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posted on 12 July 2016

Breakout Or Fake Out?

Written by

Macro Tides Technical Analysis 11 July 2016

S&P 500 - Breakout or Fake out?

The S&P traded up to 2093 in December 2014 and then spent the following 19 months trading sideways. This period of sideways chop included two jaw dropping plunges of 10% in August / September 2015 and in January / February of this year. Last Thursday, July 7, the S&P traded as low as 2089 before closing at 2109. The employment report for June last Friday provided the fuel for the S&P to finally post a new all-time high after the 19 month sojourn of going nowhere.

arrow.breakout.380x200

The key question is whether the new high in the S&P represents a breakout that will lead to the rally to 2360 I've discussed for a number of months, or is it a fake out that will frustrate bulls and lead to another sharp setback. Occasionally the stock market provides an answer that is crystal clear, but this isn't one of those times, at least from my perspective. After an assessment of a range of technical indicators, my goal is to estimate the probability of an outcome.

The rebound from the Brexit vote was remarkable since it displayed the market's resilience in the face of legitimate negative news. Given the importance of the Brexit vote, I suspect many institutional investors were hedged prior to the vote and index option data support this conclusion. When the market plunged, those hedges were quite profitable.

As the market recovered those profits progressively disappeared which added to the urgency to cover hedges. This buying certainly lifted the market and accelerated the speed of the rebound. The advance / decline line has made higher highs and the number of issues trading on the NYSE posting new 52 week highs has displayed a healthy expansion. There is a small divergence on the A/D line's RSI, but this could be negated with additional strength.

Click on any chart for larger image.

welsh.tech.2016.jul.11.fig.1.600x800

The one caveat with the A/D line and new highs on the NYSE is the significant number of interest sensitive issues traded on the NYSE in the form of closed end bond funds, municipal bond funds, and preferred stocks. Historically, participation of these issues would be considered a positive, but we live in interesting times. Central bank monetary policies have suppressed interest rates globally because economic growth has not been healthy. While this is supportive of interest sensitive sectors, it has not been good for corporate earnings, which have declined for four consecutive quarters in the U.S.

The cumulative advance/decline line and cumulative volume have been highly correlated since the beginning of 2012, which historically has also been true. However, since May 2015, cumulative volume has lagged the A/D line significantly. One explanation is that average daily volume of interest sensitive sectors is less than the average daily volume traded by the average common stock on the NYSE. While each issue on the NYSE has effectively the same weighting (each issue counts as 1), volume is entirely different. During the declines last August and earlier this year, volume expanded but contracted during the subsequent rallies.

In addition, during the declines in the S&P many interest sensitive issues rose while the average common stock fell. This explains why the A/D line didn't drop as much as net volume during the declines, and why the A/D line performed better during the rallies.

welsh.tech.2016.jul.11.fig.2.600x300

While this explanation helps explain the divergence between the A/D line and cumulative volume, it does not eliminate the negative divergence between the S&P and cumulative volume. The correlation between the S&P and cumulative volume has usually been fairly tight, so the degree of the current divergence is meaningful and has often preceded declines in the S&P.

welsh.tech.2016.jul.11.fig.3.600x300

Although the S&P made a new all-time high today, other major averages are not near a new high, except the DJIA which is just -.5% below its high - the DJ Transports -19.5%, the Russell 2000 -8.9%, and the NYSE Composite -6.3%. I expect the DJIA to make a new all-time high in coming days, but the distance the other averages have to cover is quite large.

The bank stocks are an important sector and have been lagging badly. This is due to the narrow spread between short term and long term rates, and the odds that short term rates will remain low for an extended period of time since the Fed will be in no hurry to raise rates.

Bank loan growth has also been weak. This explains why bank stocks have performed so poorly, since these conditions make it difficult for banks to make money. Unfortunately, these conditions are not likely to change anytime soon. It is difficult to see how the S&P can make a lot more upside progress in the short run, without the banking sector participating meaningful.

welsh.tech.2016.jul.11.fig.4.600x300

With the new high in the S&P, its RSI is also sporting a negative divergence. When the S&P closed at 2102 on April 20, the RSI was 68.8. On June 8, the RSI was 66.9 when the S&P was 2119, but only 61.9 today with the S&P closing at 2137. This is a sizable negative divergence.

welsh.tech.2016.jul.11.fig.5.600x300

When the S&P bottomed on June 27, the price of the S&P was oversold as measured by its RSI which dropped to 30.9. However, market internals were far from oversold, which is why this rally is somewhat suspect. The 21 day average of net advances minus declines was just -63 and not even close to the -400 or lower levels established prior to every other good trading low in 2014, 2015, and this year.

welsh.tech.2016.jul.11.fig.6.600x300

The Option Premium ratio is a good sentiment indicator as it measures if investors are too bullish and overpaying for puts. At each of the good trading lows during the last two years, the Option Premium ratio has spiked and indicated that a trading low was forming (Red arrows). On June 27, the Option Premium ratio was low and not indicative of a good trading low. As of Friday July 8, the Option Premium ratio was nearing a level more aligned with a high in the market.

welsh.tech.2016.jul.11.fig.8.600x300

In a global economy the U.S. stock market does not trade in a vacuum. While the US economy has been growing faster than other advanced economies, we are dependent on other advanced economies for contributing to global growth and the opportunity for U.S. exporters to find a market for their products.

A review of other major stock markets suggests the global economy is not all that great, and with Brexit, the outlook for Europe and Great Britain has dimmed. The difference between the FTSE 100 and the FTSE 250 mirrors the divergence evident in the major averages in the U.S. The FTSE 100 is above its April high, and highs posted last November and December. The FTSE 250, which is a broad based index, is well below those highs. This is similar to the divergence between the S&P and Russell 2000 and NYSE Comp.

welsh.tech.2016.jul.11.fig.9.600x600

A review of various technical indicators tilts the probability that the new high in the S&P will more likely prove to be a fake out, rather than a breakout. In the short term, I expect the S&P to push higher as the DJIA makes a new high. The better than expected employment report and new high in the S&P, and soon the DJIA, is likely to result in a surge of optimism as measured by sentiment indicators.

I think the odds favor that the low in February may represent wave 4 of a 5 wave rally from the March 2009 low, since the market was extremely oversold and sentiment was more negative than at any time since the March 2009 low. If correct, it suggests that wave 5 began at the February 11 low and could potentially lift the S&P to 2360 in early 2017.

My goal since April has been to identify the top of wave 1 and the low of wave 2 of wave 5. I think wave 1 ended on June 8. The decline from the June 8 high is clearly an a-b-c decline and therefore corrective. If the June 27 low was not the end of wave 2, it would have to be the first part of a larger wave 2 correction.

If this is the correct pattern, the low on June 27 represents wave A of wave 2. The rally from June 27's low would be labeled wave B of wave 2, and be followed by wave C of 2 and result in a decline below the S&P low of 1991 on June 27. This would then complete the wave 2 correction from the June 8 high of 2120.

welsh.tech.2016.jul.11.fig.10.600x300

The rebound from the low on Monday June 27 has been very impressive, and I have to accept that it might represent all of wave 2. So it is possible that wave 3 of big wave 5 to 2360 has begun. As I noted in the July Macro Tides, "If wave 3 of big wave 5 has begun, we'll know soon since the S&P 500 should explode to new highs on huge volume, after pushing above the May 2015 high of 2134." Despite the great employment report on Friday, and the surge to a new high in the S&P today, volume on Friday was 929 million shares, with today's new closing high supported by volume of 811 million shares.

From a technical perspective the odds appear to favor a bit more upside (1% to 2%), followed by a pullback that could cause the S&P to fall below 1991. However, investors have been entranced by central bank policy moves (manipulations), irrespective of their limited success. Central banks have more than pushed the monetary envelope in recent years, and the negative unintended consequences from unconventional monetary policy are becoming more pronounced, but that's not likely to stop them from doing more.

It was reported today that Ben Bernanke is in Japan, which investors think means that Big Ben is helping the Japanese craft another stimulus program. The Nikkei 225 was up 4% on July 11 on hopes it may come to pass. Great Britain's economy will slow in coming months and the Bank of England has indicated that it is ready and willing to ease policy if necessary. Last week the BOE lowered bank's reserve ratio to help banks loan more. My point is that the market may continue to push higher, if the BOJ and BOE announce more monetary stimulus, irrespective of the technical indicators.

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 S&P's rally to a new all time has lifted its year-to-date total return to 5.8% as of July 11. This is comfortably below the Tactical Sector Rotation's return, and the avoidance of the crazy volatility of the past few weeks. The Tactical Sector Rotation program is 100% in cash as I await a pull back to below 1991 and potentially as low as 1970 -1950 on the S&P, or until the technical indicators suggest a solid trading low has been established.

welsh.tech.2016.jul.11.sector.rotation

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