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posted on 18 January 2018

Short Term Technical Reversal

Written by

Macro Tides Technical Review 16 January 2017

I consult to groups of financial advisors and provide economic and financial market analysis that includes asset allocation advice and specific trade recommendations. In preparing for a meeting this morning (Tuesday 16 Jan), I collected slides showing how overbought the market had become and two early warning signs that the market was becoming vulnerable to a short term sell off.

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When the call began at 10 am PST, the DJIA was up more than 150 points but down from a gain of 282 points at its high. I told the advisors at the beginning of the call that I thought this morning’s high was likely a short term high given the level of overdone enthusiasm, and said that if the market closed down today (Tuesday) it would likely confirm that a short term high was in place.

The buy the dip mentality is so entrenched that a rebound during the next few days was likely but likely the start of a consolidation and overdue correction. The stocks that might be most susceptible were those that had run up the most and, since they were heavily weighted in the DJIA and S&P 500, could contribute to a quick pullback of 4% or more.

The fist slides I discussed were how historically overbought the DJIA and S&P 500 had become. According to the RSI indicator, and as of January 10, the Dow Jones index was the most overbought since 1904. The DJIA has gained another 600 points and is likely more overbought than at any time in its history. As of Monday, the weekly RSI is at 91.2, up from 88.3 on January 10.

welsh.tech.2018.jan.16.fig.01

Click on any chart below for large image.

The weekly RSI on the S&P is 88.9, which is the highest since at least 1959.

The overbought condition extends beyond U.S. market averages and includes global equity markets as measured by their daily RSI. Interest rate sectors are not overbought as they have declined as rates have risen.

welsh.tech.2018.jan.16.table.01

Within US equities the only sectors that are oversold are Real Estate and Utilities which have declined as interest have gone up in recent weeks. Consumer staples and Semi-conductors are neutral.

welsh.tech.2018.jan.16.table

Based on numerous surveys of investment sentiment, bullishness has reached levels that are comparable to levels recorded at other major market tops. Market don’t go down because ‘too many’ investors have become positive, but too much enthusiasm does leave the market vulnerable in the short term to profit taking. With interest rates closing in on key technical levels, (10-year Treasury yield of 2.62% and the German Bund yield closing above 0.50% on Friday), valuations are vulnerable to compression since low interest rates have been cited for years as a major support for the market’s high valuation.

A survey of 52 leading economists last month by Blue Chip Economic Indicators found the average expectation was for CPI to stay about where it is at 2.1% for all of 2018. This indicates that mainstream forecasters don’t buy the argument that inflation will move higher this year and will be surprised if it does. Although the annualized rate of CPI inflation only rose slightly in December, the 6 month and 3 month annualized change indicated that inflation pressures are still building. The six month CPI was up 2.25% while the 3 month was up 2.5%. Last week, the 2-year Treasury yield, TIPS yield, and the 10-year breakeven rate all exceeded 2.0%.

Early Warning Signals?

Here are the two signs I discussed this morning as why the market was nearing a pull back.

In addition to excessively high levels of bullishness, the Semi-conductors have often led technology in general as measured by the SMH compared to the Nasdaq 100. In 2015 SMH peaked on June 1, 2015 well before the Nasdaq 100 topped on July 20. This warning was followed a quick 12.4% decline in the S&P 500 after China devalued the Yuan. I do not expect anything close to that size of a decline since the Advance / Decline line, percent of stocks above their 200 day average, and the percent of stocks making new 52 week highs are much stronger than they were in the summer of 2015.

SMH topped on November 22, 2017 and has yet to make a new high even though the Nasdaq 100 is up 7.0%. This divergence suggests large cap tech stocks could be set for a fall soon.

As the S&P rose in July 2014, the volatility index VIX began to rise rather than fall as it usually does when the S&P goes up (red trend line). Between July 24 and August 7 the S&P dropped 4%. The S&P then rallied to a higher high on September 19, but the VIX made a higher low. This divergence was followed by a 9.8% intra-day decline between September 19 and October 15.

Since January 3, the VIX has risen even as the S&P has vaulted higher. A close above 11.06 (red horizontal line) would indicate that a low in the VIX was confirmed. This suggests that a quick pullback in the S&P could develop soon as it did in late July and early August in 2014. These charts and analysis were prepared before the market reversed lower. The VIX closed at 11.66 and comfortably above 11.06.

If this analysis proves accurate, the S&P could drop by 4% or so in the next two weeks, before mounting a rally that could make a modest new high. If this does occur and is accompanied by momentum divergences, including the VIX making a higher low, the S&P could then be vulnerable to a deeper set back. One thing is for sure, the one-way street since the end of 2017 is approaching a fork in the road.

Interest Rates

Like dominoes, the increase in the 2-year Treasury yield is pulling up the 5-year yield, which is tugging the 10-year yield higher, and slowy dragging the 30-year Treasury yield higher.

The 10-year German Bund has also joined the higher yield parade and has closed above 0.50%.

The jump in the Bund yield was spurred after the minutes of the ECB’s December meeting showed the ECB had discussed delinking its inflation target from its QE program. I discussed this potential in the November issue of Macro Tides based on an interview by ECB board member Benoit Coeure who is the head of operations at the ECB. In a November 21 interview he said:

“I expect this link to change when the governing council is sufficiently confident that net asset purchases are less needed for inflation to return towards 2 percent in a sustainable way. We were not ready to make that change in October, but I expect it will come at some point between now and September 2018."

There is a good chance that this changed will be announced after the meeting on March 8. As I concluded in the December Macro Tides:

“Whenever this change is made it has the potential to wake up the European bond market to the inevitability of the ECB winding down its QE program and the repression of European bond yields. If GDP growth is above 2.0% and inflation is closing in on 2.0%, why would anyone want to own a German 10- year Bund yielding less than .50%? This is the existential question bond managers in Europe and globally will ask themselves in the first half of 2018. This will lead them to decide to lower their European bond exposure before the ECB announces it is stopping its QE purchases and the urge/stampede to sell develops."

If this analysis is close to being on target, bond yields in the U.S., Europe, and globally could jump in the second quarter and lead to a real correction in the U.S. stock market and equities globally.

Gold and Gold Stocks

As I noted in the December 18 Weekly Technical Review when Gold was trading under $1250:

“The positioning in the futures suggests Gold is likely rally to at least $1305 and could make a run at the September high of $1357 in the first quarter of 2018."

As noted in the January 8 WTR:

“As long as Gold holds above $1300 and doesn’t close below $1305, Gold is likely to rally above $1325.56 before a more pronounced decline takes hold."

Last week gold dipped to $1309 before running up to $1344 on Monday March 15. Although it is certainly possible for Gold to break above the trend line connecting the August 2016 high with the September 2017 peak, the odds favor a test and then a pullback. This suggests selling a portion of the Gold position above $1344 or using a decline below $1326 as a stop. Longer term a rally above $1400 is possible if inflation picks up as I expect.

In the January 8 WTR I wrote that the price pattern of the Gold stock ETF (GDX) suggested it was still possible for another push above the January 2 high at $23.84 before a deeper correction unfolds. If GDX does rally above $23.84 I said I would likely sell 37% of my position since I was overweight Gold stocks. When GDX traded above $23.84 on Friday January 12, I sold 25% of my position at $23.91 and another 25% on January 16 at $24.13. On Friday, GDX broke above the red down trend like connecting the August 2016 high and the September 2017 high. The path appears clear for a run above $25.00 and a test of the black horizontal trend line connecting the February and September 2017 highs. Unless gold breaks out above $1357, I will likely sell another 25% of GDX if it trades above $25.00. The cost basis on the GDX position is $21.73.

On December 18, I established a 25% position in the Junior Gold stock ETF GDXJ at $32.035. On Friday January 12, Gold exceeded it prior high of $1225.56 and GDX traded above its prior high of $23.84, but GDXJ failed to better its prior high of $35.17. This divergence led to me sell 25% of the GDXJ position at $34.91. On January 16, I sold another 25% of GDXJ at $35.19. GDXJ broke above the blue trend line connecting the February and September highs and looks poised to rally to the black horizontal trend line above $37.00. I will likely sell another 25% of GDXJ if it trades above $37.00.

Dollar

In the January 8 WTR I noted:

“The price pattern looks as if the Dollar could drop again below 91.75 which would likely register an RSI positive divergence and set up a better rally."

The Dollar did fall below 91.75 but at the low on January 16 did not produce a RSI divergence. This suggests that the Dollar is likely to post another lower low after any intervening bounce. Sentiment is so bearish the Dollar that looking for a good trading low in the first quarter is appropriate. However, the technical picture is just not positive enough to recommend a long trade.

Euro

In the December 18 WTR I thought:

“As long as the Euro holds above the neckline of its head and shoulders pattern near 1.1675, the trend is up and a rally to 1.2200 seems likely."

On Monday January 15, the Euro traded up to 1.2296 after the minutes of the December ECB meeting were released. The Euro topped on May 5, 2014 at 1.3993 and dropped .3652 until bottoming on January 2, 2017 at 1.0341. A 61.8% retracement of that large decline would carry the Euro back up to 1.259. A look at the longer term chart of the Euro suggests it could rally back to the down trend line connecting the highs of April 2008 at 1.6008, May 2011 at 1.4938, and May 2014 at 1.3993.

As discussed in the January 8 WTR the positioning in the Euro futures reveals the largest long position by Large Speculators in history. This suggests that the Euro could make a major high between 1.23 and 1.26 in the next 1 to 3 months. Technically the pieces are not yet in place to confirm a bottom in the Dollar or a top in the Euro.

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.

The rally since mid November has been strong and has pushed the MTI to a level that suggests a meaningful correction in the S&P (greater than 7%) is likely months away.

welsh.tech.2018.jan.16.table.03

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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