Written by Jim Welsh
Macro Tides Technical Review 14 August 2017
In the July 31 WTR I noted:
“The market appears impregnable to any news. In just the last week the stock market hasn’t noticed or cared that the Republicans failed to pass any health care bill, the Fed confirmed they are going to start shrinking their balance sheet before year end, North Korea launched a missile that may be capable of reaching Denver, and a revolving door was installed at the White House to accommodate the rapid changing of personnel. This myopic lack of focus on what’s going on in the world at large is going to change at some point.”
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For one day last week financial markets did focus on North Korea and the equity market sold off sharply. On a closing basis the S&P shed -1.72% between its close of 2480.91 on August 7 and Thursday August 10 of 2438.21. The S&P’s streak of not experiencing a 3% in 2017 was not broken, so those worried about the streak can breathe a sigh of relief. According to Bespoke, the S&P has gone 279 days without a 3% pullback, which is at least the fourth longest stretch since 1928.
Click on any chart below for large image.
After last week’s sharp drop, most investors can’t be faulted for humming Peggy Lee’s great song from 1969 that asks a very pertinent question:
Is that all there is, is that all there is
If that’s all there is my friends, then let’s keep dancing
Let’s break out the booze and have a ball
If that’s all there is
Today’s pop suggests that for the buy the dippers, last week’s decline was all there is to the correction. Under normal circumstances I would say there is more correction to come, but this has been no normal market. Still, this type of sharp break and quick recovery is what often develops as the topping progresses.
As the S&P was grinding to new all-times in late July and on August 7, the S&P’s RSI was posting lower highs. This negative divergence along with the fractured trading between the DJIA and S&P, which made new highs on August 7, and the other major market averages noted last week, was the classic set up for a pullback. At the closing low on Thursday, August 10, the S&P’s RSI was the lowest (36.3) since the low on April 13 (34.4).
In addition to the market being modestly oversold on price, the internal momentum of the market, as measured by the 21 day average of net advances minus declines and the 21 day average of net new 52 week highs minus new lows were a bit overdone. The AD 21 oscillator was the lowest since mid March and the HL oscillator was the lowest since late April.
With this set up, today’s rally should not have been a surprise. After gapping higher at the opening, the S&P was gained less than 3 points after the first hour of trading, as can be seen in the 30-minute chart below. That’s not impressive.
In addition, the Equal Weight S&P, which gives each of the 500 stocks in the S&P 500 an equal representation, and the Russell 2000 have been increasingly lagging behind the S&P 500. The Relative Strength of the Equal Weight S&P broke below the red trend line in mid May and its relative strength has fallen sharply since early July. At last week’s low, the Equal Weight S&P tagged the blue trend line and has bounced.
The Russell 200 provides a better picture of how the broader market is performing and the picture since late July is not pretty. At last week’s low, the Russell bounced off the black trend line connecting the February 2016 low and November 2016 low. I expect the Russell to break below this trend line.
On December 9, 2016, the Russell reached 1392 and closed today at 1394. In 8 months the Russell has gained just 2 points. A close below the blue trend line at 1350 could lead to a quick drop to 1250-1270.
Although the DJIA, the Nasdaq Composite and Nasdaq 100, and possibly the S&P may make new all-time highs before Labor Day, the deterioration under the surface suggests the risk for a deeper correction is rising. As discussed in the July 31 and August 7 WTR’s, for more than 150 years, years ending in 7 have usually experienced a period of weakness from early August through late October. A seasonal pattern of weakness during this window of time has also been prevalent during the past 20 years. This suggests that surprises are more likely to be negative than positive. The crack in the market last week is setting the market up for a break.
Dollar
Not much has changed during the last two weeks. As noted in the July 31 WTR, the Dollar was nearing significant support between 92.00 and 92.50. On August 2 the Dollar spiked down to 92.548 and then reversed sharply. This was the first encouraging sign that a low was beginning to form. 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 92.93 is appropriate.
The low in May 2016 was 91.92 so the risk is about 1%. Adding to the position (1/4 or 1/3) on a definitive reversal, or after a bounce and subsequent decline below the 92.54 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.
Oil
The positioning in oil futures contracts suggests WTI crude oil could drop to $42.50 and potentially to under $40.00 in coming months. Large speculators are holding more long contracts than when Oil was trading near $100 a barrel and almost as many when Oil topped last February. Large speculators are trend followers who typically hold their largest long or short position near a top (long) or bottom (short).
Commercials are considered the smart money and take the opposite side of the trades of Large and Small speculators. As a result, they are holding a very large short position.
Oil Stocks, as measured by the Energy ETF (XLE), are not trading well and today XLE posted its lowest close since April 2016. The 61.8% retracement from the low in January 2016 at $52.33 to the high of $78.45 in December 2016 comes in at $62.30. At the low in January 2016, XLE’s RSI posted a large positive divergence, (Green line on RSI) even though it was much lower in price than in September 2015. If a similar divergence develops in coming months, the Energy stocks will offer a good buying opportunity.
Gold and Gold Stocks
Four 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. Last week I thought Gold still looked as if it wanted to make a run at $1300. On Friday August 11, December Gold traded up to $1298.10. I still do not think gold will breakout and close above $1306, as commercials have increased their shorts on each rally over the past month. A pullback below $1245 is possible.
In February, December Gold was trading just over $1250 and the gold Stocks as measured by the Gold Stock ETF GDX topped at $25.70. Gold is now more than 3% higher, but GDX is more than 11% lower. It would be an understatement to say the gold stocks have been lagging gold during the past 6 months. As noted last week, the relative strength of the Gold stocks compared to Gold is still not showing any signs of life. As long as this persists, the chance that GDX will trade down and close the gap at $19.43 is still alive and well. A close above $23.50 would be a short term positive.
Treasury Yields
One of the primary reasons I thought Treasury bond yields were likely to decline last March was the positioning in the bond futures. Commercials were holding their largest long position in many years, while the Large Speculators were holding a record short position in anticipation that the yield on the 10- year Treasury was about to soar to 3.0%. My guess was that the yield on the 10-year was going to fall below 2.20%, which it subsequently did.
The positioning in the futures market has reversed with the Commercials now short 10-year Treasury futures and the Large Speculators holding a larger long position than last July when bond yields were bottoming and bond prices topping.
As recommended last week, 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. On Friday, the yield on the 10-year Treasury dipped to 2.182% and the 30-year fell to 2.769%. If the stock market suffers a deeper correction as expected, bond yields could fall to near their June low of 2.103% and 2.682%, which is why I recommended a partial position.
The long 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.
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. As noted last week, the divergence between the DJIA and other major market averages has increased my conviction that the market is increasingly vulnerable to a pullback. The weakening of the broader market, as measured by the Equal Weight S&P 500 and the Russell 2000, suggests that the topping process is continuing. 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 9 of the 12 sectors are making a new low during the past 6 weeks versus 7 last week. This is another indication that the majority of sectors are gradually weakening and supportive of a correction.
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 N
