Written by Jim Welsh
Macro Tides Weekly Technical Review 24 July 2017
If you type ‘Will stocks ever’ into your browser, Google will auto-fill this question with ‘Go Down Again’. This is the mentality that results when the S&P trades beyond 2 standard deviations as it has in 2017 and discussed last week (Has The Abnormal Become Normal?). Since 1928 (89 years) the S&P has averaged a decline of 11.2% in the first half of the year. The largest decline in the S&P has been 2.9% in 2017, about one quarter of the average and the second lowest ever.
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The S&P has not experienced a decline of 5% in more than a year. This is only the sixth time that has occurred since 1950, third time since 1965, and the longest stretch without a 5% pullback since 1995 22 years ago.
There have been 6,951 trading days since 1990 when the Volatility Index (VIX) was introduced. The average for the VIX since 1990 has been 19.51. The VIX has closed below 10.0 a total of 21 trading days since 1990, or 0.302% of the time. Of those 21 days, 17 have occurred since May 7. On Friday, the VIX posted its lowest close since December 1993.
At some point in the future asking ‘Will Stocks Ever’ will result in the autofill ‘Go Up Again.’ That will occur only after the S&P has declined for months on end and is trading more than 2 standard deviations on the left side of the Bell Curve. It may occur when global investors lose confidence in central bank’s ability to suppress volatility and lift economic growth.
If this ever occurs, it will be a seminal event because the majority of investors don’t believe it will ever occur. They may prove correct in this assumption, but ignoring the possibility is foolish since the potential downside could make 2008 look like a warm-up act. At the point when investors lose confidence in central banks, the S&P will already be in a downtrend. This is why incorporating technical analysis is essential if one wants to manage investment risk.
If the global economy falters, central banks will respond with more quantitative easing since they will feel compelled to act. Equity markets will respond vigorously and rally, but probably will not exceed the prior high, if the new round of QE fails to stabilize the financial system and economic global growth continues to slide.
It was said that not even God could sink the Titanic and we know how that turned out.
The faith investors have in central banks is almost absolute. Their success has been largely dependent on the willingness of investors to support and profit from central bank policies. If that faith is ever questioned, and I believe it will be at some point in coming years, the dam will break and panic will ensue.
The odds of this developing in the next year are extremely low, but knowing where the exit is will become increasingly important as this country struggles with issues like health care, social security, and ballooning debt.
The equity risk premium is defined as the reward that investors require to accept the uncertain outcomes associated with owning equity securities. The equity risk premium is measured as the extra return that equity holders expect to achieve over risk-free assets on average. It is important to note that the equity risk premium as it is used in discount rates and cost of capital analysis is a forward looking concept. That is, the equity risk premium that is used in the discount rate should be reflective of what investors think the risk premium will be going forward.
The Equity Risk Premium is lower than it was in 2007 and approaching the low reached in 2000. Since this is a forward looking indicator, it implies that the unwinding central banks of the experimental monetary policy since the financial crisis by will proceed without a hitch. Even if Janet and Mario perform perfectly, the risk reward seems asymmetrical since the risk premium is already near a 56 year low.
In other words, the market may go up if all goes well, but the downside risk if there is a bump or two is a multiple of the upside potential.
Fed officials rarely offer an opinion about valuations, but on July 13 Lael Brainard said that valuations look a bit stretched. Compared to the highs in 2000 and 2007 her assessment is somewhat conservative since this measure of financial assets is at an all-time high.
In June the Federal Reserve and Janet Yellen sounded hawkish and increased the federal funds rate to prove their point. In testimony before the Senate Finance Committee on July12, Yellen reversed course and sounded more dovish than she had less than a month earlier after the FOMC meeting. For 1 step forward, she took a ¾ step backward. The Fed has acknowledged that it has targeted asset prices since 2010 as part of monetary policy in the expectation that QE would boost asset values and lead to more spending.
Although asset values inflated, spending and GDP growth has been tepid when compared to the other 10 recoveries since WW II.
The question thus becomes whether there is an upside limit to how high asset prices can inflate before the Fed becomes concerned about the risk posed from higher asset values. In 1999 and 2000, Alan Greenspan decided the Fed did not possess the tools needed to identify an asset bubble which is why the Fed did nothing even as the dot.com bubble kept inflating. Between November 1999 and March 2000, the Nasdaq Composite doubled in price. Greenspan may have been chastened by his irrational exuberance comment in December 1996 which proved embarrassingly premature. The S&P doubled from its level in December 1996 until the high in March 2000.
Greenspan’s Fed decided it was capable of handling the fallout from a bubble rather than trying to anticipate and address it. This decision led to an 80% decline in the Nasdaq, a shallow recession in 2001, and negative interest rates. There were many contributing factors to the housing bubble and crisis, but negative interest rates were a big factor. The lesson central bankers should have learned by now is that extreme policies cause unintended negative consequences which have led to even more experimental monetary policies via negative interest rates in Europe and Japan and QE everywhere.
The challenge facing the Fed and ECB is whether they deem it better try to let a little air out of the bond and equity bubbles in coming months, or just trust their ability to ‘manage’ markets if they throw a tantrum.
Click on any chart that follows below for large image.
The most recent unintended consequence has been the 12.9% rally in the Euro just since January. The strength in the Euro constitutes a tightening of policy since it makes exports from the Euroone far more expensive. In March 2014, Mario Draghi made a number of comments of how the strength of the Euro since July 2012 had shaved 0.4% off the EU’s already low inflation rate. These comments led to a reversal in the Euro in May 2014 and subsequent 24.7% decline from $1.399 to under $1.05 in March 2015. The large decline in the Euro led to a major rally in the Dollar Index which rose from under 80.00 in May 2014 to 100.39 in March 2015. After the ECB’s September meeting, Mario Draghi is likely to directly or indirectly address the strength in the Euro by tying it to the pace of reductions in the ECB’s bond buying program or normalizing interest rates from -0.40%.
The strength of the Euro is the main reason why the dollar has been so weak in recent weeks since the Euro represents 57% of the Dollar Index. The Dollar’s weakness has led to the largest short position in the Dollar since 2012. That extreme positioning was followed by a 5% to 7% rally in the Dollar in the first six months of 2013. Conversely, large speculators have the largest long position in the Euro since 2011.
The Dollar sliced through the support between 94.60 and 95.10 cited last week. Far more significant support comes in between 92.00 and 92.50. From a trading perspective, one either waits for the Dollar to fall into that support area before establishing a partial position, or waits for a reversal. If one is going to catch a falling knife it is better to do it near significant support.
If Draghi does make either a comment or an insinuation, the Euro has the potential of dropping sharply as Euro bulls are forced to liquidate longs and Dollar shorts are forced to cover short positions. The unwinding of record positions in the Dollar and Euro could result in a large move. Volatility has been historically low in the stock and bond markets, but has already picked up in the foreign currency market. My guess is that it is likely to spill over into the equity market in the next few months.
Stocks
The Decennial pattern suggests that a top in the S&P is likely within the next few weeks, if the pattern in years ending in 7 holds true. The trading pattern in the last 20 years also supports the potential of a top in the S&P soon. Both patterns suggest a decline is coming that could last until late October or early November. Who knows the S&P may even decline by 5%! (Sarcasm alert!)
Gold and Gold Stocks
Gold closed above $1250 so the short term trend is positive and a rally to $1280 – $1300 is possible. Gold and the Dollar don’t always trade inversely to each other, but a rally is coming in the Dollar. Gold will be over bought if it rallies a bit more and vulnerable to a correction that could drop gold back to $1200 if the Dollar rally proves dynamic. Gold is well above the trend line connecting the low in December 2015 and December 2016 which is currently near $1170 and is likely to hold even if the Dollar rallies.
As noted last week, GDX has broken below the trend line connecting the January 2016 low and December 2016 low. This suggests that the gold stocks could be vulnerable to more weakness and that GDX could close the gap it left at $19.43 as it rallied off the December 2016 low. Short term GDX bounced back to the underside of the black trend line, and today fell sharply even though gold was up marginally. This looks like a failure and could portend a bout of weakness in the gold stocks. The relative strength of the gold stocks to gold reversed higher with today’s weakness in GDX indicating that gold stocks are likely to underperform in coming weeks.
Treasury Yields
The yield on the 10-year Treasury bond jumped from 2.103% on June 14 to 2.396% on July 7 an increase of 0.293%. A 61.8% retracement of this move would target a decline to 2.213%. On Friday July 21 the yield fell to 2.225% and the yield on the 10-year German Bund dipped to 0.505%. This is significant since the German Bund recently broke out above 0.50%, so the decline back to 0.50% is a classic retest of the breakout. This ‘coincidence’ suggests that the next move in bond yields in the U.S. and Germany is up.
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.
As discussed in the July 17 WTR, the correlation between the S&P 500 and DJIA and Nasdaq is the lowest since 2003 and 2001. This has resulted in a pronounced acceleration in the rotation between various sectors. In a couple of instances, a sector has rallied enough to make it into the top 4, only to fade. For instance, the Utilities moved into the top 4 on June 2, but I chose not buy them since they were over bought with the RSI at 81.4. On June 5, the Utilities ETF XLU opened at $54.28 and closed today at $52.79. The 25% that has been in cash from the sale of the Financials since March 17 has remained in cash.
On June 26, I reduced the exposure to Technology from 25% to 12.5% XLK when it was trading at $56.10. On June 23 Health Care edged out Industrials to move into fourth place, but its RSI was above 80 on June 23. I determined that this was not a low risk entry point. On June 26, Health Care XLV opened at $80.70 and today closed at $80.96.
When XLK was trading at $54.41 on July 3 I sold the remaining portion of XLK. Today, XLK closed at $57.61. 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. On July 3, the position in XLY was lowered from 25% to 12.5% after selling 12.5% at $89.80. The remainder of the position was sold on July 6 at $88.45. Consumer Discretionary dropped out of the top 4 on July 7 and would have been sold on the opening on July 10 at $89.71. The Industrials (XLI) made it into the Top 4 on November 18, 2016 and fell out of the top 4 on June 23 and should have been sold at the opening on June 26 at $68.21. XLI was sold on July 24 at $68.63, which is also where is closed.
The Tactical U.S. Sector Rotation Model Portfolio is 100% in cash. Obviously, some additional gains in Technology were not realized by selling XLK, but I am well positioned for that elusive 5% correction. I suspect that if a correction materializes, it will develop almost without warning and could be fairly sharp. If that occurs, moving to cash in anticipation of the correction may be an advantage.
Through July 24, the Tactical Sector Rotation program is up 8.52%. The quantitative version of the Tactical Sector Rotation program, which does not include any discretion, is up 7.1%. The difference is that the quant version would have purchased the overbought sectors when they moved into the top four and been hurt by the rapid rotation in recent months.
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.
