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posted on 25 July 2016

Sentiment Suggests Pullback Soon

Written by

Macro Tides Technical Review 25 July 2016

The Call/Put ratio and the Option Premium ratio are at levels that have coincided with at least a short term top in the market over the last two years, as noted by the red arrows on each chart.

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Click on any chart for larger image. Hit back arrow to return to this page.

welsh.2016.jul.25.tech.fig.1.600x400

welsh.2016.jul.25.tech.fig.2.600x400

The percent of bulls in the weekly Investors Intelligence sentiment report now exceed the percent of bears by 31.1%, the highest since last July.

welsh.2016.jul.25.tech.fig.3.600x400

Momentum

As of Friday, 78% of the stocks traded on the New York Stock Exchange were above their 200 day average, which is the highest since July 2014. This is an indication of how overbought the market has become and a sign of strength.

welsh.2016.jul.25.tech.fig.4.600x400

The Major Trend Indicator (MTI) is a proprietary measurement of how strong or weak the market is. Generally, the MTI will make a series of lower highs prior to a correction of more than 7%. The MTI has surpassed the high it recorded in April, which is a sign of strength. This suggests that a correction of more than 7% is unlikely in the next few months.

welsh.2016.jul.25.tech.fig.5.600x40

Short term, the 21 day average of net advances minus declines has begun to weaken, but is still at a high level. The deterioration supports the notion that the S&P is vulnerable to a modest decline of 3% to 5% in coming weeks. The percent of stocks above their 200 day average and the new high in the MTI suggests any correction is likely to be followed by another rally.

welsh.2016.jul.25.tech.fig.6.600x400

Federal Reserve

The FOMC meets tomorrow and Wednesday, and will announce their assessment of the economy and decision on interest rates on Wednesday at 2pm est. There is no chance of the Fed increasing rates at this meeting. However, when they decided to keep rates steady at their last meeting, they cited a number of factors that influenced the decision. The economy had been weak in the first quarter, the May employment report had been surprisingly weak (only 38,000 jobs), and the uncertainty surrounding the Brexit vote in Britain convinced every member to vote in favor of doing nothing.

Things have changed since the last meeting. Second quarter GDP has more than doubled the level of the first quarter and will come in around 2.5%. The June employment report more than compensated for the weak May report, as 287,000 jobs were created. Brexit has come and gone, and markets have adjusted amazingly well to the outcome. Wage growth has modestly picked up in recent months, and inflation is moving toward the Fed's 2.0% target.

As I have discussed in my monthly commentary, most if not all of the Fed members want to gradually increase short term rates from their current level of 0.37%, so they have some leverage to lower rates to offset any slowdown in the economy in coming years. The Fed had an opportunity to raise rates more than once in 2015, but failed to seize the opportunity.

With the stock market at a high, and the data they are most dependent on looking good, I think the Fed will use this week's post FOMC statement to let markets know that an increase in September is a possibility, if the data continues to meet their expectations. If correct, stocks, bonds, oil, and gold could experience a quick sharp shakeout

A more serious problem could emerge on Friday 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.

As I have discussed in recent weeks, the market was not oversold nor was sentiment negative when the S&P bottomed on June 27 after the Brexit vote. Although I had previously discussed the potential of the S&P dropping below 2000 in the weeks leading up to the Brexit vote, the lack of any normal bottoming signals convinced me that patience was the better part of valor under the circumstances. Needless to say, the rally has exceeded expectations. 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.

In addition, the Utilities are very expensive and could be vulnerable to a sharp pullback if the Fed hints that a rate increase may be in the cards. In the June 8 Macro Tides I assessed the outlooks for oil prices:

"The biggest lift to oil prices in recent weeks has come from oil supply disruptions, rather than from an increase in demand. If global growth is close to the World Bank's estimate of 2.4% and the U.S. doesn't accelerate in the second half of 2016 from the 2.5% range in the second quarter, the demand for oil may not match estimates. As oil production resumes in Canada and U.S. production edges higher in coming months, the supply / demand imbalance is likely to reemerge. When oil was trading above $50 a barrel last October, producers were short -185,180 contracts. In the week ending May 31, producers had increased their short position by 56% to -289,478 contracts, when oil was trading under $50 a barrel. In the short term, the price momentum is too strong to think about going short. But there is a good short trade coming in oil, since a decline below $40 a barrel is likely before year end, if the supply / demand imbalance reverts as I expect."

Oil has broken below $44.00 a barrel and appears on its way to $40.

In other words, of the top 4 sectors, I couldn't invest in Utilities or Energy based on their fundamentals.

welsh.tactical.rotation.table.2016.july.25

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