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posted on 19 September 2016

The Correction Is Not Over

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Macro Tides Technical Review 19 September 2016

Central Banks

On Wednesday the Bank of Japan and the Fed will meet and announce whether monetary policy will be changed. The focus on the BOJ will be on whether the governors decide to push short term rates further into negative territory and if the amount of its bond and equity purchases will be increased.


As I discussed in the May issue of Macro Tides:

"The Bank of Japan announced on January 28 that interest rates would be a negative -0.1%. Rather than weakening the Yen as expected, the Yen rallied on the news and Japanese stocks fell. In February consumer sentiment fell by the most in more than two years. Many senior citizens purchased safes to hoard cash due to fears commercial banks may eventually charge them interest on their deposits. In April, Nippon Life Insurance suspended the sale of a savings product that had generated $3.2 billion in revenue in the prior nine months due to negative rates. Banks have experienced smaller profit margins and trading in Japan's short term money market has plunged by more than 70%. In response to the unprecedented backlash to negative rates from politicians, business leaders, and the public, BOJ governor Kuroda has been called into Parliament repeatedly to answer questions about the negative rate policy. As of March 10, Kuroda has visited Parliament 25 times, which is more than triple any prior BOJ governor has been called to Parliament since 2003. Given the breadth of the blowback the BOJ has received since it announced its negative interest rate policy on January 28, it was not a surprise that the BOJ decided not to push rates deeper into negative territory at the April 28 meeting."

I would be surprised if the BOJ decided to go more negative with short term rates.

Click on any chart for larger image.

Since the financial crisis central banks have been very successful in getting the outcome they wanted. As I noted last May, I thought it was noteworthy that the Yen had gone up rather than down as the BOJ wanted. Since January 28, the Yen has gained 16.6% against the dollar. The Yen has made a series of higher highs and higher lows. The key point is how the Yen responds to whatever the BOJ announces. If the Yen fails to exceed the mid August high and then closes below .9580, it will mark the first time the Yen has made a lower high and a lower low, and represent a trend reversal in the Yen. Obviously, a trend reversal in the Yen would be bullish for the dollar, since the Yen comprises 13.6% of the dollar index.

The Federal Reserve also meets on Wednesday and is likely to not raise rates, but provide more forward misguidance in its FOMC statement. Investors will pay close attention to how many Fed members vote against the decision to hold rates steady. In recent months, Esther George has been the lone dissenting vote. If she is joined by one or more members, markets will interpret it as a sign that a December hike is far more certain. This would be a positive for the dollar and probably negative for the 10-year Treasury bond.

The yield on the 10-year Treasury bond appears poised for a breakout above the blue horizontal line, although there is a gap at 1.635% that might get filled first. Either way, I think the 10-year yield is headed for 1.85% - 1.90%. Longer term, a test of the long term green down trend line, which connects the highs in 2007, 2013, and 2015 near 2.0%, is coming. As you can see, the 10-year yield has already broken out of the downtrend on the Major Trend Indicator, which suggests the path of least resistance is up. That said, the increase in the 10-year Treasury yield will resemble a tortoise.

The stock market is likely to have a knee-jerk rally on an announcement that the Fed is not raising rates, but I doubt the rally will hold. If the rally fails, there is likely to be a sharp sell-off that violates 2120 on the S&P.

Market Correction Is Not Over

For the first time since early June, the market is showing signs of weakening. The question is whether the 3% pullback is it, or is there more to come. In terms of time and price I think there is a deeper correction coming that could consume 4 to 6 weeks.

The NYSE is broadest market average as it represents almost 1700 stocks, or more than 3 times the number in the S&P 500. The NYSE dropped to the trend line connecting the February low and the post Brexit low last week (blue line). So far the bounce has not been impressive. This suggests that even if the market rallies a bit more if the Fed does not increase rates at their FOMC meeting on Wednesday the NYSE is likely to fall below this trend line. If this occurs, the S&P will likely fall below 2120.

The S&P and NYSE are likely to find support not far below the break of 2120 in the S&P and the rising blue trend line on the NYSE. Support on the S&P comes in at 2100 (green horizontal line) and about 1% lower on the NYSE, as noted by the green horizontal line. I suspect the market will be modestly oversold at these price levels, which should provide the opportunity for a better rally to develop. The 21 day average of net advances minus declines would probably get near the oversold level near the green horizontal line. During the past year, the market has rallied each time the 21 day average of net advances minus declines dropped to the green line, as noted by the green up arrows. I don't expect the S&P to get above 2180 on any rally.

The percent of stocks above their 200 day average has fallen from 81% to 72% as of Friday. If the S&P does drop to 2100, the percent of stocks above their 200 day average will fall below 70%, which will represent another crack in the market's foundation.

More importantly, if the percent posts a lower high on the expected rally from the green support trend lines on the S&P and NYSE, it will provide further confirmation that the market is becoming more vulnerable to a decline that could take the S&P down to 2050 in coming weeks. It would also open the door to the potential of a decline below the Brexit low at 1991. Ironically, this would be especially true if the S&P manages to quickly make a new high.

Guessing what central banks are going to do and how investors are going to react underscores just how out of bounds central banks have veered from their true mandates. Central bankers have displayed an unbelievable willingness to ignore how little their manipulations have succeeded in generating sustainable economic recoveries in the U.S., Europe, and Japan. To them, these policy failures only mean they haven't done enough.

Sentiment - Still Not Supportive of an Intermediate Low

The Option Premium Ratio has risen modestly, but is nowhere near the levels normally seen at solid trading lows. Given investor's obsession with central banks, it is certainly possible that the market can rally without the normal sentiment back drop of a higher Option Premium Ratio. It is worth noting that the S&P and NYSE are just about back to where they were before the Brexit vote and the subsequent sharp rally that followed the quick Brexit decline.


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 May, June and July before the 2015 summer selloff, and November and December 2015). The MTI surpassed the high it recorded in April in August, which is a sign of strength. This suggests that the odds of a correction of more than 7% are low. However, the technical underpinnings of the market have begun to deteriorate, so risk is climbing.

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.

In late June I warned that Utilities and Consumer Staples were overdone and vulnerable to a decline. After mid July both of these sectors rolled over. In the July 25 WTR, I explained why I thought Energy stocks were likely to fall since I thought oil prices where set up for a decline. A decline in XLE to below $65 still seems probable.

Small cap stocks have continued to perform well since their breakout on July 7, and now occupy three of the top four spots. As I wrote in the August 15 WTR:

"Small cap stocks have had a great run, but are extended. Potentially the Russell 2000 could rally another 2% - 3%, but the risk versus the reward of a quick spike doesn't seem justified."

After rallying less than 2%, they have pulled back and are now lower than they were in mid August. If the market corrects as I expect, small caps have more downside risk too.

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