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posted on 19 July 2016

Breakout Not Yet Confirmed

Written by

Macro Tides Technical Review 18 July 2016

Last week the question was whether the S&P had scored a legitimate breakout that represents the first leg of a rally to 2360, or was it a fake out that will frustrate bulls and lead to another sharp setback. It is impressive that the S&P was able to push higher after posting a new all-time high. The small RSI divergence in the S&P compared to its June high has been overcome, but not the divergence with the April 20 high.

arrow.breakout.380x200

As I expected, the DJIA has also made a new all-time high, along with higher highs in the advance/decline line, and an expansion in the number of stocks making new 52 weeks highs on the NYSE and Nasdaq, which had been lagging. In the 14 trading days since the S&P bottomed on June 27, the S&P has advanced on 12 days, which shows that selling pressure has been MIA. While each of these points increases the odds of a breakout, the answer to the breakout question is not yet definitive, since there remain a number of hurdles.

Small cap stocks, as measured by the Russell 2000, have performed well since June 27, but remain under an important resistance level at 1213, which dates back to February 2014. The Russell 2000 has handily exceeded its June 8 high, but its RSI is well below its June 8 level (65.1 today versus 72.0 on June 8).

Click on any chart for larger image.

welsh.tech.2016.july.18.fig.1.600x300

The DJ Transportation average has rallied up to a down trend line (8030), but has failed to break through. The divergence between the DJIA and DJTA is a big negative since the Transports have often led the market higher and lower.

welsh.tech.2016.july.18.fig.2.600x300

The Russell 2000 and the Transports remain just under their respective resistance levels, so a quick pop above resistance is certainly possible. If they do bridge resistance, the key is that the Russell 2000 and Transports do not subsequently fall back below their resistance line. If they fail to hold their breakouts, it will look like the Russell 2000 and the Transports have made at least a short term top.

The market's strong response to the Brexit decline, far better than expected employment report, and the prospect of the Fed holding rates low for longer has boosted investor's optimism about the market. On Friday, the moving average of the Call/Put Ratio was up to levels that marked highs on April 20, November 4, 2015, and May 15, 2015 and just before the S&P topped on May 20 (red arrows).

On March 21 of this year, the S&P made a short term high, before rallying into the April 20 high. The green arrows note when the moving average of the Call/Put ratio dropped to a level that was supportive of short term or intermediate rallies. As I noted last week, the Call/Put ratio did not fall below the green horizontal line as the market made its low on June 27.

welsh.tech.2016.july.18.fig.3.600x300

The Option Premium Ratio has fallen to levels that are consistent with at least a short term market high (red arrows). The Option Premium Ratio wasn't even close to the levels it reached when the market bottomed this year in February, January and last year in August and September (green arrows).

welsh.tech.2016.july.18.fig.4.600x300

The percent of Bulls in the weekly Investors Intelligence survey outnumbered Bears by 27.8%, which is the highest since last July.

welsh.tech.2016.july.18.fig.5.600x300

The sharp increase in bullishness and levels of optimism suggest the market is near a short term high.

Despite the market's follow through over the last week, the divergence in cumulative net volume compared to its high in May 2015 is still intact. While it is positive that the advance/decline line continues to make higher highs, it is concerning that volume has not confirmed the move in the advance/decline line.

welsh.tech.2016.july.18.fig.6.600x300

As noted last week, the banking sector has been underperforming the S&P since June 2015, as indicated by the black down trend line on the Banking Index (BKX). It is also evident in the down trend in the relative strength line comparing the banking sector and the S&P. In contrast, the S&P (green) has posted a new high. It is hard to see the S&P moving appreciably higher, unless the banking sector begins to perform better, by breaking above the down trend line from the June 2015 high.

welsh.tech.2016.july.18.fig.7.600x300

The market has become quite overbought as measured by the 21 day average of net advances minus declines. In the short run, this suggests the market is likely to chop around a bit, despite the elevated levels of optimism. A decline is not likely until the 21 day average of net advances minus declines registers one or two lower highs, showing that upside momentum is waning.

welsh.tech.2016.july.18.fig.8.600x328

From the low of 1991 on June 27, the S&P rallied to 2108 on July 1, a gain of 107 points. An equal rally of 107 points from the low of 2074 would target 2181. If the S&P does reach 2181, the DJIA will likely bump its trend line of resistance at 18,625 - 18,650.

welsh.tech.2016.july.18.fig.9.600x300

The odds suggest that the low on June 27 is not all of wave 2 of 5 from the February low, since the market was not internally oversold and sentiment was not that negative. The down, up, down correction from the June 8 high could represent wave A of wave 2. The rally from the June 27 low would be labeled wave B of wave 2. The increase in bullish sentiment supports this interpretation.

If this analysis is on target, the S&P would top out this week, and ultimately be followed by wave C of 2, which should 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. At that point, the market would be oversold and sentiment far more negative, setting up a great buying opportunity since wave 3 of wave 5 would follow and lead to a broad based breakout on big volume.

welsh.tech.2016.july.18.fig.10.600x300

The decline from the June 8 high was clearly 3 waves, and so far, the rally from June 27 is also 3 waves. The high of the first wave was 2108. If the S&P declines below 2108 in coming weeks, it would affirm the interpretation that the rally from 1991 on June 27 was wave B of 2. If instead, the S&P pulls back to 2120 - 2130, and then rallies above the high this week, it would complete 5 waves up.

While a 5 wave rally would reduce the odds of a decline below 1991, it would complete the initial rally from 1991 and be followed by a correction. It appears the upside is fairly limited from present levels.

In order for the market to decline, there must be a reason to sell. Although second quarter earnings expectations are very low, companies are still having a difficult time increasing revenue and earnings, which are forecast to be down for the fourth consecutive quarter.

A more serious problem could emerge on July 29, when the ECB releases the results its stress tests on European banks. European banks have an estimated $1 trillion in nonperforming loans. A number of Italian banks are in dire straits and the overall Italian banking system is plagued with nonperforming loans that amount to $350 billion, or 16% of total assets. Italy has proposed fortifying its banks with an infusion of $45 billion, which is a drop in the bucket compared to the amount of bad loans.

The problem is that Italy's proposal violates EU banking rules that insist losses must be incurred by the bondholders of the troubled banks. Politically this is a serious issue since hundreds of billions of bonds are owned by the Italian people. In the wake of Brexit, the pressure is on the EU to display some flexibility, or risk another banking crisis and the potential of Italy voting to leave the EU if losses are forced on Italian citizens.

It would be out of character for the EU to resolve this situation before July 29, so there is the potential that markets become unsettled before some agreement is reached that provides money for Italian banks without bond holders taking a big hit. Someone will redefine the fine print in EU banking rules to make it possible. If not, the insolvency of 2 or 3 Italian banks would not be received well.

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%.

Until the technical and sentiment indicators suggest a solid trading low has been established, or the market confirms that it has broken out, the Tactical Sector Rotation program is 100% in cash.

welsh.tech.2016.july.18.tact.table

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