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posted on 01 May 2017

Awaiting Corrections

Written by

Macro Tides Technical Review 24 April 2017

Stocks

In response to the French election and the outline of Trump’s tax cut plan last week, U.S. stocks had every reason to break out above the March 1 highs on the S&P and DJIA.

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Although the Russell 2000 posted a modest new high, it failed to punch through the black trend line connecting the highs in 2014, 2015, and February of this year. It is encouraging that the Russell’s relative strength compared to the S&P did close above the declining trend line from early December (bottom panel of chart). It would be negative if the Russell closed below the top blue horizontal trend line that connects the price highs around 1390, after failing to break out. The markets near term trend may be determined by whether the Russell 2000 breaks out or breaks down.

Click on any chart for large image.

As noted last week, five stocks (Apple, Amazon, Facebook, Google, Microsoft) represent 41% of the Nasdaq 100 and have accounted for more than 40% of the gain in the S&P 500 so far this year. The dominance of these five stocks became more pronounced last week, as the spread between the S&P 500 and the Nasdaq 100 widened further. While the S&P is hovering about 0.5% below its March 1 high, the Nasdaq 100 is 4.5% above its high on March 1.

Similar to the question of which came first, the chicken or the egg, the question facing the market is whether these five stocks will take a breather before the rest of the market plays catch up, or if the rest of the market is kicks into gear to help the S&P convincingly break out above 2401.

The impact of these five stocks is also apparent within the S&P 500. The equal weight S&P 500 gives the same weight to each stock within the S&P, so every stock contributes 0.2% to the calculation. The ten largest cap stocks represent 2.0% of the S&P 500 equal weight index. In comparison, the ten largest cap stocks in the S&P 500 represent 17.1% of the index. When the largest cap stocks in the S&P 500 index are zooming, the S&P 500 equal weight index lags behind the S&P 500. Conversely, when the equal weight S&P index is doing better than the S&P 500 index, it is a sign that the broader market is fully engaged in a rally and a healthy sign.

More often than not, when the equal weight S&P index is lagging the cap weighted S&P 500, the market is more vulnerable to a correction.

Since 2011, when the relative strength of the equal weight S&P index has crossed above a green trend line and continues to rise, the overall market has done well. When the relative strength of the equal weight S&P has fallen below a red trend line, a correction has usually followed. From a low in December 2013 (red arrow on left), the relative strength of the equal weight formed a topping formation (red trend line above red arrows). Although the relative strength dropped below the red trend line in October 2014, the break was quickly reversed.

In the last week of June of 2015, the relative strength of the equal weight S&P slipped below the trend line weeks before the S&P dropped by more than 12%. After a weak rebound during August and September 2015, the relative strength reversed lower before the end of October and continued to fall.

This weakness foreshadowed the sharp decline in early 2016.

Since June of last year, the relative strength of the equal weight S&P has been forming a shelf of support, which has been tested a number of times (blue arrows). The relative strength of the equal weight S&P peaked on December 8, which happens to be the same day the Russell 2000’s relative strength topped out. Should the relative strength of the equal weight S&P index fall below this shelf of support, it would increase the odds of a deeper correction in coming weeks.

Despite the huge run in the Nasdaq 100, the Nasdaq advance / decline line has yet to surpass its high from February 22. This divergence shows that even within the Nasdaq Composite, the majority of stocks have been treading water, while the Fab Five keep motoring. My guess is that this run will end within 24 hours of Apple’s earnings report, which is after the close tomorrow.

FOMC Meeting

The Fed meets on Tuesday and Wednesday and will not raise rates at this meeting. The key will be whether the Fed acknowledges the weakness in the first quarter, or sticks to the script. I think they will note that economic growth remains moderate, that the economy is nearing full employment, and note that inflation is nearing its target of 2.0%. They want the markets to know that a rate increase at the June meeting is still on the table. They may mention that the timing and size of the fiscal stimulus program will be a factor in determining future policy.

A Dollar Rally to a New High Is Hanging on by a Thread

As noted last week, the trading action in the Dollar index has traced out a triangle pattern, with wave e coming just after the results of the French election. Wave e is often a reaction to news, briefly breaks below the low of wave c, and proves to be the end of a wave 4 correction. Wave 4 triangles are usually followed by a thrust in the direction before the triangle began, which in this case means up.

The key for this pattern is the Dollar MUST not close below 98.69, which was the post French election low.

The Euro has the same pattern, but it is the exact opposite of the Dollar. If the Euro closes above the post French election high at 1.0951, the triangle pattern in the Euro would be invalidated. If the Dollar does rally strongly, the Euro should make a new low and potentially approach 100.00.

Treasury Bond Yields

The positioning in the futures market has changed significantly. On March 17, Large Speculators (hedge funds, trend followers) held a short position of -62,248 contracts, while Commercials where long +99,537 contracts. The positioning in the futures market was one of the reasons why I thought the 10- year Treasury yield could drop to 2.2%.

As of Tuesday April 25, Large Speculators are now long +20,617 contracts and Commercials are short -7,773 contracts. This is a remarkable turnaround and leaves the bond market vulnerable to higher yields in the short run. Maybe the Fed will be a bit more hawkish than the bond market is expecting. As I noted two weeks ago, I think yields are likely to drift higher with the yield on the 10-year climbing to 2.34% - 2.42%. Today, the 10-year Treasury yield traded up to 2.338%.

If the yield on the 10-year Treasury is going to make a run at 2.0%, it will be due to surprisingly weak economic data, which I don’t expect, or an event that causes a rush to safety. The odds thus favor not much happening in the short run.

Gold and Gold Stocks

The positioning in the futures market still suggests that the path of least resistance for gold and silver is down. Gold stocks continue to underperform, which is often negative for gold and silver. As noted previously, there is a gap on GDX from December 23 at $19.43 that I still expect to be filled.

At a minimum, a test of the early March low in the gold stock ETF (GDX) at $21.14 seems likely.

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

Two weeks ago I noted that the Financials ETF (XLF) had fallen to support (black horizontal line) on April 13 and its RSI was oversold at 28.0. This combination suggested that the Financials were primed for a bounce. I thought XLF might reach 24.00. On April 26, XLF traded up to $24.09 before fading and closing at $23.87. One of the keys to the market is XLF and it being able to close above $24.00, which would add weight to any close in the S&P above 2401. The downside risk is that XLF will close the gap from November 11 at $21.70. A close below the low of $22.90 would likely signal that XLF will make a run at the gap and the S&P will correct more.

welsh.tech.2017.may.01.Tacticaltable

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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