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posted on 01 August 2017

Topping Process Continues

Written by

Macro Tides Technical Review 31 July 2017

As discussed last week, the market is entering a window of time that has coincided with tops in years ending in 7 and during the last 20 years. The Decennial pattern suggests that a top in the S&P is likely within the next few weeks, if the pattern in years ending in 7 holds true. The trading pattern in the last 20 years also supports the potential of a top in the S&P soon. Both patterns suggest a decline is coming that could last until late October or early November.

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


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welsh.tech.2017.jul.01.fig.02

Earnings have been OK but that hasn’t really helped the market. Companies that have missed and disappointed have been hit hard losing on average -4.7%. What’s interesting is that stocks that merely meet expectations have traded poorly and lost -2.8% in the wake of their earnings report. This suggests that good earnings have already been priced into many stocks. This is why selling has come into these stocks on the good news. With the winding down of earnings in the next two weeks, the market does not have much to look forward to keep it climbing.

welsh.tech.2017.jul.31.fig.03

Although the first estimate of second quarter GDP was OK at 2.6%, most of the increase came from a less negative inventory drawdown of almost +0.9% and a gain of 0.3% from a decline in the GDP Price Index from 1.3% in Q1 to 1.0% in Q2. Absent the change in inventory levels and the deflator, GDP would have been 1.4%, not much better than the 1.2% in Q1.

welsh.tech.2017.jul.31.fig.04

welsh.tech.2017.jul.31.fig.05

The market appears impregnable to any news. In just the last week the stock market hasn’t noticed or cared that the Republicans failed to pass any health care bill, the Fed confirmed they are going to start shrinking their balance sheet before year end, North Korea launched a missile that may be capable of reaching Denver, and a revolving door was installed at the White House to accommodate the rapid changing of personnel.

This myopic lack of focus on what’s going on in the world at large is going to change at some point. The market’s capacity to ignore any news is spurring more bullishness. In last week’s Investors Intelligence survey the percent of bulls rose to 60.2% as the percent of bears fell to 16.5%. The plurality of bulls at 43.7% was the highest since February. Ironically, the excessive level of bullishness probably buys the market a bit more time since declines usually kick in after a peak in bullishness. A decline in bullishness in coming weeks would actually be a negative for the market as it was in the early summer of 2015.

Click on any chart below for large image.

The major market averages are not trading like a finely tuned engine. The DJIA has made news highs in the last week, but the Russell 2000 and the S&P 500 have failed to do so. Although the Nasdaq Composite and Nasdaq 100 did post a new high, both averages suffered a nasty reversal and look like they will fall more. Boeing has added more than 200 points to the DJIA in the last week which is why the DJIA has been flying so high.

The DJ Transports have lost more than 7% in the past two weeks and are testing an important trend line connecting the low in February 2016, the Brexit low in June of 2016, and the low near the end of October just before the election. After testing this trend line last week, the bounce has been particularly weak and the Transports appear ready to break below the trend line. The Transports often lead the overall market so this weakness is noteworthy, especially if it continues.

Dollar

A reversal of the downtrend in the Dollar could coincide with a reversal in a number of other markets that often benefit from a weak Dollar, ie oil, gold. As noted last week, a record long position in the Euro and record short position in the Dollar have the potential of generating a very sharp reversal in both markets.

The Dollar is nearing the significant support between 92.00 and 92.50 after closing at 92.86 today, and is deeply oversold with its RSI at 21.25. Normally, it is not wise to try to catch a falling knife. But as noted last week, if one is going to catch a falling knife it is better to do it near significant support.

From a trading perspective, taking a small long position in the Dollar (1/4 or 1/3) if it drops below 92.50 is appropriate. The low in May 2016 was 91.92 so the risk is less than 1%. Adding to the position (1/4 or 1/3) on a definitive reversal, or after a bounce and subsequent retest of the trading low makes sense. The Dollar has declined by more than 10% since January, so a rally of at least 3% to 4% is coming.

The Euro is extremely overbought as measured by its RSI which hit 77.19 today. The strength in the Euro will dampen Eurozone exports in early 2018 and inflation remains well below the ECB’s 2.0% target. This makes it conceivable that the ECB may not move as aggressively in normalizing monetary policy as the market is currently pricing in. When the ECB meets on September 21, Mario will have the opportunity to take some of the starch out the Euro.

If and when the Dollar does establish a solid trading low, the Euro could easily drop to its prior resistance near 1.14 - 1.15. I would also expect gold and oil to experience a negative reversal. This window of time that could prove important for the stock market may also be critical for a number of markets in the next few weeks.

Gold and Gold Stocks

Two weeks ago I said that if Gold closed above $1250, a rally to $1280 - $1300 was possible. So far gold has traded above $1270 and looks like it has a bit more upside. The most important level is the resistance at $1300. I do not think gold will breakout above $1300 on this rally.

The RSI on gold is almost back to the level in May when Gold topped. If it does rally a bit more, Gold will be overbought. Gold and the Dollar don’t always trade inversely to each other, but a rally is coming in the Dollar. If the rally in the Dollar proves more dynamic than an oversold bounce, Gold could drop back to near $1200.

Last week, GDX did manage to get back above the trend line connecting the January 2016 low and December 2016 low. Obviously, that was a short term positive. However, GDX is now approaching the trend line connecting the high in February and April which comes in near $23.50. If GDX is able to trade up to this trend line it will be overbought and unlikely able to punch through. The relative strength of GDX to Gold has improved modestly, but so far is merely trending sideways which is not an overly bullish message. If the relative strength of GDX was rapidly improving, the odds of breaking above the declining trend line would be much higher. The bottom line is that a better buying opportunity is likely at lower prices.

Treasury Yields

After testing the 61.8% retracement of the move from 2.103% on June 14 to 2.396% on July 7 at 2.225% on July 21, the yield on the 10-year Treasury drifted up to 2.337% on July 26. Today it closed at 2.292%. The key level is 2.423% which was the high on May 11. Sooner or later this resistance is likely to be exceeded which could lead to a test of the March high at 2.62%.

The decline in the Dollar since January has eased financial conditions far more than the two rate increases by the Fed. The decline in the Dollar will give the U.S. economy a boost, as exports pick up especially in early 2018. The Fed will infer that any pick up in the economy will further tighten the labor market and potentially lift wages. The Fed also knows that import prices will contribute more to inflation than they have during the last three years.

Each of these reasons provides the Fed with justification for shrinking their balance sheet before the end of 2018, and cause to raise rates at their December meeting. Currently, less than 40% of economists and strategists expect the Fed to increase the federal funds rate in December.

If this scenario plays out, bond yields would have a reason to rise. The Dollar would also find support from the notion that the Fed may move more quickly and decisively than markets currently expect.

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 in the July 17 WTR, 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 $52.79. 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 $80.96.

When XLK was trading at $54.41 on July 3 I sold the remaining portion of XLK. Today, XLK closed at $57.61. 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.

Consumer Discretionary dropped out of the top 4 on July 7 and would have been sold on the opening on July 10 at $89.71. The Industrials (XLI) made it into the Top 4 on November 18, 2016 and fell out of the top 4 on June 23 and should have been sold at the opening on June 26 at $68.21. XLI was sold on July 24 at $68.63, which is also where is closed.

The Tactical U.S. Sector Rotation Model Portfolio is 100% in cash. Obviously, some additional gains in Technology were not realized by selling XLK, but I am well positioned for that elusive 5% correction. I suspect that if a correction materializes, it will develop almost without warning and could be fairly sharp. If that occurs, moving to cash in anticipation of the correction may be an advantage.

Through July 31, the Tactical Sector Rotation program is up 8.52%. The quantitative version of the Tactical Sector Rotation program, which does not include any discretion, is up 6.7%. The difference is that the quant version would have purchased the overbought sectors when they moved into the top four and been hurt by the rapid rotation in recent months.

welsh.tech.2017.jul.31.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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