posted on 24 May 2016
Written by Jim Welsh
The minutes from the April 27 FOMC meeting were released last Wednesday and they confirmed my analysis of the Fed and moved markets as expected. In the April 25 Weekly Technical Review I thought the hawks on the Fed would argue that if there was a chance for a rate hike in June, the Fed would need to 'communicate' this potential to markets.
Here's what the FOMC minutes reflected:
The minutes also noted that most participants were leaning toward a hike, if incoming data reflected an improvement:
As noted in the May 9 and May 16 WTR's, seven district presidents have given speeches and interviews emphasizing the potential of an increase in June. Since second quarter data has shown definitive improvement, it was easy for Fed district presidents to guide toward an increase in June.
Since the December rate increase, the Fed has emphasized that it was data dependent. When the data was weak in the first quarter, the Fed noted the weakness at the March meeting, and inferred that incoming data had to prove a rate increase was warranted. The minutes of April 27 meeting and public comments in the last two weeks indicate that the bar has been lowered, and now the data must show enough weakness to persuade the Fed not to increase the federal funds range at the June meeting.
Two weeks ago, the federal funds futures were pricing in a 4% probability of a June rate increase. On Friday it was 73.8%, but dipped to 70% today. The probability of a July hike has dropped from 47.4% on Friday to 41.6% today. Despite all the comments by so many Fed presidents and the Fed minutes, there are still a sizable number of market participants who don't believe the Fed will act in either June or July. This suggests markets are still vulnerable, if economic data continues to be just OK. There is no press conference after the July meeting, which is another reason why the Fed is likely to move in June.
The S&P 500 is the sum of its parts, so an analysis of the charts of the 9 sectors could provide a valuable insight into whether the S&P is likely to hold above its support at 2040. The blue trend line from the lows of February defines the uptrend. Almost every sector has broken below the rising blue trend line. In order to reestablish the uptrend, each sector must get back above the rising trend line or break out above its recent high. The red trend line identifies the short term support that if broken, would increase the odds of that sector falling to longer term support and the black trend line.
The Utility sector is the only sector that is still above the blue trend line from the February low.
The above table shows how much each sector has declined from its recent high (% Below Resistance), how much each sector is above its short term support (% Above Support), and the amount of decline that could be possible if short term support is broken and each sector drops to its longer term support (% Below May 23 Cls).
Based on each sector's weighting in the S&P 500, the S&P 500 could fall -5.9% the May 23 close. The S&P closed today (23 May) at 2048.04, so a decline of 5.9% would bring the S&P down to 1927. Since it is unlikely that every sector would reach its long term support at the same moment, this is an estimate. It is interesting that it is not too far from the projection of 1970 that I have discussed. (Based on a decline that would be equal to the distance from the high of 2111 and the important support at 2040 (2111-2040 =71 points from 2040 = 1969).
The rally from the February low of 1810 to the April 20 high of 2111 was 301 S&P points. A 50% retracement would bring the S&P down to 1960. On January 13, the S&P rallied to 1950 before falling sharply to the January 20 low of 1812. It then rebounded to 1947, before falling to the low on February 11 at 1810. As the S&P came off the February low, it spiked up to 1946, fell to 1891, before breaching the resistance at 1950. This suggests the 1950 level should provide decent support, should the S&P fall that low.
After the FOMC minutes of the April 27 meeting were released, the S&P peeled off 35 points in 4 hours of trading, as it fell from 2060 to 2025 between 11am PST on May 18 and 830 PST on May 19. By the end of trading on May 19, the S&P had recovered to close at 2020.04, avoiding a close below 2040 by the slimmest of margins. The 2040 support area bent, but it did not break. That said, the market used up a far amount of energy in holding this key level of support. Should the S&P test it again, I strongly doubt it will hold.
The top panel in the chart above shows the 10-day average of the Call/Put ratio. As you can see it has dropped under 1.0, which means investors have been buying more puts than calls during the last two weeks. The blue arrows illustrate the other instances when the Call/Put ratio fell below 1.0. In each instance the S&P subsequently rallied. In the short run the S&P can bounce up to 2085, but I doubt there is much upside beyond that level. The primary difference is that the market not oversold.
The 21 day average of net advances minus declines provides a good indication of how over bought or over sold the market is and it is currently neutral. In the other instances when the Call/Put ratio was under 1.0, the 21 day average of net advances minus declines was below -400. At the lows last August and in January it exceeded -700. As of today's close it was just above zero, and not even close to being over sold. If the S&P does mange to run up to 2085 or so, the 21 day average of net advances minus declines will quickly become over bought, which would likely limit any additional price gains.
If incoming economic data continues to reflect an improving economy in the second quarter, the prospect of an increase by the Fed will become more certain. This could cause the interest sensitive and dividend play sectors (Consumer Staples, Utilities) to come under selling pressure. If the dollar rallies as I expect, oil, basic materials, energy, and industrials will retrace a good portion of their rallies since the low in February.
Financials may not benefit as much as some expect, if the 10-year Treasury yield holds below 1.95% as I think likely. If correct, the yield curve will flatten as the spread between the 2-year Treasury yield and the 10-year doesn't widen enough to lift financials. If the majority of these sectors break their support as noted in the table, the S&P will break below its support at 2040 and at least test 2000.
If the Shanghai Composite falls below its January 28 low of 2655, weakness in emerging markets is likely to intensify, and cause selling to pick up in global markets. This could easily lead to the S&P testing support near 1950 - 1970.
Once the correction is over, I continue to believe the S&P will rally to a new all-time high above last year's peak at 2134. If the February low is wave 4 of the bull market that began in March 2009, the upside target is 2300 - 2360 for wave 5. The increase in the Call/Put ratio is supportive of this potential.
Gold and Gold Stocks
Last week, gold, the Gold Bugs Index (HUI) and the gold stock ETF (GDX) experienced weekly key reversals to the downside, as each index made a higher high than the prior week, a lower low, and closed down for the week. This increases the probabilities that gold and the gold stocks will decline further in coming weeks. A test of 1207 is possible in gold and GDX could trade under $21.00, with HUI falling to 185.00.
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 2040 and potentially as low as 1970 -1950.
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