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posted on 29 August 2016

The Fed Seeks Credibility As Markets Wait

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Macro Tides Technical Review 29 August 2016

S&P 500

The big news from last week was not Janet Yellen's speech at Jackson Hole. The big news is that the S&P experienced a daily trading range larger than 1% on Friday for the first since July 11, or after 34 days of not doing so.


I didn't think Janet Yellen would tip her hand about what the Fed will do at the September 21 meeting during her speech at the Kansas City Fed's annual symposium last Friday. I thought she would acknowledge that the labor market was doing better after the last two employment reports, and that inflation was likely to trend up toward the Fed's 2% inflation target. In her prepared remarks she said,

"In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months."

She of course followed this somewhat hawkish comment with the usual caveat.

"Our decisions always depend on the degree to which incoming data continues to confirm the Fed's outlook."

Janets comments follow a number of key FOMC members who have made statements inferring a tilt toward increasing rates before the end of the year. On August 18, San Francisco Fed president John Williams said the Fed should move to raise interest rates "sooner than later". In an interview on Fox Business News on August 17, William Dudley, President of the New York Fed stated,

"I think we're getting closer to the day where we're going to have to snug up interest rates a little bit. And that's good news."

Vice Chairman Stanley Fischer noted in a speech on August 21 at the Aspen Institute, that

"We are close to our targets. I expect GDP growth to pick up in coming quarters, as investment recovers from a surprisingly weak patch and the drag from past dollar appreciation diminishes."

Clearly the Fed is attempting to use forward guidance to prepare financial markets for the potential of a rate hike at the September meeting. The Atlanta Fed's GDP Now estimate for the third quarter was 3.4% as of August 25. If the August employment report released on September 2, shows more than 150,000 jobs were created and prior months are not revised materially lower, the odds of a September rate increase will jump, especially in light of recent statements by key Fed FOMC members. The data dependent Fed will lose even more credibility, if the August jobs report and other data is decent, and they don't act.

Click on any graph or chart for larger image.

Janet did provide forward guidance on where the federal funds might be at the end of 2018. The nearby chart illustrates that the federal funds rate might be .37% or as high as 4.5% on December 31, 2018. That's a range wide enough to drive not one, but two semitracker trailer trucks through. I can only guess at the amount of intellectual capital that was spent calculating the precise measurements needed to produce such clarity. In the upcoming September Macro Tides I will discuss how the Fed's more than 10 year effort of providing forward guidance has been a failure and should be scraped.

The market continues to act in a healthy manner. The 21 day average of advances minus declines measures buying and selling pressure and helps identify when the market has become overbought and oversold. The 21 day average of advances minus declines became overbought when it rose to 654 on July 12. In the last seven weeks, it has unwound the overbought condition with the S&P holding near the all-time high. This confirms the lack of selling pressure, which has been obvious given the lack of volatility. The 21 day average of advances minus declines is nearing the level of prior short term lows on 5/19, 6/16, and 6/27 as indicated by the blue arrows. It isn't close to the intermediate trading lows indicated by the green arrows on the indicator chart and red arrows on the S&P chart.

Another indication of how overbought the market remains is illustrated by the percent of stocks above their 200 day average. As of Friday August 26, 79% of stocks traded on the NYSE were above their 200 day average, down slightly from 80% on August 19. The last time it was this overdone was back in June 2014. Until a crack in the market's façade appears, the probability of a decline of more than 3% in the short term is low

Sentiment Suggests the Upside Is Limited

After hovering at levels that have coincided with at least a short term top in the market over the last two years, the Option Premium ratio has started to trend higher. In prior instances, an increase in the Option Premium ratio, after falling to a low as indicated by the blue arrows, has been a warning of an impending short term high.


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% (See November and December 2015). In recent weeks, the MTI has flattened out and begun to marginally curl lower. This is supportive of a modest decline of 3% to 5% in coming weeks. 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, until the technical underpinnings of the market deteriorate.

Short Term - Key Levels

Since making its high on August 15 at 2193, the S&P has spent the last 10 trading days chopping around in a sideways pattern. The decline since the August 15 high does not exhibit much energy to the downside, which suggests it is corrective. If so, the S&P is likely to make a new high above 2193. The S&P low on Friday was 2160. A close below 2160 will likely be followed with a modest decline to 2120 - 2135, the top of the trading range which began in May 2015.

In order for the S&P to have a larger than 3% decline, economic data must come in stronger than expected in September and early October. The market is set up to handle one rate increase, without too much downside. I don't think it is ready for two hikes. If the data is solid going into October, the market will be faced with pricing in a second hike in December. This assumes that this Friday's employment report exceeds 150,000 new jobs.

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 I have discussed since early July, the Utility and Consumer Staples sectors were over bought, over owned, and overvalued, and were ripe for a correction. Although both have declined since early July, I think the correction is not over. The Fed is going to increase rates, which provides those long these sectors a reason to lighten up. Given how over owned they became, I suspect there is more selling yet to come.

Oil prices are likely to head lower going into October, which would make oil stocks vulnerable to a pullback in coming weeks. If the Dollar rallies above 97.50 in coming weeks as I expect, gold, gold stocks, and Basic Materials could get hit a bit.

The Russell 2000 was the one sector I thought could extend its rally, and it has. The rally in small cap stocks is a positive sign since it shows the rally has expanded from big blue chip stocks. The negative is that it reflects the willingness of investors to assume more risk, since small cap stocks sport higher betas and are more volatile.

One sign that the overall rally is running out of gas and that the market is more likely to experience a more significant decline will be given when the Russell 2000 and technology stocks begin to falter.


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