Written by Jim Welsh
Macro Tides Technical Review 22 May 2017
In Case You Missed It
On Wednesday May 17, 2017, the S&P declined 1.8%, the Nasdaq Composite plunged 2.6%, while the DJIA shed 379 points or 1.8%. The headline making decline followed a period of 15 days in which the S&P traded in a 1% range. The last time that occurred was 1968 forty nine years ago.
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The S&P has endured 4 trading days in which the index moved by more than 1% this year, compared to 31 days through May 22, 2016. The primary reason for the lack of volatility has been the lack of selling pressure. Although sentiment has become a bit too bullish and upside momentum has slackened, the market has been either resilient or comatose, since the initial high by most market averages on March 1. The one constant has been the strength in technology and the affair with the ‘Jive with the Five’ big name tech stocks.
In conversations with advisors on Wednesday, who wondered if the sharp decline was the beginning of something more serious, I said I didn’t think so. The selloff was driven by political news, rather than economic news. Since the investigations are probably months from completion, most investors will remain focused on the outlook for the economy, until evidence emerges that Trump or someone high in the chain of command colluded with the Russians during the campaign.
Since most strategists expect the economy to rebound in the second quarter, any dip in the market is viewed as a buying opportunity. The bullish sentiment may be elevated, but that’s not a problem until the constructive economic outlook is challenged.
Click on any chart for a large image.
In recent months, I have discussed the Big Picture for the S&P 500. Bull markets advance in 5 waves, with waves (1), (3), and (5) being rallies, and waves (2) and (4) intervening declines. Wave (3) ended in May 2015, which was followed by a wave (4) correction that ended in February 2016. During wave (4), the advance / decline deteriorated significantly, the percent of stocks above their 200 day average weakened noticeably, the S&P fell by -15.2%, and the Russell 2000 lost -27.2%.
The rally that began in February 2016 is wave (5) which should subdivide into 5 waves itself. Wave 1 ended in April of 2016, with the decline in response to the Brexit low representing wave 2. In all likelihood, wave 3 ended on March 1, when the majority of market averages peaked together.
Wave 4 has been unfolding since that peak and based on the underlying strength of the advance / decline line, percent of stocks above their 200 day average, and chart patterns in the major averages at the March 1 high, the expectation was for the S&P to correct about 5% and ideally close the gap at 2311.
There are three important takeaways from the preceding charts.
1. The first is that the major trend of the market is up. Every major average is comfortably above the trend line connecting the low in February 2016 and the pre-election low on November 4, 2016 (lower blue trend line). Although the percent of stocks above their 200 day average has deteriorated a bit since February, it is still a healthy 62% as of today’s close. Prior to the selloffs in August and September of 2015, the percent was below 50%, and below 40% before the sharp decline in early 2016.
The advance / decline line made a new high today. It is rare for the market to experience a meaningful decline when the A/D line is acting so well. Prior to the declines in 2015 and 2016, the A/D line was weakening months in advance.
Finally, the Major Trend Indicator is still signaling that the bull market is intact. The decline last week in the S&P wasn’t even able to break below the short term trend line (blue line) connecting the lows on December 29 and April 13.
2. The second important takeaway is that the 5 wave pattern in the S&P suggests that the bull market that began in March 2009 is nearing its end. Although wave 4 may throw another curve or two, and possibly close the gap at 2311, the next meaningful rally in the S&P is likely wave 5 of wave (5).
One of the confirming signs is the level of bullish sentiment. The percent of Bulls over Bears in the weekly Investors Intelligence survey has exceeded 40% for most weeks during the last five months. This by itself is not a good timing indicator, since it can stay high for months as it did in the second half of 2014 and first half of 2015.
As long as the underlying technical indicators remain healthy, the S&P is unlikely to experience a decline greater than 7%. As discussed, a correction greater than 7% didn’t occur in 2015 and 2016, until after the underlying technical indicators had been weakening for months.
3. The third important takeaway is the next bear market is not far away based on the price pattern of the S&P. After wave 5 of wave (5) is complete, the Fat Lady will sing a jazz funeral. The average bear market decline in the past 100 years has been 37%. However, the next bear market could be far worse since valuations are high and the Federal Reserve doesn’t have the same interest rate leverage it had prior to 2008.
As you might remember, the federal funds rate was 5.25% in 2007, so the Fed was able to materially lower rates to help the economy and financial markets.
Today, the federal funds rate is less than 1% and will be nowhere near its 2007 level, even if the Fed increases rates twice more in 2017. Large bear market declines unfold over a period of many months in response to an economic recession or financial crisis. Although the U.S. economy is not setting records, growth of 2% or better is likely based on current financial and economic conditions.
Globally, Europe and Japan are on a better economic foundation than they have been in years, which is good for them and the U.S. The one area of concern is China. Debt has been growing faster than GDP for a decade, so China’s debt to GDP ratio is over 275%. The shadow banking system is rife with leverage, bad loans, and shady dealings, and the Peoples Bank of China has been tightening monetary policy and increasing interest rates, which is already weighing on over indebted corporations.
My experience has been that prior to a correction of more than 7%, the technical underpinnings will deteriorate well in advance of a decline. Monitoring the fundamentals of the U.S. and global economy should also provide some advance warning before the next bear market takes hold.
The Euro and the Dollar
Last week I noted that as long as the Euro did not close above 1.1036, which was the high after the election, the Euro had made at least a short term high. On May 16, the Euro blew through 1.1036 and closed well above that level, as stops were hit. Although the Euro is overbought (RSI at 74.4), and sentiment has become fairly bullish (net longs by Large Specs for first time since 2014), the Euro looks like a test of 1.1350 – 1.14 is certainly possible.
The Dollar broke down on May 16 and could drop to 96.38. That is where the current decline would equal the initial decline of 4.96 points from the January high of 103.82 to 98.86. The Dollar index is oversold (RSI 26.7) and no one likes the Dollar, so a rally is coming, just not yet.
Treasury Bond Yields
After being bullish in mid March when the 10-year Treasury was yielding 2.6%, I turned neutral on the bond market, after the short covering I expected drove the yield on the 10-year Treasury bond below 2.2%. I thought the yield on the 10-year could climb to 2.34% – 2.42%, and on May 11 it reached 2.423%.
If the yield on the 10-year Treasury is going to fall below the April 18 low of 2.177%, it will be due to surprisingly weak economic data, which I don’t expect, or an event that causes a rush to safety. When the stock market had its one day swoon on May 17, the 10-year Treasury yield fell by more than 10 basis points. The pattern in the 10-year yield supports the potential of a decline to 2.0%, which leaves open the possibility for another sharp decline in the stock market that may actually last for more than one day.
Gold and Gold Stocks
The positioning in the futures market has turned neutral. Large Specs have cut their longs and Commercials have reduced their short positions. Relative to the highs and lows in Gold and Silver over the past year, the positioning is not extreme. Gold and silver have traded better than I expected, with Gold climbing above $1260 and Silver over $17.00. The ratio of the Gold stock ETF (GDX) to Gold has improved, but not enough to break below the rising blue trend line. As long as the ratio is rising, it indicates that gold stocks are on balance underperforming. Prior to the rally in the first quarter, the ratio dropped below its moving average AND the rising blue trend line. As of today’s close, it’s close to breaking below the trend line but not there yet.
Tactical S&P Sector Rotation Portfolio Model: 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.
The Technology sector (XLK) has been in the Top Four of the Sector Relative Strength Ranking since October 2, 2016, and has been in the number one position for weeks.
The Financials (XLF) moved up into the Top 4 on October 28, just before the big run up after the election. The Industrials (XLI) made it into the Top 4 on November 18, 2016.
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.
I have said that the Financials are one of the keys to the market, since a real breakout above 2400 will need the participation of the Financials. Last week, the Financials ETF (XLF) dropped to its prior low. The bounce so far has lagged the market. If Treasury bond yields decline to new lows, the Financials may not hold support at $22.90. The price pattern suggests that last week’s low is likely to be broken and that XLF may fall to $21.70 in order to close the gap.
The Industrials ETF (XLI) briefly dropped below its short term support trend line, but the rebound has been strong.
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.
