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posted on 27 June 2016

SP 500 Has Dropped Below 2026. Now What?

Written by

Macro Tides Weekly Technical Review, 27 June 2016

This is a quote from last week's article (before the Brexit vote):

"Since early mid March the S&P has not made a lot of upside progress, but it sure has bounced around based on the latest Fed comment or Brexit poll. Sometimes the most difficult thing to exercise is patience. So far my patience has been rewarded. The Tactical Sector Rotation program is 100% in cash as I await a pull back to below 2026 and potentially as low as 1970 -1950."

During an interview on CNBC on Friday June 24, Jeff Gundlach made a couple of comments that caught my attention. He said that

"80% of returns are captured in 20% of the time, and that it was prudent to wait for bargains. What's really important in investing is patience. Sometimes it's OK to make a few percent in safe investments."

Here's the video. His comments about patience are at the 3 minute mark.

Stock Market

After the FOMC minutes of the April 27 meeting were released on May 18, 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 2040.04, avoiding a close below 2040 by the slimmest of margins. As I noted in the May 23 WTR,

"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 2040 again, I strongly doubt it will hold."

My expectation of a decline below 2040 and potentially as low as 1950 - 1970 was not predicated on the Brexit vote passing. I thought Britain would vote to stay in the EU, as undecided voters, fearing the unkown Brexit represented, would feel motivated to vote for the status quo. To me, the Brexit vote was an asymmetrical event. A vote to stay was priced in and would have virtually no positive impact on economic growth in the Britain, EU, or the global economy. A vote to leave on the other hand would be clearly negative for Britain's economy, with subsequent spill over affects on the EU and the global economy. I thought the U.S. stock market was vulnerable to a global growth scare as I discussed in the June 8 Macro Tides Monthly report:

"The slowdown in job growth in recent months and the information provided by the Fed's Labor Market Conditions Index suggests a strong rebound in job growth is not likely. If anything, job and wage growth could soften in coming months and crimp consumer spending. The rebound in gas prices isn't a positive since it lowers disposable income. And it's hard to see how the November election will lift consumer confidence in coming months, since both nominees are viewed negatively. Growth in the second half of this year may be challenging and there is a rising potential of a growth scare that could upset the stock market since valuations are high."

The Brexit vote simply will accelerate the awareness of what was already developing.

The S&P closed below 2040 on Friday, dropped below 2026 today, and closed at 2000 after falling to an intra-day low of 1991. I think today's low will be exceeded before a good trading low can take hold. In coming days, I suspect there will be rumors of a firm or firms that were caught off guard by the huge moves in many financial markets.

The British Pound has plunged 12% in two days, with many other currencies off by 4% to 7%. Stocks of major banks in the EU, i.e. Deutsche Bank, Barclays, and others, have lost 35% or more. Large U.S. banks are down by 12% or more, while equity markets around the world have lost almost $3 trillion in value. Margin calls have the potential to cause forced selling as investors or firms are unable to meet margin calls, especially if markets continue to decline in the next few days.

As discussed in prior Reviews, I think wave 4 from the March 2009 low ended at the February 11 low. Wave 5 has the potential to lift the S&P to 2360 - 2400 by early next year. Wave 5 will sub-divide into 5 waves itself. I think that the first part (wave 1) of wave 5 from the February low ended on June 8 when the S&P reached 2120. The rally from the February low of 1810 to the June 8 high of 2120 was 310 S&P points. A 38.2% give back of the rally would bring the S&P down to 2002, while a 50% retracement would bring the S&P down to 1965.

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 is important support, should the S&P fall that low.

On CNBC today I heard a number of analysts comment that they were encouraged that the decline on Friday and today was 'orderly'. These comments reflect complacency which is not what I want to hear. Whenever the market is near a solid trading low, the market is rarely orderly, and few are not worried about the market going much lower. These comments and the current level of technical indicators suggest that the odds favor lower prices before a trading low is in place. It could be a matter of a few days or a couple of weeks.

While I do not expect the S&P to fall below 1950 during wave 2, it is possible for wave 2 to retrace up to 99% of wave 1. Before wave 2 of wave 5 finishes, I expect the 10-day Call/Put ratio will be below 1.0, the 21 day net advances minus declines will be under -400, and the Option Premium ratio will spike above 1.30 at a minimum. In other words, I will put more emphasis on the technical indicators that have done a good job of identifying a market low than the percent of retracement by the S&P.

On Friday, the moving average of the Call / Put Ratio was 1.037 and will definitely be lower after today. Sentiment shifts more quickly when there is an obvious reason for either a rally or a decline. Given the headlines and market reaction to Brexit, I suspect sentiment will turn negative quickly.

Click on any chart for larger image.

As of Friday, the moving average of the Option Premium was .974, not even close to 1.30. The 21 day net advances minus declines after today's decline was only -63 and not oversold.

The S&P has peeled off 121 points in less than 2 days of trading so a bounce is coming. There is a gap at 2032.57, between the low on Friday and the high today that is likely to be filled. My guess is that the market will fill the gap before heading lower.

When the banking sector broke its support in January, it led the market lower. This is why watching how the banking sector performs in coming days could prove valuable. If the S&P Bank Index and Regional Bank ETF fall below there long term support lines, more weakness is likely. Conversely, if they hold support and begin to rally, that would be a positive for the overall market.

Gold and Gold Stocks

Since gold stocks have been this year's biggest winners, they will probably be supported by window dressing at the end of the second quarter. The Gold Stock ETF closed today at $27.06 but its RSI was only 63.0 compared to 74.8 on April 29 when GDX was $25.83. This is a large negative divergence and worthy of lowering exposure.

Producers and Commercial Specs were more short Gold last week than they were when it was trading above $1900, and have shorted every rally since March. Large speculators and Managed Money have their largest long position ever. These trend followers are usually wrong at important highs and lows. When gold was bottoming in December they were net short! In contrast, Commercial Specs were net long, and Producers had the smallest short position in years. (Study the chart below) Gold experienced a sharp decline of more than $100 in May and I think another $100 decline is coming that will bring gold below $1260 at a minimum. If the rally from the low of $1199 at the end of May has been a B-wave, a Cwave decline could bring gold back to $1200 in coming months.

The Commercials only covered a small portion of their short position when gold was trading near $1200, and then increased it as gold rallied. My guess is they increased their short position even more when gold spiked higher on Friday after the Brexit vote.

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.

Since June 10, the Major Trend Indicator has fallen from 2.26 to 1.43 today and will continue to decline in the next few days, even if the market rallies. The June high was lower than the high in April. The next rally is important. If the MTI posts a high that is lower than the June high, the pattern of lower highs in the MTI will represent an important warning. We'll cross that bridge if and when it occurs.

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%.

Sometimes the most difficult thing to exercise is patience. I have been waiting for the S&P to pull back below 2026 and potentially as low as 1950 -1970, and finally that patience has been rewarded. As of today's close the S&P is down about -2.5% in the second quarter, while the Tactical Sector Rotation program has been 100% in cash since mid March.

I was interviewed on CBS radio in Chicago Monday morning and asked about investors buying Utility and Consumer Staple stocks even though they are expensive. Most investors don't realize the risk they are assuming, if the stock market rallies in coming months to a new high in wave 3 of 5. In March 2009, Healthcare was number one in the ranking, Consumer Staples were ranked number 2, and Utilities were number 3. Investors consider each of these sectors as safe and a place to hide when the market is declining.

But once the market began to rally in March 2009, these sectors were jettisoned for other sectors that offered more upside beta. By June 2009, Utilities had fallen to number 9, Staples to 8, with Healthcare dropping to 6. Given how crowded the trade in Utilities and Consumer Staples has become, the rush out could be painful, if the stock market rallies in coming months to a new high in wave 3 of 5.

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