Written by Jim Welsh
Macro Tides Technical Review 11 December 2017
Institutional Mindset
With the end of the year less than 3 weeks away it worth thinking about how money managers, mutual funds, and hedge funds will want to show their clients how they were positioned on December 31.
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With few exceptions these professionals will want their clients to see that they are close to 100% invested. What most institutional investors will not be doing is increasing their allocation to cash before the end of the year.
The table below shows how much each sector contributes to the S&P 500. Information Technology (IT) has the largest weighting by far with 23.93% compared to 14.82% for Financials. The IT sector has been led by mega cap tech stocks and has gained more than 30% in 2017, so it has contributed far more to the S&P’s gain in 2017 than any other sector. The Financials are in second place with an increase of 19.7%.
The only difference between what professional money managers’ portfolios will hold on December 31 will be which sectors they over weight or underweight relative to the sector’s weighting in the S&P 500. Most will lean toward overweighting the sectors that have outperformed the S&P 500 in 2017, which means Information Technology and Financials will be over weighted. The underperformers in 2017 have been Energy, Consumer Staples, and Real Estate. Money managers hope that overweighting the winners of 2017 and underweighting the losers will make them look smart going into 2018 even if their performance lagged in 2017.
The majority of equity money managers will lag the S&P unless they were over weighted the FAANG stocks which accounted for a large share of the increase in the S&P 500 in 2017.
The correlation between S&P sectors is the lowest since 2000, which is the last time IT stocks were so in favor. The Head Spinning Rotation I discussed last week is reflective of the extraordinary rotation the market has experienced since last spring. As a contrarian I will go out on a limb and forecast that in 2018 the correlation between S&P sectors will increase. This implies that a rotation out of IT will unfold sometime in 2018 and contribute to a correction in the S&P since the IT sector carries the largest weighting.
Ironically, the cut in corporate taxes could be a factor since technology and software companies will benefit far less than many other sectors. With the 2017 gain of over 30%, IT likely represents a larger than 23.93% weighting in a lot of portfolios. IT companies already sport a relatively high P/E ratio, so money managers may be inclined to trim their IT holdings to the benchmark S&P 500 weighting in the first quarter of 2018 and use the proceeds to buy stocks that will benefit more from the tax cut and have a lower valuation.
As I discussed last week, the improvement in relative performance of value stocks versus growth stocks follows two prior attempts that failed to reverse the trend – in June and September as noted by the blue lines.
“When the relative strength line (black line) is above the blue 134 day average, it indicates that Value is doing better than Growth and weaker when it is below the moving average. Despite last week’s fireworks, the jury is still out on whether last week’s trading represents a true reversal since the black relative strength line is below the red trend line and blue moving average. During February and March 2016, the relative strength of the Value stocks built a small trading range (base) before decisively breaking out in April. I suspect something similar will occur between now and the end of January. The rotation out of big name growth stocks last week (FANG) is likely to be used by some investors as an opportunity to buy the big name growth stocks. If this does take place, the Value stocks will lag for a time. It is premature to determine whether the shift into more cyclical oriented sectors like Industrial, Financial, and Transportation stocks is the beginning of a multi-month trend or just a quick rotational blip.”
Click on any chart below for large image.
As expected, the selloff in the big name growth stocks was viewed as a buying opportunity. The Nasdaq 100, which is dominated by FAANG stocks looks like it will rally to a new high soon. The bounce in the big name tech stocks has caused the relative strength of the Value stocks to once again slip further below the red down trend line and the 134 day moving average.
A more important trigger that could cause money to flow out of growth stocks may come from interest rates if they increase during the first quarter as I expect. The Fed will increase the federal funds rate at the FOMC’s meeting on December 13. I do not expect the FOMC’s post meeting statement to rock the boat. The gavel will be passed from Janet Yellen to Jerome Powell in February and it seems unlikely that the Fed would say anything that suggests it will deviate from the gradual pace of rate increases until he sits in the Chairperson’s chair. The Fed’s dot plot reflects what each individual member of the board expects for the federal funds rate and inflation in 2018 and 2019, and might attract attention if it changes much from the prior meeting. I don’t expect it will.
The ECB meets on Thursday and will not drop its commitment to tying its QE program with the attainment of inflation reaching its 2.0% target. As I discussed in the December issue of Macro Tides, the ECB is likely to drop its commitment to 2.0% as a precondition for modifying its QE program in 2018. In a November 21 interview Benoit Coeure, who is the head of operations at the ECB said:
“I expect this link to change when the governing council is sufficiently confident that net asset purchases are less needed for inflation to return towards 2 percent in a sustainable way. We were not ready to make that change in October, but I expect it will come at some point between now and September 2018.”
Even though economic data in the Eurozone has continued to come in better than expected since November 21, I doubt the confidence of a majority of those on the Governing Council is sufficient to make that change. As such, the ECB’s meeting is likely to represent a non event.
Market Internals
On October 13, 68% of the stocks on the NYSE were above their 200-day average when the S&P posted a new high of 2557. Even though the S&P keeps logging new closing all-time highs, fewer stocks are participating in the party. Normally, this would represent a yellow warning flag of an impending set back, but the seasonal influence can override this risk going into the end of the year.
After spiking into a high on December 4, the percent of NYSE stocks making a 52 week high continues to diverge significantly with its mid October level which indicates the breadth of leadership is narrowing.
Between August 18 and October 20, the S&P 500 rose from 2425 to 2575, an increase of 150 S&P 500 points. During this time the cumulative Advance / Decline line rose by a 15,196 issues, or by 101 issues for each 1 point increase in the S&P 500. The S&P 500 has rallied from 2575 to high of 2651 on Friday or 76 S&P 500 points. During this gain, the Advance / Decline line only increased by 2,106 issues through Friday, or by 27.7 issues for each 1 point increase in the S&P 500.
This is an indication that the S&P 500 is becoming increasingly dependent on a shrinking number of big cap stocks to keep the uptrend in price intact. Cleary, the market has been losing internal strength since October 20.
Dollar
Unless the Dollar rises above the neckline of the inverse head and shoulders at 94.25, the downtrend is intact. There is a good chance the Dollar will test the September low of 91.01 in the first quarter before a potentially major rally commences. There remains a very large short position in the Dollar and an above average long position in the Euro. If the Dollar is able to close above 94.25, a bout of short covering is likely to push the Dollar higher as short positions are covered.
I think the concept that markets discount the future is hogwash. This is another example of misleading Wall Street ‘wisdom’, which is why I’m repeating it from last week’s WTR. According to the sages of Wall Street markets are a discounting mechanism. Since December 2016 the Federal Reserve has raised the federal funds rate three times with a fourth hike coming on December 13, and the US economy has produced two quarters of better than 3% GDP growth for the first time since 2014.
The Dollar Index will have declined more than 10% from 103.00 on December 15, 2016 so what exactly was the Dollar discounting in December 2016? So much for the direction of interest rates in dictating the direction of a currency! A test of the September 8 low at 91.01 is coming, but may not occur until January.
Euro
As long as the Euro holds above the neckline of its head and shoulders pattern near 1.1675, the trend is up and a rally to 1.2200 seems likely. The positioning in the Euro is already imbalanced to the long side. If the Euro does rally to 1.220 it would likely offer an opportunity to go short the Euro, and long the Dollar, especially if the Dollar trades below 91.30.
Treasury Bonds
Not much has changed. The yield on the German 10-year Bund closed today at 0.295% so it continues to be an anchor for the 10-year Treasury bond yield.
The 10-year German Bund yield is likely to climb above 0.50% in the first half of 2018. If and when it does, it will represent a technical breakout and suggest a move up to 0.75% – 0.90% could follow quickly. If the spread between the 10-year Bund and 10-year Treasury bond holds near 2.0%, the Treasury yield would breakout above the March high at 2.62%. This would open the door for a move to the December 2013 high of 3.03% in the first half of 2018.
A move up to 3.17% to 3.20% on the 30-year Treasury bond, the highs last December and in March is likely in the first half of 2018. It took nine months for the yield to rise from 2.20% to 3.20%. An equal move in yield and time suggests the yield on the 30-year Treasury could approach 3.75% by June of next year
Gold and Gold Stocks
The positioning in the futures market showed a marked improvement in the data through December 5 after Gold tested support near $1260. The smart money Commercials lowered their short position from -246,541 contracts to -189,890 contracts last week and Producers cut their short position from -184,757 contracts to -158,420 contracts. This indicates that as Gold dropped to support near $1260, the Commercials and Producers were fairly aggressive in covering their short positions. As expected, Gold subsequently fell below $1260 and it is likely the Commercials and Producers reduced their short positions even more. The data through December 12 won’t be available until Friday afternoon.
The improvement suggests that it is time to look for an entry on a partial position since there remains downside risk in Gold and the Gold stocks, in part due to tax loss selling. Gold stocks continue to underperform Gold which is another negative. From a high of $1357 on September 8, Gold dropped to $1260.72 on October 6. From the high of 1305 on October 16, an equal decline of $97 would bring Gold down to under $1210. However, the RSI on Gold and GDX is near 30 so both are already somewhat oversold.
A 25% position is recommended if Gold drops below $1230 and GLD trades under $117.00, which should be increased to 50% if Gold falls below $1215 and GLD trades under $115.00.
As expected the Gold stock ETF (GDX) closed below $22.60, and noted last week a close below $22.20 would usher in a new leg lower. GDX traded down to $21.40 today which pushed its RSI down to 30. Tax loss selling could push GDX down below $21.00. A 25% position is recommended if GDX trades under $21.30 which can be increased to 50% if GDX trades under $21.00. The relative strength of GDX to Gold is continuing to weaken which is why buying weakness is advised. If and when the relative strength of GDX closes below its blue moving average and the black trend line, a more aggressive position will be warranted.
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. The MTI continues to indicate that a bull market is in force.
Although the Major Trend Indicator is positive, the MTI has been posting lower highs since peaking in early March. Since late July, the odds of the S&P continuing the streak of no corrections of either 3% or 5% seemed quite low based on historical patterns and signals from a number of reliable technical indicators. The Tactical U.S. Sector Rotation Model Portfolio has been 100% in cash since July 24 based on the probability of a 5% correction. In my judgment (so far incorrect), upside potential has been limited relative to the level of risk.
Through November 24, the Tactical Sector Rotation program is up 9.6%. Although the Major Trend Indicator is below its peak registered in early March, the MTI continues to hold above the green horizontal line which is another sign that the market is not yet vulnerable to a decline greater than 10% or a major trend change.
Since mid August I have tried to identify special situations that were uncorrelated to the stock market and oversold. On August 24 I purchased the Powershares DB Agriculture fund (DBA) at $18.66 and sold it on November 15 at $19.02. On August 29, I purchased the Dollar ETF (UUP) at $23.83, since I thought the Dollar was poised for a rally. This position was sold on November 14 at $24.43. On October 27, I purchased the VanEck Oil Services ETF at $23.67. This position was reduced by 40% on November 8 at an average price of $25.79. The balance was sold on December 4 at $25.42.
A partial position to short long term Treasury bonds was established on December 7 when the 30-year Treasury bond was yielding 2.71%. This was accomplished by buying the short Treasury bond ETF (TBF) at $21.73. This ETF is NOT leveraged and moves inversely with 30-year Treasury yields. If long term yields rise in the first half of 2018 as expected, TBF will rise in value.
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.
