Written by Jim Welsh
Macro Tides Technical Summary 19 June 2017
Federal Reserve’s Bias Becomes Hawkish
In the June Macro Tides, which was published two days before the Fed’s meeting on June 14, I noted that the bias of the Federal Reserve was to look for reasons not to act in 2015 and 2016.
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I thought the Fed’s bias had changed with the FOMC now needing reasons why it should not increase rates. I didn’t think the apparent shift in the FOMC’s bias had not been recognized, let alone acknowledged by the financial markets. As expected, the FOMC raised the federal funds rate for the second time in 2017.
What was noteworthy is that this increase occurred against a back drop of slowing job growth, no measurable pick up from the 2.5% in annual wage growth, inflation slipping further below the Fed’s target of 2.0% in recent months, weakness in the auto sector which had previously been a contributor to growth, tepid growth in housing, and the dimming prospects of Trump’s growth oriented fiscal policies being passed in 2017.
Citi’s Economic Surprise Index has plunged +58 in mid April to -78.6 last week. This is the largest decline in the last five years and the Fed decided to ignore it, which they wouldn’t have done in 2015 and 2016. This suggests that my analysis was quite prescient.
For the most part, the majority of financial markets don’t believe the center of gravity within the Fed has shifted toward a more hawkish bias. Despite the 25 basis point increase in the federal funds rate, the yield on the 10-year Treasury bond is basically unchanged. The spread between the 2-year and 10-year Treasuries has narrowed from 1.35% to .79% since December.
The decline in the Citi Economic Surprise Index has occurred in part because expectations for economic growth soared after the election and hopes for a strong rebound in the second quarter, which has failed to materialize. The narrowing in the yield curve has resulted from weaker than expected data and the decline in hopes for the Trump’s growth agenda being passed in 2017.
According to a recent survey, the percent of businesses and consumers who believe that corporation and personal tax cuts will be implemented in 2017 has fallen significantly since mid March. The percent of households expecting their tax rates to fall is down from over 70% to 31%, while the percent expecting lower taxes for corporations is down to 39% from 75%.
As hopes for tax relief has waned, consumer spending, as measured by retail sales has weakened. Y-O-Y auto sales have turned negative from 2016 and fewer people are dining out.
Commercial and Industrial loans have declined from an annual increase of 8% just before the election to just 2%. Clearly, corporations are unwilling to move forward on investments until the prospects for tax cuts revive.
The sharp contraction in lending is certainly not due to a pronounced decline in the economy which continues to chug along at a rate of 2% to 2.5%. In early May, the Atlanta Fed’s GDPNow forecast was projecting GDP growth of 4.3% in Q2. As of Friday June 16, the projection is down to 2.9%. I didn’t expect GDP growth to reach the 3.5% forecast in Q2.
Dollar
The foreign currency market took notice of the change in the Fed’s bias. After disappointing retail sales and softer CPI inflation data were announced at 8:30 am e.s.t. on June 14, the Dollar weakened. A few hours later, after the FOMC raised the federal funds rate, and more importantly, indicated it would begin to pare its balance sheet before the end of 2017, the Dollar reversed.
What made the reversal even more interesting was the price level the Dollar reversed from. In the May 22 WTR I thought the dollar had more downside:
“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 low was 96.32 just .06 below the target. More importantly is the strength of the rebound since the low. Today, the Dollar traded up to 97.57 before closing at 97.55, up 1.25% since last Wednesday.
Further confirmation of a solid trading low will come if the Dollar is able to close above the trend line connecting the three prior trading lows. That trend line comes in near 98.25. I expect the Dollar to succeed in bridging 98.25. From the high at 103.82 to Wednesday’s low of 96.32, the dollar lost 7.50 points or 7.22%. At a minimum, a rally that retraces 38.2% of the decline seems likely, an increase of 2.7% to 3.6%. This would target a rally to 99.05 to 99.80.
Click on charts that follow for large images.
The decline from the January high at 103.82 is very choppy and lacks the impulsive quality of a long term decline. The fact that the Dollar bottomed (at least so far) so close to the target of 96.32 could prove important since it was based on a corrective pattern. In plain English, there is a small probability that the Dollar could rally more than expected and trade up to 101 or higher in the next few months.
Euro
As discussed the last two weeks
“The positioning in the futures market as discussed below suggests waiting to short the Euro until it gets above 1.13 may be missing an opportunity. The pattern in the Euro looks as if it is close to a short term high.”
Large speculators are now holding their largest long position since 2014 and 2011. Since large speculators are trend followers, they are usually caught being too long at tops and too short at bottoms. After peaking in May 2014, the Euro dropped 25.2% by March 2015. After peaking in May 2011, the Euro subsequently fell 19.4% before bottoming in July 2012. History suggests the Euro could be vulnerable to a meaningful correction in the next six to twelve months at a minimum.
Gold and Gold Stocks
After the FOMC increased the federal funds rate and Chairperson Yellen sounded more hawkish than market participants’ anticipated, gold fell sharply and the gold stocks swooned from the high of the day.
As discussed in the last three WTR’s, the positioning in the futures market has become even more negative as Commercials and Producers increased their shorts as gold traded above $1280, while Large Specs increased their longs:
“The increase in bullishness by Large Specs suggests gold is vulnerable to another decline that could shake them out and bring gold down to near $1200. At a minimum, a pullback to $1245 – $1255 seems likely.”
As long as the ratio of the Gold stock ETF (GDX) to Gold is rising and above the red trend line, it indicates that gold stocks are on balance underperforming.
Gold traded down to $1243.50 today and appears ready to test the rising trend line connecting the lows in mid March and mid May. Although a bounce from this trend line is likely, my guess is that a close below this trend line ($1225.00) would lead to a test of $1200.
The Gold stock ETF GDX is testing the trend line (black) connecting the intermediate low in December and the trading low in early May. A temporary bounce from this trend line seems likely, but ultimately GDX is likely to test the lower blue trend line that forms the lower channel of the range GDX has been trading in since the high in early February.
The ratio of the Gold stock ETF (GDX) to Gold continues to rise and is above its blue moving average and red trend line. Prior to the next meaningful rally in GDX, the ratio will fall below its moving average and close below the red trend line as it did in late December. This signal was followed by a 20% rally in GDX.
Oil
Despite the OPEC deal to extend their cutbacks in production, along with a number of non-OPEC countries, oil prices can’t seem to find a bid. A close below $43.75 could be followed by a flush to near $40.00. That would be a negative for High Yield and Junk bonds given their exposure to energy debt. Who knows, maybe the equity market will take notice!
Stocks
Since the March 1 high at 2400 I have expected the S&P to decline to 2311 in a wave 4 decline. After this decline the S&P would rally to 2500 or higher. On March 27 the S&P traded down to 2322, bounced to 2378 before dipping again to 2332. In recent weeks, I’ve discussed the potential of the recent new highs in the S&P as being part of an irregular wave a down, b wave up, which would be followed by a c wave decline that would bring the S&P down to 2332 if not lower. Today’s rally and close of 2453 lowers the probability of the c wave, but does not eliminate it for a number of reasons.
While the DJIA and S&P made a new high, the Transports, Russell 2000, and the Nasdaq 100 and Composite did not. In addition, only 2 of the 10 sectors in the S&P made a new high – Industrials and Health Care. On June 2, 339 stocks made a new 52 week high but only 223 stocks did so today. Granted it wouldn’t take much additional strength for the Russell 2000, Nasdaq averages, and the number of new highs to confirm a further new high in the S&P. This means the next two days could be interesting.
The price pattern in the Nasdaq 100 and Composite may have completed a corrective bounce after the sharp sell off on June 9 and June 12. Both averages rallied from a low on June 12 to a high on June 14 to complete wave A. This bounce was followed by a decline to test the June 12 low for wave B, which ended on June 15. Today’s rally exceeded the high on June 14 by a small margin and either completed wave C, or will with a small move higher tomorrow.
Both averages have yet to retrace 61.8% of the decline from the June 9 high and June 12 low. The 61.8% retracement for the Nasdaq Composite is 6254 and is 5797 for the Nasdaq 100. As long as these levels aren’t breached, another decline below the June 12 low is possible.
For many weeks I have said the Financials could hold the key to the S&P. In the June 5 WTR I wrote,
“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. The Financials ETF (XLF) dropped to its prior low on May 17 and the bounce so far has lagged the market. The price pattern suggests the low on May 17 is likely to be broken and that XLF may fall to $21.70 in order to close the gap. If this weakness occurs when the technology flyers come down to earth a bit, the S&P could test the May 17 low of 2353. Without the participation of the financials, I doubt the move above 2400 will be sustained.”
The House of Representatives passed a bill to reform Dodd-Frank on June 8. In response the Financial ETF XLF was able to break out above $24.00 (blue line), a level it have previously tested only to fall back.
When XLF broke its rising trend line on March 17, it closed at $24.45 compared to $24.54 today. Since its sell signal on March 17, XLF is up less than 0.5%. Chart analysis suggests that XLF is still vulnerable to a decline that pulls it below the support at $22.90. From its high in early March, XLF declined in a clear 5 wave pattern which suggested that the larger trend had reversed from up to down. The rally since the low on March 27 has been quite choppy which implies that it is corrective bounce after the impulsive 5 wave decline off the high. The rally since the March 17 low appears to have completed an A-B-C rebound at today’s high which was marginally above the 61.8% retracement ($24.38) of the 5 wave decline. If this pattern analysis is correct, XLF will experience another 5 wave decline (C) that will bring it below the low of wave (A).
As discussed previously, near term the fundamentals for the Financials are not all that positive. The yield curve is more compressed now than at any time since last August when XLF was trading under $20.00. Banks are in the business of making loans but loan volume is barely growing. Volatility in most markets is extremely low, so the trading departments of the major banks are not having a field day. The reform of Dodd-Frank by the House is a big positive, but it must be passed by the Senate and any differences will then have to be reconciled. This will take time. The beneficial impact of a lessening in the regulatory burden is many months away, but the cited negatives will impact earnings in the second quarter.
Psychology has been the dominant driver of the market in recent months and enabled the market to ignore disappointing economic news, a change in Fed policy, falling oil and industrial commodity prices, and the lack of legislative progress on Trump’s growth agenda. While this persistence is impressive, it is reflective of a one-way mentality that historically doesn’t end well. In the short run, this Mindless Momentum can override the near term technical weaknesses cited in the market averages and in the pattern in XLF. We’ll know soon.
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 previously, 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 (Chart pg. 7).
The Utilities moved into the top 4 on June 2, but I chose not buy them since they were over bought and its RSI was 81.4 on June 2. On June 5, the Utilities ETF XLU opened at $54.28 and closed today at $53.92. The 25% that has been in cash from the sale of the Financials since March 17 will remain in cash for now.
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.
The Tactical U.S. Sector Rotation Model Portfolio is 75% invested – 25% in Technology, Consumer Discretionary, Industrial, and 25% in cash.
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.
