Written by Jim Welsh
Macro Tides Technical Review 07 August 2017
The DJIA had been up for 10 straight days through Monday, setting a new all-time high each day, as it ‘Runs for the Roses’, as Joe Granville would have said. Some of you may actually remember Jumpin’ Joe who was quite a character, but also the inventor of On Balance Volume and author of a number of astute market calls in the late 1970’s and early 1980’s. Joe had a deep disdain for the research published by Wall Street firms.
I saw Joe at an investment conference sponsored by E.F. Hutton, which in the 1980’s had a TV ad that said, “When E.F. Hutton talks, people listen.” As part of Joe’s show (no other way to describe it), Joe would play the piano, as a monkey would dance on the stage. The Monkey represented Wall Street Research. Joe used the expression ‘Run for the Roses’ to describe the last portion of a rally as the DJIA ran to new highs, but other averages failed to do so.
A look at how most averages have performed since July 24 through Monday illustrates that the headline grabbing all-time highs in the DJIA are masking the weakness in the rest of the market. As you can see, the S&P is the only other average that is at least positive during the DJIA’s record run and the S&P is up an underwhelming 0.4%. The unweighted S&P 500 that treats each stock in the S&P 500 as equal is down -0.3%, while the Russell 2000 has shed -1.7%.
This is the kind of price action that normally precedes a correction. But as the following information shows and the table below highlights, this has not been a normal market in 2017. According to Bespoke, the S&P has gone 274 days without a 3% pullback, which is the fourth longest in history going back to 1928. Mathematically this means the S&P hasn’t experienced a 5% pullback in 2017. The last time the S&P has avoided a 5% correction so deep into a year was in 1995 22 years ago.
Between 1900 and 2013, the DJIA experienced a 5% decline about three times per year, and a 10% correction about once a year. It has now been 18 months since the DJIA fell by more than 10%.
The lack of even a 3% correction is not just a U.S. phenomenon, but also applies to the European and Asian equity markets as well. The last time this trifecta occurred was in 1993.
As volatility has been squeezed out of financial markets by coordinated central bank policies, investors have piled into trades that have handsomely profited by shorting volatility on just about every asset class.
Shorting volatility has become a crowded trade as the Speculative Exposure in VIX Futures indicates. The short VIX position is the largest in history.
As I noted in last June, the lack of volatility is not limited to the US stock market but envelopes a broad list of asset classes. Based on rolling 26 week returns for 11 different assets classes that encompass 5 equity regions, four income categories, and two alternative asset classes, the level of volatility is the lowest of the past 22 years. Global investors are short volatility in many asset classes because it has been working. The risk is that a pick-up in volatility will quickly spread to other asset classes and start a chain reaction of selling as investors scramble to cover their losing short volatility positions.
I have no idea when this will happen, but believe it is just a question of time. Maybe something as off the wall as Venezuela defaulting on its bonds could provide enough of a spark to get it going. Congress is going to have to address the debt ceiling and their recent performance hardly inspires confidence. That should be obvious to everyone, but why is complacency so high about the outcome of the debt ceiling debate. I can’t imagine that the debt ceiling won’t go down to the last minute if not second.
As discussed the last two weeks, the market is entering a window of time that has coincided with tops in years ending in 7 and during the last 20 years. 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. The disparity between the DJIA’s action and the other major market averages are supportive of a top forming soon.
Dollar
As noted last week, the Dollar was nearing significant support between 92.00 and 92.50 and was deeply oversold with its RSI at 21.25. On August 2 the Dollar spiked down to 92.548 and then reversed sharply. This is the first encouraging sign in weeks of a low forming, but more basing is needed. Ideally, the Dollar will post a lower low so that a divergence can form in its RSI.
From a trading perspective, taking a small long position in the Dollar (1/4 or 1/3) if it drops below 92.50 is appropriate. The low in May 2016 was 91.92 so the risk is less than 1%. Adding to the position (1/4 or 1/3) on a definitive reversal, or after a bounce and subsequent retest of the trading low makes sense since there should be an RSI divergence. The Dollar has declined by more than 10% since January, so a rally of at least 3% to 4% is coming. A reversal of the downtrend in the Dollar could coincide with a reversal in a number of other markets that often benefit from a weak Dollar, ie oil, gold.
Click on any chart that follows for large image.
As noted last week, the Euro was extremely overbought as measured by its RSI. On August 2, the Euro spiked to a new high and then reversed. Since its RSI got so overbought, the Euro is likely to test its high again, which is why the Dollar may have another dip to a new low.
Fundamentally, the Euro’s strength amounts to tightening of policy since it will weigh on future inflation and certainly depress exports in the first half of 2018. This might lead Mario and the ECB to reduce their monthly bond purchases from $60 billion a month to $50 billion. Remember their first cut was from $80 billion to $60 billion so the expectation is that they will make another cut of $20 billion and bring their purchases down to $40 billion a month. Optimism in the Eurozone soared after the elections in France and the Netherlands went much better than feared. This high level of optimism is likely to wane in coming months. One of the first tests will come when Macron attempts to change labor laws in France. If it is met with widespread strikes, it will drive home the point that real fundamental change although badly need will still be hard to come by.
Gold
Three weeks ago I said that if Gold closed above $1250, a rally to $1280 – $1300 was possible. On August 1, Gold traded up to $1280.30 on the December contract before backing off. Gold still looks as if it wants to make a run at $1300. I do not think gold will breakout above $1300 on this rally, as commercials have increased their shorts on the recent bounce. If Gold does make a run toward $1300, my guess is the commercials will short even more aggressively.
Since peaking in early February, the gold Stocks as measured by the Gold Stock ETF GDX have been trending lower. In order to break out of this downward pattern, GDX would have close above $23.50, which doesn’t seem likely even if Gold tests $1300. The relative strength of the Gold stocks compared to Gold is still not showing any signs of life. A solid rally in the Gold stocks is not likely until they show some life. In recent days, every attempt to rally has been met by selling and GDX has consistently closed in the lower half of each day’s trading range. As long as this persists, the chance that GDX will trade down and close the gap at $19.43 is still alive and well.
Treasury Yields
Yields on 10-year and 30-year Treasury bonds have drifted lower after popping in late June into early July. Sooner or later, the yield on the 10-year Treasury bond is going to test 2.42% and probably make a run back to the high in March at 2.62%. This suggests that the intermediate trend is up in terms of yields.
As I have discussed previously, the longer term projection is for the 10-year yield to break out above 3.0% and potentially reach 3.4%. Since the low in July 2012, the 10-year has had two moves higher in yield and both were about 1.3%. My guess is that something similar will develop over the next year and an equal rally of 1.3% from the June low at 2.10% will lift the yield to 3.25% – 3.4%. Buyers will certainly come in if the yield reaches 3.0% as pension funds increase their allocation to Treasury bonds. If the 10-year yield drops below 2.20%, it would offer an opportunity to establish a partial short position. If the 30-year yield drops below 2.806%, it would offer an opportunity to establish a partial short position through one of the inverse ETFs.
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.
The Tactical U.S. Sector Rotation Model Portfolio is 100% in cash. The divergence between the DJIA and other major market averages has increased my conviction that the market is increasingly vulnerable to a pullback. 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. The red boxes in the table below highlight that the relative strength in 7 of the 12 sectors are making a new low during the past 6 weeks. Real Estate and Energy, although not red, are barely above their recent relative strength low. This is another indication that the majority of sectors are gradually weakening and not participating as the DJIA scales new heights.
Through July 31, the Tactical Sector Rotation program is up 8.52%.
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.
