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posted on 21 November 2016

Extreme Sector Rotation And Tax Considerations Will Drive Markets To Year End

Written by

Macro Tides Technical Review 21 November 2016

Tax Changes Impact on the Stock Market

Last week, I noted that the rush out of bonds, dividend paying stocks, and big blue chip technology stocks and rotation into banks, industrials, and small caps was the most extreme rotation in such a short period of time I’ve ever seen.

spinning.top.380x200

The bifurcation within the market this rotation created is likely to influence trading going into year end and early next year, as investors compare current tax rates to what they might be in 2017. Trump would like to replace the current 7 brackets with 3 brackets and lower the maximum rate from 39.6% to 33% for singles earning more than $112,500 and $225,000 for couples.

He also wants to eliminate the 2.3% Net Investment Income tax on dividends, interest, and capital gains.

Trump’s proposal provides an incentive for taxpayers to push income into 2017 and maximize deductions and capital gain losses in 2016. As a result, sectors that have performed well and are close to their 2016 highs will experience less selling pressure prior to year end, than the sectors that may be up on the year, but are well off their 2016 highs. If the market continues to rally into the end of the year, the sectors that are most off their 2016 high are likely to continue to underperform.

welsh.tech.2016.nov.21.table.01

The sectors that will experience tax loss related selling before year end are those sectors that are down the most from their 2016 high. Although the gold stock ETF (GDX) is up 53.6% for the year, as of November 18 it was -50.8% below its high. There are a lot of investors who jumped into gold stocks after they had rallied significantly. After bottoming last December, GDX soared above its current price by mid-March, so the majority of investors who bought over the last 8 months are underwater. The same pattern exists in Gold and the gold ETF (GLD), and Silver and the silver ETF (SLV).

As interest rates fell to the lows of 2016 in early July, dividend paying stocks were richly priced. As I noted in the July 25 ETR,

“The Utilities are very expensive and could be vulnerable to a sharp pullback if the Fed hints that a rate increase may be in the cards."

On November 18 the Utility ETF (XLU) closed at $46.29, down -12.1% from its close of $52.67on July 25. Consumer Staples have suffered the same fate as Utilities and have declined -10.9% since their July high.

Click on any chart image below for larger image.

welsh.tech.2016.nov.21.fig.01

Real estate is another sector that has been hammered since topping out on July 29 in anticipation of higher rates. Even though the real estate ETF (IYR) is down less than 2% for the year through November 18, it has fallen -16.4% from its high.

Since the election, Treasury bond yields have soared, so ETFs that hold Treasury bonds have declined sharply since November 8. The Treasury ETF (TLT) that holds bonds with an average duration of longer than 20 years has plunged -19.1% since its high in July.

The additional selling pressure that is likely in these sectors before year end has the potential of creating a buying opportunity as these sectors become even more sold out. The need for income remains just as strong as it was in July, and these sectors now offer higher yields. The only difference is they were over-loved and over-owned in July, which is certainly not the case now.

The sectors that have benefitted from the post election rotation are likely to continue to be supported by the lack of tax loss selling since these sectors are near their highs for 2016, so the potential for losses is quite small. These sectors will benefit further as institutions and advisors want to have them in their portfolios before year end, so they can show investors they are properly positioned for 2017 at the end of the fourth quarter.

The downside to all this good news is that these sectors will have great gains going into 2017. Some investors could be tempted to book profits in, especially if Trump’s plans run into resistance from a few Republicans and Elizabeth Warren Democrats.

One of the more obvious speed bumps is the debt ceiling limit which is due in March. There are some Republicans that are concerned about debt and the deficits that are likely if Trump’s tax and spending plans become law. Members of the Tea Party may have become tired of the regular increase in the debt ceiling both parties have approved.

I assume there will be a few democrats that suddenly get an aversion to higher government deficits since they won’t be the right kind of deficits, i.e. the result of income distribution programs.

The debt ceiling debate has the potential to become quite a show, but the stock market may not find it so entertaining. The markets are already pricing in changes in economic growth that are not right around the corner. There is a valley between the current expectation of changes that are expected to benefit specific sectors in the domestic economy and the reality of when the changes are likely to impact economic growth in general and those sectors in a meaningful way. The gap between expectations and reality will likely smack investors in the face sometime during the first quarter, probably after Trump is sworn in as President. The investment wake-up call could become a cold shower if the first quarter of 2017 follows the pattern of the past 5 years in which the first quarter GDP was weak.

Whether it is due to another polar vortex, faulty seasonal adjustments, or other factors, a first quarter slowdown could discourage investors who have bid up financials, small caps, and cyclical stocks. A first quarter slowdown and political dissension could make some investors more willing to take profits, especially with lower tax rates acting as an additional incentive.

This suggests that, barring a buying stampede before year end, it might be wise to not take full positions in the favored sectors immediately, as a first quarter decline in the stock market could provide a better entry than chasing stocks that are already up 10%, 15%, or more in less than 2 weeks.

Stock Market

In last week’s Review I said,

“I expect the S&P to surpass its prior all time high of 2193 as some big name tech stocks (Amazon, Google, Facebook) bounce."

Today the S&P did make a new high which was possible because these cap weighted stocks did rally along with the continued surge in financials. The S&P will run into some resistance near 2210, which is where the black trend line connecting the May 2015 high and August high at 2193 comes into play.

Seasonality is very favorable this week as 17 of the past 22 Thanksgiving weeks have been positive. Sentiment has become decisively more bullish in the 2 weeks since the election. The percent of bulls in the weekly American Association of Individual Investors survey has jumped from 23.6% bulls to 46.7% as of last Tuesday November 15.

Between November 2 and November 15, the National Association of Active Investment Managers Index of exposure to the market jumped from 58.08% to 83.42%. Since the market has continued to climb since November 15, it is probably a safe bet that bullishness has increased further. When investors can understand why the market is going up or down, the shift in sentiment is usually more pronounced and quicker to turn, whether it’s bullish or bearish.

The crescendo of positive spin in the wake of Trump’s victory has been fairly one-sided, i.e. tax cuts for individuals that will lift consumer spending and GDP, corporate tax cuts which will boost earnings, tax repatriation that should boost stock buybacks and maybe investment, repeal of Dodd-Frank that is a godsend for banks, a rewrite of Obamacare that will cure the health care cost spiral, and a general overhaul of regulation that has smothered small company start ups.

The only thing missing is a cure for the common cold, which Trump will address in his second term. There is a line from a Grateful Dead song that always comes to mind when sentiment appears to be getting a bit overdone:

“When life looks like easy street, there’s danger at your door."

The market has been a runaway freight train so the risk of anything more than a modest pullback of 1% to 3% should be the limit to the downside in the next two weeks. While the percent of stocks making a new 52 week high has not been impressive, the preponderance of bond funds traded on the NYSE must be acknowledged for the lag.

The number of new highs on the Nasdaq last week was healthy, as 680 stocks made a new high last week, while only 135 posted a new 52 week low. On the NYSE there were 450 new 52 week highs and 355 new lows last week. The difference is evident in the percent of stocks on the NYSE and Nasdaq making a new high compared to the NYSE. The breadth of new highs on the Nasdaq indicates that the overall market is in good shape.

Dollar

As discussed last week, the Dollar has also benefited from an unwinding of positions in the Euro and emerging market currencies, and has rallied back to what could prove important resistance. I thought the rally in the Dollar would carry above 100.51, which it did on Friday, trading up to 101.54.

Last May, sentiment was bearish with the majority of economists and strategists expecting the dollar to drop further, after it had fallen from 100 to 93.00. As discussed in the May 2, 2016 Weekly Technical Review, I thought the dollar would bottom between 92.00 and 93.00 in the first half of May. It bottomed at 91.88 on May 3.

Since May 3, the Dollar has been in rally mode and now, after months of upward progress and strength following the election outcome, more than 90% of traders are bullish. I think the Dollar is nearing a high in anticipation of a Fed rate increase on December 14. On Friday, the RSI for the Dollar index was 81. This suggests a spike high is not likely. Although the Dollar may push modestly higher going into the Fed meeting or year end, the next bigger move is likely to be down.

Yen

In the September 19 WTR I discussed the Yen and noted that if the Yen failed to exceed the mid August high and then closed below 0.9580, it would mark the first time the Yen had made a lower high and a lower low in many months, and represent a trend reversal in the Yen.

I thought a meaningful decline in the Yen would likely spark a good rally in the Nikkei, and if the Nikkei closed above 17,100, a move up to 17,500 was likely. As the Yen began to weaken in late September, the Nikkei began to move higher and broke out above 17,100 on October 20. On Friday the Nikkei closed at 17,967.

welsh.tech.2016.nov.21.fig.08

Treasury 10-year Yield

Sentiment towards the bond market in general is about as negative as it can get, with virtually everyone on TV and in print proclaiming yields can only go higher. Trump is going to ramp up government spending and the deficit, which will lead to more inflation. Even if this all comes to pass, the jump in yields seems overdone. If the economy slows in the first quarter and the political path to accomplishing everything Trump has proposed isn’t as smooth as expected, yields have a window in which they can fall in the first quarter. This is a tough position to take since the expectation for higher interest rates is almost universal.

The Treasury bond ETF (TLT) is approaching what has the potential of being good support between118.00 - 120.00. There is a gap at 129.71. If TLT retraces just 38.6% of the decline from 143.62, it could fill the gap. This is a counter-trend trade since I think the long term trend in bond yields has probably turned higher. Counter trend trades by their nature are more risky than trades that have the long term trend at their back.

As noted earlier, tax loss selling in Treasury bonds before year-end is likely to make for choppy trading, so buy weakness, not strength. If the stampede out of bonds gets even more out of hand, a stop on a close below 116.00 will help manage the risk.

Gold

If bond yields are going higher because inflation is coming why then is gold falling? As discussed last week, from its peak on July 6 at $1377.50, gold fell to $1248.20 on October 7, a decline of $129.30. An equal decline from $1338.30 high on November 8 would target a low of $1209.00.

The correction that began in July followed a rally of $331.30 from $1046.20 last December. A 50% retracement of that rally from the July 6 high of $1377.50 would bring gold down to $1211.85.

The RSI on Gold was 25.5 on Friday, which is oversold. Gold has rallied each time the RSI has fallen below 30 as noted by the green arrows. These calculations suggest that gold is near at least a good trading low and potentially an intermediate low that could be followed by a rally above $1400.00 in 2017.

The percent of gold bulls, which exceeded 90% back in June, has been less than 10% for the past week. Gold’s decline accelerated after a couple of well-known investors turned negative on gold after the election. Even if gold is not destined to rally above the August peak, pattern analysis and sentiment indicate that a multi-week rally is coming that could exceed 25% for gold stocks. In the September issue of Macro Tides I wrote:

“I think the odds favor gold eventually breaking below $1310.70."

In the October 4 WTR I noted that gold had plunged below $1310 with gusto, and was likely to establish a significant trading low in coming weeks between $1210 and $1258. Although tax loss selling may keep a lid on Gold, the Gold ETF (GLD), and the Gold stock ETF (GDX) before year end, it’s time to buy weakness, using a close below $112.00 as a stop on GLD and a close below $18.65 as a stop on GDX.

Tactical S&P Sector Rotation Portfolio Model: Relative Strength Ranking

Although the S&P made a new high Monday, the Major Trend Indicator is well below the high it made mid-Augustust as the S&P reached 2193. If this divergence persists in coming weeks, the market could set up a shorting opportunity in early 2017. Given the strong upside momentum since the election and the impact of lower taxes next year, selling pressure is likely to remain muted through year end in most sectors.

In the seven days after the election, $39 billion flowed in equity ETFs. This inflow was a record and is another reflection of how broadly the bullish sentiment has become in a matter of days. In a conference call on the morning of November 9, I suggested that the Industrials and the Russell 2000 could benefit from the excitement about infrastructure spending and the perception that a pick-up in U.S. economic growth would benefit domestic small cap stocks. After Financials, those two sectors have shown more improvement in relative strength than any other sector.

welsh.tech.2016.nov.21.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. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Nasdaq 100 is composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange. All indices, S&P 500, Russell 2000, and Nasdaq 100, are unmanaged and investors cannot invest directly into an index.

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