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posted on 10 October 2016

The Big Squeeze

Written by

Macro Tides Technical Review 11 October 2016

Cusp of Volatility - Redux

As discussed last week, the S&P has been trading in a narrow range since early September and is approaching the apex of a small triangle (converging red trend lines).

cusp.volatility

I thought the S&P would break out by the end of the last week after the employment report was released on Friday morning. Although an upside break above the red trend line seems less likely, the black trend line should provide resistance and limit the upside to 2210 or so. A much larger wedge triangle has been developing in the S&P, formed by the high in May 2015 and the low in February. The lower band of this triangle is defined by the blue rising trend line under the S&P, which comes in around 2130. I continue to expect the S&P to break below the trend line and September 12 low at 2119. If it does break down, a decline to 2050 - 2070 should follow quickly.

Click on any chart for larger image.

welsh.tech.2016.oct.11.fig.1

As the S&P has been chopping sideways, the market’s internal strength has been getting weaker. The percent of stocks above their 200 days average has been drifting lower, which suggests the market has been absorbing some selling pressure.

welsh.tech.2016.oct.11.fig.2

This modest selling pressure is also evident in the 21 day average of advances minus declines. Not only has it been slipping, but it hasn’t improved much when the market has rallied. This is a subtle sign that selling pressure is gradually rising under the surface.

welsh.tech.2016.oct.11.fig.3

If the S&P does close below 2119, a noticeable pick up in selling pressure is likely. Last week, gold fell hard once it took out its prior support at $1310. Although not likely to be quite as dramatic as gold’s decline last week, the market feels as if it is setting up for a sharp break.

Small cap stocks have been the real leaders since July 7. On Friday the Russell 2000 broke below its rising trend line connecting the June Brexit low and the low in early September (red line), before rebounding today. Sooner or later a test of the blue trend line near 1200 is likely.

welsh.tech.2016.oct.11.fig.4

A review of oil, gold, Dollar, the 10-year Treasury yield, and the Yen suggest the markets are set up for an increase in volatility.

Last week I thought the oil rally probably ended last Tuesday or would with oil topping below $50 a barrel. I was wrong due to poor chart analysis. After bottoming in early August just below $40.77 a barrel, oil rallied to $50.00, a gain of $9.23. From the recent low at $43.06, an equal rally of $9.23 would end just above $52.00. Oil rallied today after Russia said it would participate in cutting production. But here’s the rub, no one is really cutting production. Saudi Arabia and Russia will keep oil production near record levels, even though increased production from Iran, Libya, and Nigeria will more than compensate for the 700,000 barrel ‘cut’ announced two weeks ago. If correct, oil will decline to under $44 in coming weeks.

welsh.tech.2016.oct.11.fig.5

welsh.tech.2016.oct.11.fig.6

In the September issue of Macro Tides I wrote “I think the odds favor gold eventually breaking below $1310.70, even if it first bounces back up to $1360 in coming weeks." Gold rallied to $1357 in early September and last week plunged below $1310 with gusto. As noted last week, Gold is likely to establish a significant trading low in coming weeks between $1210 and $1258, which was the low just before the Brexit vote. The low in Gold last week was $1243.20. Although it is possible that gold has bottomed, I don’t think so. My guess is that gold may bounce up to $1280, but then decline below last week’s low before a low is formed. Based on the Commitment of Traders report as of October 4, the smart money (commercials, producers) were not aggressive in covering their shorts, and the trend followers (large speculators, money managers) didn’t sell their long positions aggressively. The odds favor more price weakness before a sustainable rally is likely.

In addition, the dollar still looks as though it will rally above 97.50, which might pressure gold. As expected last week, the Dollar closed above 96.50 last Thursday, which should pave the way for the move above 97.50. Both the Euro and Yen appear on the verge of breaking down. If the Euro closes below 111.50, the Dollar will get a boost, since the Euro is 57% of the dollar index.

welsh.tech.2016.oct.11.fig.7

welsh.tech.2016.oct.11.fig.8

welsh.tech.2016.oct.11.fig.9

So far, the Yen has failed to exceed the August high, and looks headed for a close below the early September of .9580 on the Yen cash. A close below 95.80 should result in a drop to below 94.00. The Yen represents 13% of the Dollar index, so any Yen weakness will also lift the Dollar.

In the September 19 Weekly Technical Review I assessed the potential for the 10-year Treasury yield to increase in coming weeks. “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." On Friday, the 10-year yield traded up to 1.77%, and closed above the blue trend line. I still expect the yield to move up to 1.85% - 1.90%

welsh.tech.2016.oct.11.fig.10

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.

The Major Trend Indicator has continued to weaken which supports the potential of a decline in the S&P to 2050 - 2070. As discussed last week, a decline to 1200 on the Russell 2000 seems likely.

There is a smaller chance that the S&P could experience a deeper decline, based on the price pattern. As discussed previously, the February low probably is wave 4 from the March 2009 low. This suggests the S&P has the potential to rally to 2360 or so in coming months, before the bull market ends. It’s possible that the rally from the Brexit low was wave B of a larger A-B-C correction, which would end after the S&P had finished wave C below the Brexit low at 1991 on the S&P. All of this is a moot point until the S&P closes under 2119 and the rising blue trend line.

welsh.tech.2016.oct.11.fig.11

welsh.tech.2016.oct.11.tactical.table

Disclosure

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices, S&P 500, Russell 2000, and Nasdaq 100, are unmanaged and investors cannot invest directly into an index.

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