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posted on 12 September 2016

Investing In A Time Of Fed Forward Misguidance

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Macro Tides Technical Review 12 September 2016

S&P 500

For the first time in 44 trading days (almost 9 weeks for those counting) the S&P had a close that was greater than 1% from the previous close. Going back to 1928 the S&P had traded in a 1% range for more than 40 trading days just 32 times, or a miniscule .14% of the 22,090 40-day windows. In 69% of the prior occurrences, the S&P broke out of the sideways pattern to the downside.


While this is interesting cocktail chatter, the markets are operating in a different world given unprecedented central bank intervention. The market sold off in part on Friday because a normally dovish Fed president made some hawkish comments. Today (Monday) the market rallied in anticipation and following comments from a Fed president who was far more cautious about the Fed raising rates. As I discussed at length in the September Macro Tides, forward guidance as practiced by the Fed has been elevated to an art form of misguidance. The Keystone Cops were supposed to act stupid and be funny. Sadly, the Fed may comprise the majority of a minority of investors who take the Fed seriously.

In order to assess whether Friday's decline was the beginning of something larger, it is necessary to review the health of the market before the 2.45% decline that seemed to come from nowhere. A large part of the decline was driven by positioning in the futures and options markets, once the S&P broke out of the trading range it had been mired in for so long. In effect, selling begat selling which is why the S&P closed at the low of the day to the penny. The sectors that have benefited from investors reaching for yield - Consumer Staples, Utilities, Real Estate - were hard hit. Too many people own these sectors, and if the Fed does raise rates, these will be vulnerable to a rotation out of them. As of Thursday 81% of the stocks traded on the NYSE were above their 200 day average. This is a high percentage and a reflection of strength. After Friday it dipped to 74%, which is still a healthy number.

Click on any chart for large image.

In the April of 2015, only 62% of stocks were above their 200 day average. When the S&P posted its all-time high of 2134, that percent had fallen to 55%. In order for the market to become vulnerable to a large decline, the internals of the market will have to weaken significantly in coming weeks.

At the close on Friday the 21 day average of net advances minus declines had fallen to a level that has led to a rebound in the market every time it has been reached since the low in February (blue arrows). This suggested that the S&P was likely to hold support near 2120 and that another rally was likely.

In an email I sent yesterday to a select few, I thought the S&P would find support near the green horizontal line (2120) and then rally at least to 2150 (red line). At today's high (2164) the S&P had very nearly retraced 61.8% of the decline from 2193 to 2119 = 2165. The S&P will now encounter the resistance that has formed since August 5 with the S&P trading between 2160 and 2190. As long as the S&P does not close above 2195, the S&P is likely to settle back into the trading range. The key going forward is whether the internals weaken or remain strong, if the market chops sideways.

Sentiment Continues to Suggest the Upside Is Limited

At the close on Friday the RSI for the S&P was down to 30, which is about where it was after the Brexit selloff. This suggested that a bounce was in order. However, the Option Premium Ratio was well below where it was after the Brexit decline, and nowhere near as high as it was at the intermediate trading lows of the past 18 months (red arrows on Option Premium chart).

The buy the dip mentality is so pervasive that a rally to a new high in the S&P can't be ruled out, despite the absence of technical readings that would normally appear prior to a good rally. This type of 'bubble mentality' will eventually inflict pain, but until a reason to sell materializes, the market can continue to churn. Since May and June of 2015, the majority of stocks are lower as measured by the NYSE composite and the Russell 2000.


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). The MTI surpassed the high it recorded in April in August, 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.

As I noted in the August 29 WTR, the MTI had flattened out and begun to marginally curl lower. I thought this was supportive of a modest decline of 3% to 5% in coming weeks. The S&P dropped just over 3% from its high of 2193 at today's low. Should the S&P post a marginal new high, the MTI would likely record its first divergence since early June, which was followed by the late June decline. If the current rebound fails to follow through, the market will be set up for a deeper decline. We'll see. At this point there is no way of knowing with certainty.

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.

Small cap stocks have continued to perform well since their breakout on July 7.

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