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posted on 18 July 2017

Has The Abnormal Become Normal?

Written by

Macro Tides Technical Review 17 July 2017

I have been expecting a modest 4% to 5% correction that would bring the S&P down to 2308 (small gap) or a bit lower since the S&P first reached 2400 on March 1. Rather than correcting, the S&P has chopped sideways. As recently as June 29 the S&P traded down to 2406 and closed at 2409 on July 6. After a dip to 2413 on July 11, the S&P has run up to 2463 primarily on the back on comments by Janet Yellen that suggested a less hawkish view. But what the S&P hasn’t done is pullback which engenders a level of frustrating and disbelief.


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One lesson that investors learn sooner or later is that markets can and do trade in patterns that are outliers from a normal distribution. The term bell curve is used to describe the mathematical concept called normal distribution. ‘Bell curve’ refers to the shape that is created when a line is plotted using the data points for an item like the S&P 500 that meets the criteria of ‘normal distribution’. The center contains the greatest number of a value and this point is referred to the mean. In simple terms, it is the highest number of occurrences.

The important thing to note about a normal distribution is the curve is concentrated in the center and decreases on either side. This is significant in that the data has less of a tendency to produce unusually extreme values, called outliers. The bell curve signifies that the data is symmetrical and thus reasonable expectations as to the possibility that an outcome will lie within a range to the left or right of the center. The following ‘rules’ will help explain the probability factors of a normal distribution.

  1. The total area of the bell curve is equal to (100%)
  2. About 68% of the area under the curve falls within 1 standard deviation.
  3. About 95% of the area under the curve falls within 2 standard deviations.
  4. About 99.7% of the area under the curve falls within 3 standard deviations.

welsh.tech.2017.jul.17.fig.01

The following statistics suggest that the way the S&P and volatility have traded in 2017 puts this year’s environment just beyond 2 standard deviations, and with a probability of less than 5%. Since 1928 (89 years) the S&P has averaged a decline of 11.2% in the first half of the year. So far in 2017, the largest decline in the S&P has been 2.9%, about one quarter of the average and the second lowest ever.

The S&P has not experienced a decline of 5% in more than a year. This is only the sixth time that has occurred since 1950 and the longest stretch without a 5% pullback since 1995 22 years ago. There have been 6,946 trading days since 1990 when the Volatility Index (VIX) was introduced. The average for the VIX since 1990 has been 19.51. The VIX has closed below 10.0 a total of 15 trading days since 1990, or 0.216% of the time. Of those 15 days, 11 have occurred since May 7.

The typically close relationship between the Dow Jones Industrial Average and the S&P 500 has broken down. The 20-day correlation between the two closely followed yardsticks of U.S. stock market performance last week fell to 0.47, the lowest levels since 2003, according to WSJ Market Data Group. That’s a far cry from near-lockstep trading that usually occurs between the two. Over the past 15 years, the average correlation between the Dow and S&P 500 is 0.96.

The unusually disparate day-to-day price moves are a result of the sector rotation that has taken hold of equity markets.

Over 15 years, the Dow and Nasdaq benchmarks have a correlation of 0.83. Since last month, however, the Dow and Nasdaq have been negatively correlated, meaning they’ve moved in opposition. That’s rare, and late last month’s -0.45 correlation between the Dow and Nasdaq was the weakest since 2001.

welsh.tech.2017.jul.17.fig.02

welsh.tech.2017.jul.17.fig.03

The lack of even a modest correction in the S&P, the extraordinarily low level of volatility, and the breakdown in the correlations between major market averages support the conclusion that the trading pattern so far in 2017 has been abnormal. Considering how the market has traded when compared to how the economy has actually performed so far in 2017 borders on the paranormal.

The Citi Economic Surprise (CES) Index has provided a good indication of whether the S&P’s forward P/E would increase or decrease in coming months. When the CES has been below zero, the S&P’s P/E has fallen as a result of a decline in the S&P. The S&P’s P/E has risen when the CES has been above zero. The CES fell below zero in early 2015 but the S&P didn’t begin to decline until the summer, and by early 2016 had corrected by more than 10%.

Going back to 2007, the divergence between the CES and the S&P has never been larger than in the last few months.

welsh.tech.2017.jul.17.fig.04

When investors begin to behave oddly, it’s usually not a good sign. A line from a Grateful Dead song sums it up:

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

The market can certainly defy the odds and continue to trade as it has in recent months. But the Bell Curve indicates that a return to a more normal trading environment is inevitable.

Central Banks

As discussed in the July Marco Tides Monthly Report, the Federal Reserve and the European Central Bank are on the threshold of the second biggest experiment in monetary history. The biggest experiment was the decision to use Quantitative Easing to stabilize the financial system and then continuing to expand their balance sheets long after the crisis had passed:

“Like all good things the era of central bank monetary experimentation is coming to an end, as is the tranquility associated with it. Central bankers established new frontiers in monetary policy in response to the financial crisis and then continued to go where central banks had never gone before. Now they must navigate the unwinding of negative interest rates and bloated balance sheets without impairing economic growth or destabilizing financial markets. They must accomplish these tasks without a play book since no central banker has ever been down this road. Effectively, Janet and Mario must perform a Reverse 3 1/2 Somersaults in the Tuck Position from the 33 foot high dive platform after reading a couple of books about diving. To assume they can pull this off without a hitch is foolhardy since the risk for a Taper Tantrum Sequel is high."

Click on any chart below for large image.

Quantitative Easing quelled volatility in the stock market and the unwinding of it is likely to lead to an increase in volatility in coming years. The increase in the 89-day average of the VIX will probably be gradual at first. A daily close above 15.0 by the VIX will usher in a period of turbulence.

The Decennial Pattern

The Decennial Pattern suggests the market could experience an increase in volatility in the next few months.

Within each decade going back 160 years, the years ending in 7 or 8 have often experienced significant market disruptions, not only in the U.S. but throughout world.

The following list (Courtesy of Erik Hadik, Inside Track) reviews how the Decennial Cycle has coincided in sharp declines during July-November in years ending in 7 or 8:

  • 1857--Panic of 1857: Rail stocks peaked in July 1857; July-Sept. 1857 decline culminated with Sept. 1857 'Panic'. Overall decline lasted into the spring of 1858.
  • 1907/1908--Panic of 1907 (Oct.) AKA--Banker's Panic (50% drop in NYSE); July-Oct. 1907--DJIA drops from 80+ down to 52--a drop of 35% in 3 months.
  • 1917--Stock crash--40% drop from late-Nov. 1916 into Dec. 1917. Roughly 36% of that decline occurred in June-Dec. 1917--when the DJIA dropped from 110 to 70.
  • 1937/1938--Second stock market crash (49%) following abrupt Fed tightening; Industrial production plummeted 30%, unemployment rose 30% (from 14+ to 19%), manufacturing dropped almost 40%,
  • 1947/1948--UK economic (& fuel) crisis/Sterling Crisis
  • 1957/1958--Global Economic Crisis (Eisenhower Recession)
  • 1967/1968--UK/Sterling Crisis & devaluation… beginning of gold drain that led to 1971 Nixon Shock in US.
  • 1977/78--Jan. 1977-March 1978-- 26% decline in DJIA.
  • 1987/1988--Aug. - Oct. 1987 'crash' (40% drop in DJIA).
  • 1997/1998--Asian Financial Crisis & Russian Ruble Crisis; July 1997 ushers in Asian Financial Crisis & triggers July.-Oct. 1997 sell-off in stocks; Crisis continues & is joined by Ruble Crisis in 1998-- triggering another July-Oct. sell-off.
  • 2007/2008--American/European Financial Crisis (Iceland, UK). Many Indices experienced July 2007 peaks and initial sell-offs into Aug. 2007, followed by a retest of highs in Oct. 2007. In this case, the majority of the decline came during the '8' year--in June-Nov. 2008.
  • 2009 Bull market-- The two sizeable corrections since the low in March 2009 were in July-Oct. 2011 & July-Sept. 2015.

Despite the new all-time highs in the major averages, the potential for a correction of 5% remains since numerous technical indicators are below prior levels when the S&P was at lower levels. The negative divergences suggest that upside momentum continues to wane which normally presages a correction.

Gold and Gold Stocks

Positioning in gold futures has become more constructive as large speculators have significantly reduced their long position and commercials have cut back on their short position. This suggests that the downside risk in gold is small. Longer term I continue to believe that gold will exceed its high in August of 2016 of $1385 at some point in the next year. Short term, gold recently broke below the trend line connecting the March and May low.

Gold has rallied and is testing the underside of the trend line, which is classic. Gold would need to close above $1250 to turn the short term trend positive. Gold is well above the trend line connecting the low in December 2015 and December 2016 which is currently near $1170.

Gold stocks as measured by the gold stock ETF GDX have basically same pattern, but with one important difference. GDX has broken below the trend line connecting the January 2016 low and December 2016 low. This suggests that the gold stocks could be vulnerable to more weakness and that GDX could close the gap it left at $19.43 as it rallied off the December 2016 low. Short term GDX has bounced back to the underside of the trend line. In addition, the relative strength of the gold stocks to gold continues to rise also indicating that gold stocks are underperforming even as they rally.

Treasury Yields

In the March 13 WTR, I wrote:

“If upcoming economic numbers show a bit of softness, those short may be forced to cover quickly, which would lead to a rally in Treasury bonds and cause yields to drop. The Treasury bond ETF (TLT) has dropped below its mid December low of 116.80. Now that TLT has made a new price low, it is possible to count the pattern from the price high last July as a 5 wave decline. A 38.2% retracement would lead to a rally to 126.00 or so, while a 50% retracement would bring TLT back up to 129.00. TLT has a good chance of making a low within a day or two of the Fed meeting on March 15. Any price reversal would shift the odds to a low being in place."

The low in TLT was $116.49. In the June 26 WTR I recommended that at least half of the position in TLT be sold:

"This morning (June 26) TLT traded as high as $128.57 so it is near the 50% retracement level of $129.00. The yield on the 10-year Treasury could fall to 2.0% as I have discussed (June 5 WTR), but it is certainly time to sell at least half of the TLT position."

TLT opened at $127.43 on June 27 and continued to decline after Mario Draghi made comments about how well the European economy was performing.

The reaction to Draghi’s comments on the global bond market was not a surprise as I had discussed this potential in the June 10 issue of Macro Tides:

“One of the factors that are likely to trigger higher Treasury bond yields in the U.S. is an increase in European bond yields. Specifically, if the yield on the 10- year German Bund closes above 0.50%, the Bund yield could quickly rise to 0.9% to 1.0%. An increase of this magnitude would certainly cause Treasury yields to rise. A decision by the ECB to reduce the amount of its monthly bond purchases could be a trigger for yields to rise throughout Europe."

The German Bund closed above 0.50% on July 6.

As noted, the decline from the high last July in TLT to the low in March was a 5 wave decline, which indicated that a counter trend rally was coming. That rally ended on June 26 and the next decline in bond prices has begun.

Large institutional bond managers are not going to wait to see if the Fed and ECB are capable of handling the unwinding of their monetary experiment. Instead, they will do some selling sooner rather than later to reduce their sovereign bond exposure.

How high could the 10-year Treasury yield go? During the first Taper Tantrum in 2013, the 10-year Treasury yield rose by about 1.30%. From the low of 1.32% in July 2016, the 10-year Treasury yield increased to 2.62% in March 2017, an increase of 1.30%. From the recent low of 2.10%, an equal rise of 1.30% suggests the potential of the 10-year yield climbing to 3.40%. An attack on the high of 3.03% in December 2013 is almost certain in coming months. I will point out that during Taper Tantrum I, Speculators in May 2013 were holding a long position that was 1/3 of what they hold now. This means the potential for a sharp move in yields is higher now than in 2013.

Dollar

A trading low in the dollar has been elusive, but the evidence of a trading low soon continues to mount. Sentiment toward the dollar has soured and positioning in the futures market has reached a level that has coincided with a trading low in recent years. The dollar established a low in early May 2016 when traders were as short the dollar as they are now. The Euro represents 57% of the dollar and large speculators have the largest long position in the Euro in many years. Many of the factors Draghi cited are why so many have become wildly bullish the Euro: the elections went better than expected, reforms might be possible in France, optimism about the eurozone economy is the highest in years, while growth in the U.S. has languished.

The dollar is approaching what should be significant support between 94.60 and 95.10, and is oversold as measured by its RSI. A rally to 97.50 is coming.

Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking

The Sector Relative Strength Ranking is based on weekly data and used in conjunction with the Major Trend Indicator (MTI). 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 MTI crossed above its moving average on February 25, 2016 generating a bear market rally buy signal. The MTI confirmed a new bull market on March 30, 2016. As discussed earlier, the MTI continues to indicate that a bull market is in force.

As discussed in March, the combination of fundamental analysis and technical chart analysis suggested reducing exposure to Financials was warranted, especially after the Financials ETF XLF decisively broke below its rising trend line on March 17.

As discussed earlier, the correlation between the S&P 500 and DJIA and Nasdaq is the lowest since 2003 and 2001. This has resulted in a pronounced acceleration in the rotation between various sectors. In a couple of instances, a sector has rallied enough to make it into the top 4, only to fade. For instance, the Utilities moved into the top 4 on June 2, but I chose not buy them since they were over bought with the RSI at 81.4. On June 5, the Utilities ETF XLU opened at $54.28 and closed today at $52.16. The 25% that has been in cash from the sale of the Financials since March 17 has remained in cash.

On June 26, I reduced the exposure to Technology from 25% to 12.5% XLK when it was trading at $56.10. On June 23 Health Care edged out Industrials to move into fourth place, but its RSI was above 80 on June 23. I determined that this was not a low risk entry point. On June 26, Health Care XLV opened at $80.70 and today closed at $79.84.

When XLK was trading at $54.41 on July 3 I sold the remaining portion of XLK. Today, XLK closed at $56.86. The Russell 2000 entered the Top 4 on August 19, 2016, and remained in the Top 4 until it was replaced by Consumer Discretionary (XLY) on May 5. On July 3, the position in XLY was lowered from 25% to 12.5% after selling 12.5% at $89.80. The remainder of the position was sold on July 6 at $88.45. Today XLY closed at $90.41. The Industrials (XLI) made it into the Top 4 on November 18, 2016.

The Tactical U.S. Sector Rotation Model Portfolio is 25.0% invested - 25% Industrial, and 75% in cash. Obviously, I am well positioned for that elusive 5% correction.

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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