Written by Jim Welsh
Macro Tides Technical Review 26 June 2017
What Are the Odds?
Since 1928 (89 years) the S&P has averaged a decline of 11.2% in the first half of the year. So far in 2017, the largest decline in the S&P has been 2.9%, about one quarter of the average and the second lowest ever. With one week remaining in the first half of 2017, and given the level of the volatility index as I write this (9.87), it’s probably a safe bet the S&P’s maximum decline of 2.9% won’t be exceeded this week!
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Data on the volatility index (VIX) goes back to 1990, so there has been 7,120 trading days, assuming an average of 250 trading days per year. The VIX has closed below 10.0 a total of 12 trading days since 1990, or 0.154% of the time. Of those 11 days, 8 have occurred since May 7.
These statistics are remarkable all by themselves, but even more so given the environment in which they were recorded. The correlation between the S&P and the economy is fairly high, which makes sense. When expectations for the economy are met or exceeded, the S&P usually does OK and well if expectations are surpassed.
Not surprisingly, the S&P usually falls if economic data comes in less than what has been forecast. As can be seen in the comparison between the S&P and the Citi Economic Surprise Index, the correlation remained fairly tight up until mid April when data began to come in under expectations. This chart goes through May 26 and since then the S&P is up about 1%, but the Surprise Index has fallen to -78 as of June 19 from -38 as depicted in the chart. The gap between the S&P and the economy has gotten wider.
This isn’t the only anomaly.
Although the stock market has dismissed the softer economic data, the bond market has not. Since mid March, yields on the 10 year and 30 year Treasury bonds have fallen from 2.62% to 2.12% and to 2.69% from 3.2%. In mid March I thought Treasury yields were going to decline and recommended TLT.
Click on any chart below for large image.
In the March 13 WTR, I wrote,
“If upcoming economic numbers show a bit of softness, those short may be forced to cover quickly, which would lead to a rally in Treasury bonds and cause yields to drop. The Treasury bond ETF (TLT) has dropped below its mid December low of 116.80. Now that TLT has made a new price low, it is possible to count the pattern from the price high last July as a 5 wave decline. A 38.2% retracement would lead to a rally to 126.00 or so, while a 50% retracement would bring TLT back up to 129.00. TLT has a good chance of making a low within a day or two of the Fed meeting on March 15. Any price reversal would shift the odds to a low being in place.”
The low in TLT at $116.49 occurred on March 13, two days before the Fed increased the federal funds rate on March 15. This morning TLT traded as high as $128.57 so it is near the 50% retracement level of $129.00. The yield on the 10-year Treasury could fall to 2.0% as I have discussed (June 5 WTR), but it is certainly time to sell at least half of the TLT position.
The decline in rates has been being fueled by weaker than expected economic data and declines in inflation in the last few months. This has led many market participants to doubt whether the Fed’s more hawkish talk will actually be followed by a rate increase in September or even December.
The green line shows what the market believes the Fed will do with rates compared to what the Fed has projected (red line). In 2019, the Fed says the federal funds rate will be 3.0%, but the market thinks 1.5% is more likely. This is an enormous gap. Something’s got to give and the market believes it will be the Fed.
In mid February WTI oil traded above $54.00 after OPEC affirmed that members were adhering to the agreement. According to the Intercontinental Exchange and the CFTC, money managers held the largest long positions in oil futures and option contracts on record. With OPEC holding down production, the consensus was that oil prices could trade above $60 a barrel and money managers were positioned for the rally. Between mid April and last week, WTI oil dropped by more than 20%, which caused the oil stock ETF (XLE) to fall by more than 10%. The decline in oil and oil stocks had virtually no impact on the S&P as other sectors rallied.
For years the stock market benefited from extremely accommodative monetary policies – rates near 0% for 7 years and three quantitative easing programs. Even after four rate increases, monetary policy is still accommodative since real interest rates are below zero. The federal funds rate is 1.12% and the PCE measure of inflation is 1.7%, so the real fed funds rate is -0.58%.
Initial interest rate hikes have rarely derailed a bull market and this cycle has been no exception. The stock market is able to overlook the initial increase in the cost of money because economic growth is strong which is expected to boost earnings. The Fed has increased the funds rate 3 times in the past six months, even though economic growth has slowed from the third quarter of last year. More importantly, the Fed indicated a more hawkish outline of future rate increases and how it plans to shrink its $4.5 trillion balance sheet.
S&P 500
Since the S&P reached 2400 on March 1, I have expected the S&P to correct 4% to 5%. Bullish sentiment had become extreme and I thought the economy would slow in Q1 and not rebound as strongly as forecast in the second quarter. I expected bond yields to decline as economic data confirmed the slowing in the economy and the S&P would follow with a modest correction. Technically, there have been indications that the upward momentum in the S&P was waning, which is usually a precursor for a modest correction. When the S&P closed at 2440 on June 2, the RSI was 70.3 compared to 82.4 on March 1. The percent of stocks making a new 52 week high peaked on December 9 and has made a series of lower highs.
The cumulative total of net volume peaked in February and has not confirmed the successive new highs in the S&P. The percentage of stocks above their 200 days average also peaked in February at 72%. When the S&P closed at 2430 on June 14, the percent had dipped to 65%.
The deterioration in these and other indicators was not life threatening for the market but it did suggest the S&P was vulnerable to a modest correction of 4% – 5%. Many advisors have told me they appreciate the level of precision and clarity I provide. I state what I expect and why, and provide specific S&P levels. I generally target the outcome that has the highest probability of occurring.
Given the deterioration in the technical indicators and the failure of economic data to meet expectations, I would have pegged the probability of a 4% – 5% correction at 80% to 90%. The odds of a 7% decline at 50% to 60%, and maybe 20% or less for a 10% decline, since the deterioration in the technical indicators wasn’t that bad and the economy is still growing at 2% or so.
I would have put the odds of the S&P rising by 1.5% with volatility remaining historically low, despite disappointing economic growth, lower bond yields, and narrowing spreads at less than 5%.
The primary reason the S&P has been able to avoid a modest correction has been an accelerated rotation between various sectors within the S&P. Instead of all the sectors pulling back together, each sector has experienced a breakout to the upside while other sectors have traded sideways or corrected. Since this process has been going on for awhile, money poured into the biotech sector last week after it broke out last Monday. The S&P Biotech ETF (XBI) rallied more than 6% from last Monday’s close to today’s high. This helped the Health Care ETF (XLV) within the S&P, which was up 2.5% from last Monday.
Of the ten S&P sectors, 8 have experienced a breakout, while energy has declined. Real estate (XLRE) is pressing its resistance line and may breakout soon. The problem with Real Estate is that the overall fundamentals are poor, other than having a decent yield. Even if Real Estate does breakout, it unlikely to run like biotech did.
After breaking out, most of the sectors have rallied 3% to 4% for 3-4 weeks and then rolled over. The exception was Technology. Most sectors remain above their break out level, but Staples and Financials have come back to their break out points. Since every sector has had its opportunity to shine, it is difficult to see how the S&P can make much upside progress from here now that the rotation game has apparently run its course.
Expectations relative to how the economy has performed in the second quarter were too high. This suggests the next step is for expectations and earnings projections to come down for the second half of 2017. Any revision lower will come with a caveat, unless Trump’s growth agenda is passed by Congress. The market may ignore any downward revisions, as it has dismissed everything else in recent months, but the odds don’t favor that outcome.
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. The Utilities moved into the top 4 on June 2, but I chose not buy them since they were over bought and the XLU since the RSI was 81.4. On June 5, the Utilities ETF XLU opened at $54.28 and closed today at $53.57. 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.
After the big jump in Health Care last week, it edged out Industrials to move into fourth place. Its RSI was above 80 on Friday, so this is not a low risk entry point. This morning Health Care XLV opened at $80.70, the high for the day before closing at $80.39. I will continue to hold Industrials.
This morning Technology stocks gapped higher at the opening and immediately were hit with selling pressure. Clearly, investors are using the tech stocks as a source of cash to invest in other sectors, which is why market breath was positive on the NYSE and Nasdaq despite the lower closes in the Nasdaq Composite and 100. This process is likely to continue as investors rebalance their portfolios and take some profits off the table in the FAMANG stocks that on average are up more than 30% this year. This morning I reduced the allocation to Technology (XLK) from 25% to 12.5% when XLK was trading at $56.10.
The Tactical U.S. Sector Rotation Model Portfolio is 62.5% invested in stocks – 12.5% in Technology, 25% Consumer Discretionary, and 25% Industrial. 37.5% is in cash.
Dollar
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 98.20. I expect the Dollar to succeed in bridging 98.20, but it needs to prove itself by doing so. 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 over the next 2-3 months.
Euro
Large speculators are 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. The Euro has broken the uptrend from the mid April low, but needs a close below 1.1080 to confirm at least a short term top.
Gold and Gold Stocks
As noted last week, the Gold stock ETF GDX was 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 seemed likely, which has transpired. GDX may be able to rally up to $23.00 or so. 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 improved last week but is still above the red trend line. The RSI is near 50 so pricewise it is in no man’s land.
Gold has twice failed to breakout above $1300 but continues to hold above the trend line connecting the mid March and mid May low. I would be surprised if gold didn’t bounce if it dropped to the trend line near $1230. Like the gold stocks, gold is in no man’s land until it closes above $1280 or below $1225. I still favor a decline to near $1200 before gold rallies above $1300 and eventually above last July’s high of $1385.
Oil
As noted last week, a close below $43.75 could be followed by a flush to near $40.00. Despite any near term bounces, oil looks destined to test $40.00 a barrel. Last week the High Yield ETF (HYG) and Junk bond ETF (JNK) broke below the rising trend line connecting the low last November and low in March. Both have bounced with the rebound in oil and appear to be testing the underside of the trend line broken last week. A failure to reclaim the trend line followed by a close below last week’s low would confirm a top.
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.
