econintersect.com
       
  

FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.



posted on 03 October 2017

The Tax Cuts Are Coming! The Tax Cuts Are Coming!

Written by

Macro Tides Technical Review 02 October 2017

After failing not once but twice, and after seven years of promises, the Republicans conceded on Tuesday September 26 they would not be able to deliver on repealing or reforming the Affordable Care Act. The repeal of the ACA was considered essential in paving the way for tax cuts. On Wednesday, September 27, the republicans announced their tax cut plan although many details were missing. For the stock market, the lack of details and the failure to achieve anything on health care hasn’t mattered.

ready.fire.aim

Buy first ask questions later has been the order of every trading day. The presumption must be that the tax cut legislation will sail through Congress and add approximately $10.00 to S&P earnings in 2018.


Please share this article - Go to very top of page, right hand side, for social media buttons.


The assumption that Democrats will happily agree to the elimination of the deduction for state and local taxes or that conservative Republicans won’t have a problem with the increase in deficits and debt seems unrealistic if not naïve. The prospect of tax cut legislation though has been the pot at the end of the rainbow since the election, and the primary reason the S&P has experienced a pullback of only 2.9% in the first nine months of 2017.

Markets have a tendency to record tops and bottoms on news so the potential of at least a short term high soon must be considered. As I have noted for weeks, with the advance / decline line making a new high along with the majority of the major market averages, the risk of a decline of more than 5% is low.

Despite the new high in the advance / decline line and the majority of market averages, I have thought the risk of a 3% to 5% pullback was greater than 50-50, since the percentage of stocks making a new 52 week high has been trending lower for months. Obviously, that hasn’t occurred even as the number of days without a 3% setback is now the second or third longest since 1928. As noted last week, the range of .49% last week was the smallest since 1972 and volatility, as measured by the VIX Index, is also historically low.

The period of 2004 - 2006 was very similar to the current environment. The advance / decline line was in a strong uptrend and posted new highs continuously in those years. The VIX Index was low most of the time using a 22 day average compared to an average of 20.0 since 1990 for the VIX. Although the VIX was not as low as it has been in recent months, the VIX average did spend a fair amount of time below 12 in 2005 and 2006, and there is a good explanation for why the VIX is lower now.

In recent years, shorting volatility has been a huge winning trade since each spike higher in volatility has been followed by lower volatility. Last week, a record amount of contracts were short the VIX. Shorting the VIX pushes the VIX down and helps to partially explain why the moving average of the VIX has been trading just above 10 in 2017. In 2004 -2006 there were no products to short the VIX.

During the period of 2004 - 2006, the Advance / Decline Line continued to make higher highs, just as it has since the trading low in February 2016 and during 2017.

Click on any chart below for a large image.

The 22 day average of the VIX traded below 15.0 for most of 2004 - 2006 and below 12.0 at times

Since the election the 22 day average of the VIX Index has traded under 15.0 and below 12.0 since May.

While a stable economic environment has contributed to the low level of volatility in the stock market in recent months, a record level of VIX shorts have been pushing the VIX lower and explains in part why the VIX has been so low. When the underlying fundamentals of the economy deteriorate at some point in the future, or the S&P experiences a ‘normal’ 5% correction, a short squeeze in the VIX is likely to develop and cause the VIX is climb above 30.0.

In the past, a rise above 30.0 in the VIX would have required a 10% decline or greater. But with the short VIX trade so large it won’t take as much of a decline in the S&P to cause a far larger rise in the VIX. The overall level of the VIX during 2004 - 2006 wasn’t much different than in 2017 when this VIX shorting activity is factored into the analysis.

There are many indicators to measure the short to intermediate term momentum of the market. One of my favorites is the percent of stocks making a new 52 week high. In the period of 2004 - 2006, the Advance / Decline Line consistently made higher highs and volatility was low. Despite the strength in the A/D line, and low volatility, the S&P experienced 6 declines in which it fell by more than 4.4%. Prior to each decline, the percent of stocks making a new 52 week high registered a divergence by making a lower high (blue arrows) even as the S&P and A/D line were making a higher high. Four of the 6 declines were greater than 7.0% with the largest correction occurring in 2006 when the S&P dropped 8.08%.

Now, let’s fast forward to 2017. In recent months, the percent of stocks making a new 52 week high has been recording lower highs. This was one of the reasons the potential for a 3% to 5% pullback seemed likely despite the higher highs in the A/D line. Since 1928, the S&P has averaged three 5% corrections per year. In the vast majority of instances in which the percent of stocks recorded a lower high a pullback in the S&P of 5% was realized.

The timing of the tax cut announcement was fortuitous as it occurred just before the end of the third quarter which likely amped its impact. The beginning of the month inflows certainly contributed to today’s strength. The A/D line posted another new high as did the majority of major market averages.

The number of stocks making a new 52 week high has jumped since the tax cut announcement which has pushed the percent of stocks making a new 52 week high up nicely. Although it is still below the highs it recorded in December and February it has bettered the high in July. This suggests that the rally has more to go in the short term.

In coming weeks it will become apparent that the tax cut legislation is not going to proceed smoothly on its way to becoming law. Even if one likes sausage, the making of a sausage link is not as appetizing as eating one with all the trimmings. The market surely expects the Democrats to launch their usual class warfare commercial that only the rich will benefit. But when conservative Republicans’ voice their opposition to any tax cut that isn’t revenue neutral, investors will be forced to accept some measure of reality. At a minimum, the pail of political cold water should lead to a period of consolidation. According to the CNN Fear and Greed Index, the short term enthusiasm for stocks is overdone as of today’s close.

Dollar

In the last two weekly technical reviews I offered this assessment of the Dollar.

“A move above 93.35 would break the pattern of lower highs and lower lows and suggest a change in trend has occurred."

Last Wednesday the Dollar traded above 93.35 and reached 93.65 today. From the low at 91.01, the Dollar has now traced out a series of higher lows and higher highs. The next stop should be near 94.14, which was the high on August 16, and where some selling could occur.

I expect the Dollar to rally a minimum of 4.5 points and maybe 7.5 points from 91.01. One of the reasons the Dollar is likely to rally is the behavior of the Commercials and Large Specs in the Dollar futures. When the Dollar was topping out in January, the Commercials (red line middle panel) were short more than -58,000 contracts. On September 26, they were actually long +335 contracts. In May 2016 as the Dollar was making an intermediate low near 92.00, the Commercials were short -15,000 contracts.

They’re more bullishly positioned now than in May 2016.

The Dollar subsequently rallied from 92.00 to 103.84 in January. In May 2016, Large Speculators (green line middle panel) were long +10,400 contracts, and by January 2017 held +53,000 long contracts. Large Specs are trend followers and typically wrong at intermediate trend changes. As of last week, they are short -6.603 contracts, so they will be forced to buy back their short position if the Dollar rises, which will help the Dollar rally further. I’m still long the Dollar ETF UUP.

Treasury Bonds

From the bottom in the 30-year Treasury bond yield of 2.10% in July 2016, the yield rose to 3.20%, an increase of 1.10%. A 50% retracement targeted 2.65% which was reached on September 7 and has been followed by a sharp rise. The yield on the 30-year Treasury bond has closed above the down trend line connecting the May and June high for 4 consecutive days, adding further confirmation that the low in yields on September 7 was an intermediate low. I expect the yield to rise to 2.91% - 2.94% (blue horizontal trend line) before the 30-year yield becomes overbought and a rally in bond prices develops.

Emerging Markets

Last week the Emerging Markets ETF (EEM) closed below the green trend line from the low in July and traded down to near the blue trend line which has been in place since the low in December. If the Dollar continues to rally, the blue trend line is expected to be broken. Today’s trading action is instructive. After being up $0.215, EEM faded, closing up only $0.01 and just $0.03 from the low. A decline to near $42.00 is certainly possible.

Gold and Gold Stocks

Gold has negated the breakout above $1296.00 cash as I expected. From the high at $1357, Gold fell to $1288, before bouncing to $1313 on September 26 in response to news about North Korea. An equal decline of $69 would bring Gold down to $1244, so a drop below $1260 remains likely.

It is bearish that the Commercials (red line middle panel) didn’t cover more of their short position during the recent decline, which is why a decline under $1260 is possible. The aggressive shorting by the Commercials was a primary reason I thought the breakout above $1296 was a false breakout and would be followed by a large decline.

The outlook for the Dollar is constructive, which was expected to pressure Gold and it has. In recent months, Gold stocks have not shown good relative strength to Gold which was another reason why a decline in Gold was expected. Until Gold shows more definitive signs of a trading low, the Gold stocks are likely to remain weak. At the next good buying opportunity in Gold stocks, I would expect the relative strength of the Gold stocks to improve significantly as it did between late December and mid February. That improvement was a great indication that the Gold stocks were really ready to rally strongly.

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. The MTI continues to indicate that a bull market is in force.

For the three weeks through Aug. 10, the closing levels of the S&P 500 never had a daily swing of more than 0.3 percent, which had never occurred since 1928, which is as far back as the data goes. Through today, the average daily trading range for 2017 has been 0.534%, the lowest ever.

The S&P hasn’t experienced a 3% decline in 330 days the third longest stretch on record.

The S&P hasn’t had a 5% correction since June 28, 2016 462 days ago. It is the longest period without a 5% decline since 1995, and the third longest since 1950. Since 1928 the S&P has averaged three 5% declines per year, so this streak is truly amazing.

Although the Major Trend Indicator is positive, the MTI has been posting lower highs since peaking in early March. A number of other technical indicators that I discuss regularly such as the percent of stocks above their 200 day average, the percent of stocks making a new 52 week high, as well as sentiment indicators like the Call/Put ratio and Investors Intelligence percent of bulls have all flashed warnings of a 5% correction in recent months.

Since late July, the odds of the S&P continuing the streak of no corrections of either 3% or 5% were quite low based on historical patterns and signals from these reliable technical indicators. Records are made to be broken, but I don’t manage risk or money expecting a new record to appear when the probability of one is extremely low.

The Tactical U.S. Sector Rotation Model Portfolio has been 100% in cash since July 24 based on the probability of a 5% correction. In my judgment, upside potential has been limited relative to the level of risk.

I did not expect investors to so willingly embrace the potential of a tax cut given the performance of the Republican held Congress to date. You’re familiar with this old saying. Fool me once, shame on you. Fool me twice, shame on me. The expectations the election created, with Republicans controlling both Houses of Congress and the White House, included immediate repeal of the ACA, quick action on taxes, and solid leadership out of Washington.

Instead, investors have been treated to a barrage of Tweets, no changes on healthcare, and bumbling leadership. This has led to investors embracing a new version of the Fool Me idiom. Fool me once, shame on you. Fool me twice, it’s OK. Fool me thrice, Hip Hip Hooray!

Through August 31, the Tactical Sector Rotation program is up 8.52%.

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.

>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical Investing Post Listing










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted. You can also comment using Facebook directly using he comment block below.




Econintersect Investing








search_box
Print this page or create a PDF file of this page
Print Friendly and PDF


The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.







Keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government





























 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2017 Econintersect LLC - all rights reserved