Written by Jim Welsh
Macro Tides Technical Review 05 March 2018
The market shrugged off the risk of a trade war and enjoyed a nice rally today. Investors, at least for today, concluded that Trump’s push for steel and aluminum tariffs will never happen since the push back was quick and widespread, or were just a bargaining lever to get Canada and Mexico to accept more concessions in the NAFTA negotiations.
I have no idea what Trump’s motives are and how steadfast he will be in pursuing tariffs. The willingness to dismiss his tariff proposal so quickly makes me a bit wary that investors are hoping he will drop the tariffs just so the market can go up. After record setting periods without a 3% or 5% correction, a pullback is annoying and if Trump just gets over his tariff fetish he can get back to tweeting about new stock market records.
This narrative overlooks that Trump campaigned on renegotiating long standing trade agreements and is following through on his campaign pledges. In Trump’s speech at Davos Switzerland on January 26, he said:
“The United States will no longer turn a blind eye to unfair economic practices, including massive intellectual property theft, industrial subsidies and pervasive state-led economic planning.”
This comment was primarily directed at China. Few would disagree with the goal of fair trade. As always the devil is in the details. The proven history that tariffs and trade barriers are bad economic policy doesn’t mean much to someone who thinks “Trade wars are good and easy to win.”
It’s one thing to campaign on the premise that previous administrations have done a terrible job in negotiating trade deals that are costing America jobs and billions of dollars every month. It’s another to announce tariffs that are going to adversely affect friendly trading partners like Canada, South Korea, and Mexico when the intended target – China- is barely affected.
If Trump’s tariff proposal is intended to make Canada and Mexico more pliant during NAFTA negotiations, it seems a backassward attempt. A frontal assault is not the best approach if one wants our trading partners to make changes and be able to sell them back home. How can our trading partners negotiate and make concessions without looking weak to their countryman after such a very public gauntlet is thrown down?
Bluster and threats must have worked for Trump in C-Suite boardrooms, and maybe world leaders will be cowed by the President’s negotiating prowess and acquiesce to every demand. I doubt that’s the likely outcome and would expect more bombast from every country involved. After all, that’s how what once was unimaginable becomes reality.
The path of the coming trade negotiations is unknowable but the pattern of the decline from the high on January 26 to the low on February 9 and the subsequent rebound can be very instructive. The following discussion is fairly technical which may give you a headache, but it may be worth it! Imagine looking through a microscope and seeing a different world. Understand though that this different world is present all the time, but you just never took the time to notice the clues that were right in front of you.
Click on any chart below for large image.
It is fairly clear that the S&P 500 declined in a 5 wave pattern from the January 26 high and is labeled (A). This suggests that the correction that started on January 26 is the first part of a larger correction. This outlook was reinforced by the form of the rally since the February 9 low which has taken the form of an A up, B down, C up and is labeled (B). The S&P 500 rallied from 2533 to 2789 or 256 points for wave (B). The decline since the high on February 27 at 2789 is wave 1 of another 5 wave decline that would be labeled (C) (not shown).
If this is the pattern, the rally from the low of 2648 on March 2 to the high today of 2728 is wave 2. Once wave 2 is finished the decline will resume. The bad news is that wave (C) could bring the S&P 500 down to 2449 which would make wave (A) and wave (C) equal. (2873 – 2533 = 340 points) (2789 – 340 = 2449) The good news is that once the 5 wave decline for wave (C) is finished, the correction from the January 26 high would lead to another rally and may set the stage for the bull market to resume.
Wave 1 of (C) dropped the S&P 500 from 2789 on February 27 to 2648 on March 2, a decline of 141 points. A 61.8% retracement would allow the S&P 500 to reach 2735. The high on March 5 was 2728 which is obviously fairly close to the target. It is possible that today’s high of 2728 is the end of wave 2. If the S&P 500 closes below 2695 soon, the S&P 500 is probably on its way to test the February 9 low at 2533 and probably fall below it.
There is a second pattern that doesn’t change the longer term outlook but would impact trading in the next week. The longer term outlook is that the 5 wave decline from the high on January 26 at 2873 is the first part of a larger correction that will eventually bring the S&P down to 2533 and probably below that level. This is how the short term trend may unfold differently.
The rally from the February 9 low took the form of an A up, B down, C up. But rather than being all of wave (B), it may be wave (A) of (B). The decline from the February 27 high of 2789 is wave (B) of wave (B). The rally from the March 2 low at 2648 is wave 1 of wave (C) of (B). At a minimum (C) of (B) should exceed 2789 the high of wave (A).
Based on how the S&P 500 has traded since the January 26 high at 2873, it is possible to guestimate a price target for (C) of (B). The 78.6% retracement of the 340 point decline from 2873 to 2533 is 2800. Wave (A) traveled 256 points (2789 – 2533 = 256). If wave (C) of (B) is 61.8% of wave (A), the S&P 500 would reach 2806 (256 * .618 = 158 + 2648 = 2806). So using two different measurement techniques, there is a price target of 2800 and 2806. The proximity of these targets increases their validity. Once wave (C) of (B) is complete, wave (C) is expected to bring the S&P 500 down to at least 2533.
If the S&P 500 tops at 2806, the target would be 2466 (2806 – 340 = 2466) which would make wave (A) and wave (C) equal. There is one caveat that must be mentioned. Although it is not common, it is possible that wave (B) could reach 2904, and thus exceed the prior high on January 26. If (A) and wave (C) are equal (2789 – 2533 = 256), the S&P 500’s target would be 2648 + 256 = 2904. When this occurs it is labeled an irregular (B).
Assuming you’ve already taken two aspirin or consumed a stiff scotch, the first question that has popped into your head is ‘How can this information (gibberish) be used to manage risk?’ The two key takeaways are this: If the S&P 500 falls below 2695 soon, it is likely to keep declining down to 2533 and maybe 2449. Therefore if you don’t like the idea of watching the S&P fall to 2533 or possibly 2449, you should, if the S&P 500 falls below 2695 soon, 1) hedge your portfolios, 2) do some selling, or 3) go short using a stop above 2747.
The second takeaway is this. If the S&P 500 trades above 2789 and you don’t like the idea of watching the S&P 500 subsequently fall to 2533 or possibly 2449, you should 1) hedge your portfolios, 2) do some selling, or 3) go short using a stop above 2840.
Treasury Yields
As discussed in the March issue of Macro Tides there is a good chance that Average Hourly Earnings (AHE) for February will come in less than the 2.9% reported for January. If this proves correct, Treasury bond yields could drop. If the February AHE comes in at 2.7% or 2.6%, bond prices could rip higher since there is a very large short position in Treasury bond futures.
The positioning in the 10-year Treasury futures market suggests the next major move in yields is down, not up as most investors expect. Granted this is a tough call since the deck seems stacked against yields falling. Commercials are considered the smart money and are holding a near record long position. As of February 26, they were long 631,797 contracts. In January and late February of 2017, as the 10-year yield was topping near 2.60% they were long 644,599 contracts and 594,711 contracts (red line middle panel).
This suggests that they will be buyers on any additional weakness in bond prices.
Large (green line middle panel) and Small (blue line middle panel) Speculators are holding a large short position that is almost as large as in January and February 2017. A decline in yields would generate losses on those short positions, which is what occurred after Treasury yields fell and bond prices rose after March 2017. To stem their losses Large and Small speculators would buy Treasury futures thereby pushing Treasury bond prices up and yields down further.
However, the trading action in the next few days could be wild. ADP will release its estimate for job growth for February on Wednesday. If it is above 200,000 jobs, bond yields could jump. And, it is certainly possible that wage growth held at 2.9% in February or even went up. If so, bond yields are sure to test their recent highs (10-year 2.943% – 30-year 3.221%). The employment report for February will be released on March 9. However, the positioning in the futures market suggests that after any uptick in yields, they are likely to come down in coming weeks.
As I noted in the February 26 WTR: “The price pattern for the 10-year Treasury bond indicates that the high last week may have been wave 3 of the rise in yields since the low in early September. If correct, the 10-year yield could mount a more strenuous test of 3.03% in the next two weeks, and could for a brief time trade above 3.03%. If this pattern is correct, wave 4 would allow the 10-year yield to fall below 2.80%, possibly as low as 2.74%.”
A new high in yields would represent wave 5 and be followed by a decline in Treasury yields.
In the February 12 WTR I made the following suggestion:
“If bond yields climb on the CPI and PPI reports and the Treasury ETF (TLT) falls below $117.50 (chart below), a good short-term trade may develop. If yields fall and retest their breakout levels, TLT may rally to $121.00 – $122.00. A close below $115.25 should be used as a stop. The primary trend in bond yields is up, so this is a counter-trend trade which means the risk is higher.”
On February 12 TLT traded down to $116.51. Given the positioning in Treasury futures I would cancel the stop at $115.25 since there could be a quick spike lower before yields reverse lower. Instead, add to the position if TLT falls below $115.25 since a decline to $115.00 or a bit lower is possible.
Crazy World
Last week I asked this question (and gave the following discussion):
“What could cause yields to drop meaningfully and stocks to fall back to the February 9 low?”
“It would be necessary for something to threaten the economy for yields to fall and stocks to drop hard. My guess is that protectionism could do it. On Friday February 23 Trump indicated his willingness to slap hefty tariffs on steel and aluminum. Although a final decision may not occur until April, the rhetoric could easily heat up before then with our trading partners responding with plans to slap tariffs on American products.”
The jury is still deliberating as to what causes the S&P 500 to eventually fall to 2533, but the issue of trade is certainly one reason. Of course, the S&P 500 may not decline to 2533. We’ll see.
Dollar
As noted last week:
“If Trump does push an agenda of protectionism in coming weeks that could easily spark another decline in the Dollar.”
Although the near term picture may include a new low below 88.25, the intermediate outlook remains the same. In coming months, the Dollar has the potential to rise to 95.00.
Euro
The positioning in the Euro futures suggests the next big move in the Euro is down irrespective of any short term squiggles. It is possible that the new high on February 16 was an irregular B since it went above the prior high. The low last week was likely wave C. It is possible the Euro could rally to another new high on the back of Dollar weakness due to trade disharmony.
On February 16 I established a partial position in the Euro inverse ETF EUO which is leveraged 2 to 1 at $20.89. After Trump announced his decision to proceed with tariffs, I sold my position in the Euro inverse ETF EUO at $21.38. I will look to reenter this position in coming weeks, especially if the Euro does indeed rally to a new high.
Gold
Gold recorded an intra-day high of 1361.24 on February 16 before reversing lower. A close below $1306 would set Gold up for a decline to $1275 and potentially $1250. Gold stocks continue to underperform Gold which suggests a decline to $20.50 on GDX is possible.
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. Based on the buy signal, a 100% invested position in the top 4 sectors was adopted. The MTI confirmed a new bull market on March 30, 2016. The MTI continues to indicate that a bull market is in force. Past performance may not be indicative of future results.
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.
