen on April 28, gold traded down to $1240, and then leapt to $1271.70 in the following hours. Last Monday, gold traded up to $1306, dipped to $1270.60 last Thursday, before it rallied to $1297.70 on Friday. An equal of $35.40 decline would bring gold down to $1262.30, not far from today's low of $1262.80.
The most noteworthy aspect of today's trading was not the 2.2% decline in gold, or the 6.4% decline in the gold stock ETF GDX, but the fact that gold and the gold stocks could not manage to rally during the course of trading today. That is very different action than how gold, and especially the gold stocks have traded since January. This heavy trading suggests gold and gold stocks are headed lower. My guess continues to be that gold will test and likely break below $1207, and GDX could dip under $21.00 in coming weeks.
After gold rallied to $1306 in response to the BOJ's lack of action, large speculators increased their long position in gold from 220, 857 contracts to 271,648 contracts, an increase of 50,791 contracts in just one week. This is the largest long position held by large speculators in history. Conversely, Commercials increased their short position by 54,783 contracts to -294,901. This is a larger short position than in 2011 when gold was trading near $1900.
As noted in the last two WTR's, the S&P needed to make a lower low and then a lower high, before the uptrend could be considered at risk. The S&P has fulfilled the first part of the process. However, the decline to date has been very choppy, which is a sign that the pullback is a correction, and not likely the first stage of a much larger decline. This aligns with the analysis that I've presented that the low in February was wave 4 from the low in March 2009.
The current correction is likely wave 2 of a five wave rally that has the potential to lift the S&P to 2360. The initial rally off the February low covered 301 points, so the decline of 72 points (23.9%) in the S&P since the April 20 high seems too shallow for wave 2. If correct, the decline of 72 points is just the first part of a bigger correction. My guess is that after a bit more rally (2075- 2090?), the S&P will decline by at least 72 points before this correction is finished.
A 38.2% retracement of the 301 point rally would target 1996, while a decline to 1960 would represent a 50% retracement. Sentiment is already turning less bullish. The Call/Put Ratio peaked on April 20 as the S&P reached its high of 2111. As of Friday, the 10-day average of the C/P ratio was 1.034, down from 1.225 on April 20. It is likely to fall below 1.00 before the correction is over.
In the American Association of Individual Investors (AAII), the bears outnumbered the bulls by 8.0%, which is likely to get even more bearish in coming weeks. However, the percent of bulls in the weekly Investors Intelligence survey still showed 19.5% more bulls, so more time and a deeper correction is likely before the percent of bulls diminishes enough to support a strong rally.
I would also expect the market to become modestly oversold at the next decent trading low. This suggests that the 21 day average of net advances minus declines could get down to the green line or slightly below it. The Option Premium ratio is likely to get above the green line before the market bottoms.
As you can see, the 21 day average of net advances minus declines and the Option Premium ratio signaled the trading lows last August and September last year, and in January and February this year, as identified by the blue arrows. It would be classic for the economy to show enough improvement for the talking heads to begin discussing whether the Fed will raise rates at their June 14-15 meeting, and for the stock market to experience most of its decline prior to the meeting. As I said last week, 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.
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.
In the last two Reviews I've discussed the potential of new leadership taking hold in the market. I noted that since early April the top three sectors, Consumer Staples (XLP), Utilities (XLU), and Technology (XLK) had experienced a pullback, while economically sensitive sectors had been the leaders. As I noted last week, Energy (XLE), Basic Materials (XLB), Industrials (XLI), and Financials (XLF) were over bought.
The key to deciphering whether a true change in leadership was afoot was how the economically sensitive sectors performed during any pullback. As the S&P sold off last week, Utilities and Consumer Staples rallied, while the economically sensitive sectors displayed weakness. Basic Materials and Energy lost more than 3%, while Industrials and Financials gave up more than 2%.
This suggests it is too early to anticipate that the market's leadership has truly changed. The real test for Consumer Staples and Utilities will come if and when the prospect of a rate increase becomes a real concern for the market before June 15.
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