posted on 02 August 2016
Written by Jim Welsh
Macro Tides Technical Review 01 August 2016
Federal Reserve FOMC Statement
Coming into 2016 the Federal Reserve overstated the odds of raising rates (4 hikes), and then used its communication policy (numerous Fed speakers singing the same tune) to prepare the markets for a rate increase at the June meeting. The Fed then looked foolish when they had to back track, after an unusually weak May employment report on June 3 and the upcoming Brexit vote on June 23 in the UK convinced them not to raise rates.
With the stock market at a high, and the data they are most dependent on looking good, I thought the Fed would use the post FOMC statement on July 27 to let markets know that an increase in September was a possibility, if the data continues to meet their expectations. The Fed's FOMC statement noted:
The statement deliberately avoided anything overt, since the Fed doesn't want to repeat their mistake from earlier this year when they almost promised a rate increase at the June meeting.
This damaged the Fed's credibility, which is why market participants responded to the FOMC statement by lowering the odds of a rate increase in September and December, according to the Federal funds futures. This view was reinforced when the first estimate of second quarter GDP came in at 1.2%, rather than the expected 2.5%.
The Q2 GDP report understated the underlying strength in the economy. Companies slashed inventories in the second quarter which shaved 1.2% from GDP. At some point in coming quarters, companies will restock and rebuild inventories, which will add to future GDP. Final sales, which excludes inventories and adjusts for inflation, grew 2.6% in the second quarter. The Fed won't take the first estimate of Q2 growth at face value.
After the S&P closed at 2137 on July 11, I thought, from a technical perspective, the odds appeared to favor a bit more upside (1% to 2%, 2180), as noted in the July 11 WTR. In the July 18 WTR, I wrote:
Amazingly, the S&P has traded in a 1% range for 13 trading days, the longest, most narrow trading range in more than 40 years.
Click on any chart for larger image.
The trading range is about 17 points wide (2176 - 2159), so a breakout to the upside would target a rally to 2193. As I discussed in the July 18 WTR, 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. The intra-day high today was 2178, which is obviously close to the 2181 target. The target of 2193 would be activated if the S&P closes above 2178. A close below 2159 should lead to a test of 2115 - 2125 at a minimum, since that range acted as resistance for more than a year.
The 21 day average of advances minus declines has unwound from its high of 654 on July 12 to 277 as today's close. The S&P closed at 2152 on July 12, so this unwinding has occurred while the S&P was rising to 2171 today. This underscores how little selling pressure there has been, even as the S&P has traded sideways since July 14.
This tilts the odds toward the S&P breaking out to the upside. If the breakout does occur, and the 21 day average of advances minus declines posts a lower high, it would provide the first concrete momentum evidence that a correction was forthcoming.
Sentiment Suggests a Pullback Is Coming Soon
The Option Premium ratio continues to hover 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.
The weekly National Association of Active Investment Managers (NAAIM) survey last week showed the highest allocation to equities this year, and the third-highest reading since 2013. Active investment managers are predominantly tactical and trend following in their approach.
As you can see, they lowered their exposure to the market as it fell in August and September last year, increased exposure after the market rallied in October and November, and then jumped out as the market fell in January and February this year. The last time the reading was this high was in May 2015, after which the S&P made no net progress. In the weeks following the high in May 2015, the market's internals weakened, which set up the sharp decline during August and September.
The market's internals are still quite healthy, so one of the keys in coming weeks is whether they begin to deteriorate. The high NAAIM reading indicates that these managers have already moved into the market, which suggests there is less sideline money from this contingent to move the market higher. That said, the market can hold up and push higher, until the market is given a reason to sell. A 20% decline in oil prices and mediocre earnings has so far elicited no selling pressure.
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, and unchanged from Friday July 22. This is an indication of how overbought the market remains and a sign of strength, even as it has traded sideways for 2 weeks.
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. This does not preclude a modest decline of 3% to 5% in coming weeks.
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 since early July, 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.
In addition, after generating a total return in the first quarter of 8.9%, I thought waiting until the technical and sentiment indicators suggested a solid trading low had been established made sense. (Q1 return does not include management fees) Past performance is no guarantee of future results. Needless to say, the rally has exceeded expectations, which has been frustrating.
My other concern has been the sectors that have comprised the top 4 sectors in the Weekly Relative Strength analysis. In the June 8 issue of Macro Tides I assessed the outlook for oil prices and concluded that oil prices were likely to head lower from $50. Last week I noted that oil had broken below $44.00 a barrel and appeared on its way to $40. Today WTI oil traded under $40 a barrel. If oil declined during July as I expected, a 25% allocation to the energy sector seemed risky. Since June 8, the Energy ETF XLE has declined from a high of $70.26 to $65.20 today, a decline of -7.2%, and down -5.0% since it entered the top 4 on July 1.
XLE will probably bounce at its support near $64.25 (blue horizontal line), but the imbalance between supply and demand in oil is likely to continue to weigh on oil prices in coming weeks. Demand from refiners is expected to decline by more than 1 million barrels a day between now and early October. The chart displays the annual seasonal pattern in refinery demand, which bottoms near week 41 each year. If oil prices drop to $36 a barrel, after any brief bounce from support at $40, I suspect energy stocks and the XLE will not hold support at $64.25.
As I discussed last week, the Utilities are very expensive and could be vulnerable to a sharp pullback, if the odds of a September rate hike increases. The Utilities have underperformed during the post Brexit vote rally, as investor's embraced risk on sectors like Technology and Biotechnology. Since July 6, the Utility ETF XLU has declined by -1.65%, while the S&P has rallied 3.3%.
Consumer Staples are also overvalued as yield seeking investors have bid the sector up to one of its highest valuations in history. Since July 6, the Consumer Staples ETF has dipped -.90%, as the S&P gained 3.3%. The lone exception has been Basic Materials, which is up 5.9% since it entered the top 4 on May 16, and up 3.5% since July 6, slightly ahead of the S&P.
In other words, of the top 4 sectors, I had reservations about 3 of the top 4, which have underperformed the S&P, especially since July 6. Utility and Consumer Staples companies are low beta dividend paying stocks and have been market leaders since late last year.
Normally, (unfortunately, these are anything but normal times), the stock market experiences a correction when it undergoes a leadership change. Just about every sector has been exploited during the rally, so most sectors are overbought and vulnerable to at least a short term pullback of 3% to 5%.
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