Written by Jim Welsh
Macro Tides Technical Review 12 March 2018
As Expected Average Hourly Earnings Fell In February
The January employment report shook the Treasury bond market and the stock market since Average Hourly Earnings (AHE) rose 2.9% from January 2017.
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As bond yields increased, a modest correction in the stock market turned into a rout as over levered investors in short volatility positions were swamped as volatility soared. Investors were understandably bracing for a potential repeat when the February employment report was announced on Friday March 9. There were a number of reasons why I thought that AHE were overstated in January and would probably fall from 2.9% as noted in the February 12 WTR:
“The average workweek was down 0.2% in January and hours worked were down 0.5% due to bad weather. Average Hourly Earnings for Production and Nonsupervisory workers, which represent 82% of the workforce, rose just 2.4% from January 2016. Conclusion – the 2.9% increase in AHE was likely overstated in the January employment report.”
If AHE moderated, I thought Treasury yields could fall as discussed last week:
“Since the employment report on February 2, the bond market has begun to price in a fourth Fed rate increase. If wage growth temporarily moderates, the bond market may scale back its expectations for a fourth hike.”
In February AHE fell from 2.9% (which was revised to 2.8%) to 2.6%, which definitely helped prevent the bond market from blowing up given the 313,000 new jobs in February. This outsized increase in jobs was possible in part by an increase of 50,000 retail jobs and an increase of 61,000 construction jobs. It is unlikely that 50,000 retail jobs were created since there is no major holiday that would prompt such a large increase. No slight is intended toward Valentine’s Day, but it doesn’t feel like a rebirth of the Age of Aquarius has overtaken the country, especially if one listens to the news.
Much of the country experienced well below temperatures and above average snow during January which shut down construction activity. In contrast, the weather in February came with above average temperatures and below average snow. With contractors working hard to catch up on jobs after January, the seasonal adjustments the Labor Department uses likely overstated the actual number of construction jobs created in February. Even if one lowers the 313,000 based on retail and construction, the February employment was still quite strong.
The markets responded quickly after the January employment report indicated that AHE grew 2.9% from January 2017 and also when AHE were to have grown only 2.6% in February. As noted, Average Hourly Earnings for Production and Nonsupervisory workers, which represent 82% of the workforce, rose just 2.43% from January 2017, and unchanged from the 2.43% they grew in December 2017 from the prior year. This important tidbit was overlooked in early February causing the bond market to consider the potential of a fourth rate hike by the Fed. The financial markets generated an audible sigh of relief when February AHE was only up 2.6%.
However, Production and Nonsupervisory workers, which represent 82% of the workforce, saw their pay increase from 2.43% to 2.52% in February. By itself an increase of 0.09% is not earthshaking, but it does underscore that under the surface wage pressures continue to build. This reinforces my expectation that after a brief lull in wage inflation, wage inflation will likely accelerate before Labor Day.
Click on any chart below for large image.
As the chart above illustrates (chart compliments Dave Martin AlphaStream Analystics), AHE for Production and Nonsupervisory workers has made higher lows and higher highs since 2013 which is the definition of an uptrend. If AHE exceeds 2.62% in coming months it will set another new high and better the high recorded in July 2016.
The Federal Reserve will increase the federal funds rate when they meet on March 21 by 0.25%. Although they are unlikely to alter the dot plot from 3 hikes in 2018, the increase of 313,000 jobs in February could raise concerns that the labor market is tightening faster than they expected. For a few FOMC members this could elevate their concern of the Fed falling behind the curve, which may be confirmed when the minutes of the March 21 meeting are released on April 11.
Sometimes more is learned by how markets respond to news than the news itself. The 313,000 increase in jobs was clearly bearish for Treasury bond prices and would have reasonably been expected to cause yields to climb to a new high. That didn’t happen. The yield on the 10-year Treasury rose to 2.943% on February 21, when the FOMC minutes from the January 31 meeting were released. After Friday’s employment report, the 10-year Treasury yield climbed to 2.914% and closed today at 2.870%. The 30- year Treasury yield closed today at 3.129% after peaking at 3.221% on February 21 and 3.178% on Friday.
For those investors short Treasury bond futures expecting lower prices and higher yields, Friday and today were likely frustrating days, since the bearish employment report failed to push Treasury prices down. This trading action suggests that positioning in Treasury futures is partly responsible for such a muted response in the face of news that should have been quite negative.
As I have discussed in recent weeks, Large Speculators have taken a large short position in the 10-year Treasury futures. A similar position in February 2017 was followed by a significant rally in bond prices that brought the yield on the 10-year Treasury down from 2.62% in March 2017 to 2.034% in early September.
The chart pattern suggests that the 10-yield on the 10-year Treasury has the potential to fall to 2.77% to complete wave 4. If this occurs, the pattern suggests that the 10-year Treasury yield could then rise and test the December 2013 high of 3.03% and possibly push above 3.03% for a brief time. The positioning in the bond futures market suggests any rise above 3.03% could be a good buying opportunity.
The pattern on the 30-year Treasury bond indicates that wave 4 could bring its yield below 3.05%. I recommended the purchase of the Treasury bond ETF TLT at $117.50. If the 30-year yield does fall below 3.05%, selling a portion of TLT might make it easier to sit through the subsequent decline that could lift the 30-year yield to 3.25% – 3.28% for wave 5. If the 30-year yield does climb above 3.25%, a buying opportunity could present itself. Add to the position if TLT falls below $115.25 since a decline to $115.00 or a bit lower is possible if the 30-year yield climbs above 3.25%.
Stocks
The stock market is at an interesting juncture. After a lengthy discussion last week of the two possible trading patterns in the S&P 500 I concluded with this summary:
“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″.
After testing the 2700 area three times on March 7 (2704.18, 2701.74, 2702.38), the S&P held support and then rallied into the close for Wave 1 in blue. This trading behavior tilted the odds that the S&P 500 was more likely to rally above 2789. After a modest dip intra-day on March 8 (wave 2 in blue), the S&P 500 again finished with a higher close. After the employment report on Friday, the S&P 500 gapped higher and ran into the close. This morning the S&P 500 rose to 2797 wave 3 in blue before pulling back. There may be some additional weakness early tomorrow which would complete wave 4 in blue. If this pattern is correct, wave 5 (not shown) should allow the S&P to exceed 2797. Wave 5 could potentially reach 2800 or 2806 as detailed last week.
“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 * 0.618 = 158 + 2648 = 2806). So using two different measurement techniques, there is a price target of 2800 and 2806.”
I’ll repeat the instruction from last week since the S&P has traded above 2789 and may move a bit higher tomorrow. 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.
My assessment of the pattern in the S&P is that the decline from the January 6 high to the February 9 low is wave (A). The rebound since that low is wave (B) which may be followed by wave (C) that holds the potential to retest or break the February 9 low at 2533. Although it is not common, it is possible for wave (B) to exceed the prior low during a large decline or prior high (2873) as in this case. There are a number of reasons why this possibility cannot be dismissed.
The S&P 500 may be bolstered if Treasury yields fall as expected since that could be perceived of a less aggressive Fed. More importantly, the Semi-Conductor Index and the Nasdaq 100 have been market leaders and both made a new all-time high today. One sign that a correction is on its way would be some weakness appearing in these indexes. Rallies end when the leaders run out of gas.
The Russell 2000’s relative strength has improved in recent days and it too has the potential to make a new all-time high. The odds of a correction are higher when the relative strength of the Russell 2000 is weakening. The NYSE advance-decline line and the Nasdaq Composite A-D Line are close to making a new all-time high. Market corrections are far more likely when the A-D Lines are well short of a prior high.
There are also a number of negatives that support the possibility of a high soon. The Nasdaq 100 recorded a new high today, but its RSI is well below the prior high in January. Not only is the divergence large, but today’s RSI is below 70.0 which is a sign of relative weakness despite the new price high. The Semi-Conductor Index (SOX) has recorded the second lower high in its RSI even though the price has broken out. A close below 1400 would negate the breakout and be bearish.
The RSI for the Russell 2000 is likely to record a lower high if the Russell 2000 does manage to make a modest new high. While the big cap tech heavy Nasdaq 100 posted a new all-time high, the S&P 500, Russell 2000, DJIA, and DJ Transports didn’t. If four cylinders of a six cylinder motor are not in sync with the other two, car trouble is likely to develop. When some major market averages make a new high, but others fail to, the market’s internal engine may be about to sputter.
It would be negative if the market reverses lower with these market average divergences in place. Although the S&P 500 may be able to push a bit higher than 2806 before the big cap tech stocks run out of gas, the odds of a meaningful correction remain high and warrant a more defensive positioning.
For those more aggressive, establishing a partial short position in the S&P 500 if it exceeds 2797 still makes sense. That way you’ll have some buying power if the Nasdaq 100 and Semi-Conductors run further and the S&P 500 does mange to push higher. Once the Nasdaq 100 and Semi-Conductors reverse lower, the short position can be increased.
Dollar
The Dollar had a fairly muted response to the strong jobs report which leaves open the possibility of the Dollar testing or briefly falling below the low of 88.25. The bigger picture remains the same. In coming months, the Dollar has the potential to rise to 95.00.
Euro
Last week the ECB dropped its pledge to increase its monthly purchases if the EU’s economy slowed. Only Mario Draghi can split hairs so finely, as the ECB moves toward addressing the withdrawal of its QE program at a glacial pace. This tiny step though is a hawkish move. Just as the Dollar didn’t rally on the strong jobs report, the Euro didn’t move up on the ECB’s announcement. 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 on March 1. I reestablished the position on March 8 at $20.25. If the Euro marches to a new high I will add to this position. The positioning in the Euro futures suggests the next big move in the Euro is down irrespective of any short term squiggles and I don’t want to miss it.
Gold
Gold recorded an intra-day high of 1361.24 on February 16 before reversing lower. Since then it has chopped around and tested the lower end of its range but failed to break down. It is possible that Gold could test the upper part of its range and rally again to near $1361. There is nothing compelling in the short term and sometimes being patient for a trade to set up is the most important aspect of trading. My bias is that Gold is likely to breakdown so shorting Gold if it rallied up to near $1360 might be tempting. A close below $1306 would set Gold up for a decline to $1275 and potentially $1250.
Gold stocks continue to underperform Gold which is a negative. Although a quick bounce to $23.15 is possible, the pattern suggests a decline to $20.50 on GDX is likely to follow any near term strength.
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.
