Written by Jim Welsh
Macro Tides Weekly Technical Review 11 June 2918
The FOMC will increase the federal funds rate to a range of 1.75% to 2.0% at their June 13 meeting. While this will be the headline, far more focus should be on the more obscure Dot Plot, which is published quarterly by the FOMC after meetings in March, June, September, and December.
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The median forecast for the federal funds rate at the end of 2018 by the 15 voting members at the March 21 meeting was 2.10%. The Dot Plot indicated an affirmation of the Fed’s goal of increasing the federal funds rate 3 times in 2018, bringing it up to a range of 2.0% to 2.25%. There were 6 members who indicated their support for 3 increases and 6 who thought 4 increases would be appropriate. If the Dot Plot remains unchanged, the Fed will be signaling its commitment to 3 increases in 2018, unless incoming data changes the outlook.
However, if just one of the 6 members who expected 3 increases upgrades their assessment of the economy and inflation and now supports 4 rate hikes, the Dot Plot will show 7 members favoring 4 increases and 5 who support 3 increases. Although less likely, it is possible that one of the 6 members who thought 4 increases were appropriate in March now supports a fifth increase. This subtle shift in the Dot Plot might enough to unsettle financial markets and there is strong economic data to support a tilt toward a fourth rate hike within the Fed.
In May the unemployment rate fell to 3.8% which is the lowest since April 2000. If it drops to 3.7% in coming months as seems likely, it would be the lowest since October 1960. By any assessment the Fed has achieved its goal of maximizing employment. There are now more people looking for work than there are unemployed workers, which is rare and can be expected to put upward pressure on wages in coming months.
The FOMC has been surprised that wage growth hasn’t been stronger causing some members to question the validity of the Phillips Curve and the efficacy of the Non Accelerating Inflation Rate of Unemployment (NAIRU) on wage growth in the current environment. No one knows with complete confidence the degree with which wage growth is being suppressed by demographics, as high paid baby boomers are replaced by younger lower paid workers, or the impact of technology and artificial intelligence.
While FOMC members have been perplexed by the lower correlation between the U3 unemployment rate and wage growth, it would be a mistake to think they have abandoned NAIRU. My guess is that most members believe that the threshold has been lowered but still believe in NAIRU and that wage growth will accelerate as the U3 unemployment grinds lower in 2018. The spread between the Fed’s estimate of NAIRU (red line) and the U3 unemployment rate (purple line) is already quite wide. The probability of an increase in wage inflation is rising.
The Federal Reserve’s preferred inflation measure is based on the Personal Consumption Expenditures index (PCE) and the target since 2012 has been 2.0%. The PCE is hovering just below 2.0% so the Fed is very close to achieving its second mandate of stable prices after years of falling short. The Fed has indicated that it will allow PCE inflation to rise above 2.0%. But that doesn’t mean there won’t be some concern by some Fed members that the Fed could fall behind the inflation curve, if the correlation between NAIRU and wage growth increases. This is why the potential for one member to support a fourth increase in the federal funds rate to reduce the risk that the Fed falls behind the inflation curve is greater than the financial markets have priced in.
Stocks
I expected the Nasdaq 100 (QQQ) would make a new all-time high and noted how strong it was trading:
“The RSI is in a strong uptrend and suggests the Nasdaq 100 may have more upside before a pullback commences and more time before a real decline takes hold.”
The Nasdaq 100 QQQ did push to a new high on June 7 and then had a modest pullback. After the January peak (3) the Nasdaq 100 declined and rallied and appears to have completed a triangle at the low on April 25 which represents wave (4). Since the April 25 low, the Nasdaq 100 has rallied and formed what would be labeled as wave 1, 2, 3, 4, (in red). All that is required to finish the rally since April 25 is for it to rise above the June 7 high of 175.93.
Click on any chart below for large image.
The pattern in the Russell 2000 is slightly different but it too is potentially nearing an important high. From its January peak (3), the Russell experienced a simple a, b, c correction, which ended on April 2. To date, the Russell 2000 has completed wave 1, 2, 3, and 4 in blue. Wave 4 ended on May 29 and the Russell has continued to advance in wave 1, 2, 3, 4 in red for wave 5 in blue. All that is required to finish the rally since April 2 is for the Russell 2000 to rise above the June 7 high of 1679.99.
The Nasdaq 100 and Russell 2000 have been the leaders and for the stock market is form a top these two sectors must stop moving higher. The pattern in each average suggests a high could form this week. Absent news that causes an increase in selling pressure, these averages may hold up until the end of June due to “portfolio dressing”. Most money managers and mutual funds will be eager to show the world that they are invested in the winners. In addition, the annual rebalancing of the Russell 200 could also provide support for the Russell.
As noted last week:
“The weighting of the FAANG stocks in the S&P 500 and the Nasdaq 100 may allow the S&P 500 to trade above the blue trend line briefly.”
The S&P 500 has managed to trade above the blue trend line, which dates back to a high in April 2016. If the analysis of the patterns in the Nasdaq 100 and Russell 2000 are correct, the S&P 500 may push modestly above the March 13 high of 2801.90 and could near 2823. From its low on February 9, the S&P 500 rallied 269.21 points for wave a. An equal rally from the April 2 low (wave b) would target 2823.01 for wave c and complete the entire move up from the low on February 9. However, any move above 2801.90 would complete the pattern from the February 9 low. This pattern suggests the S&P could then fall below the February 9 low of 2532 during the third quarter.
Even if the S&P 500 doesn’t experience such a dramatic decline, there are reasons why it is close to a short term high at a minimum. The Option Premium Ratio is a sentiment indicator that helps identify tops and bottoms in the market. A high ratio develops near a market low, and a top occurs if the OPR falls to an extremely low level below near 0.50.
On November 9, 2010 the S&P 500 closed at 1227 with the OPR at 0.4892. The S&P 500 subsequently dropped -4.3% by November 29, 2010. In 2011 the S&P declined by -6.1% by March 16, 2011, after the OPR fell to 0.5011 on February 15. On January 23 the OPR reached 0.502 just 3 days before the S&P 500 topped on January 26, which was followed by a subsequent decline of -10.9% from the January 23 high. The OPR fell to 0.503 on June 8, 2018 which suggests the S&P 500 is near a high.
The S&P 500 did rally an additional 2.6% after the signal on January 19, 2011 before the S&P 500 topped and a second OPR signal was generated on February 15, 2011. The S&P 500 rallied 1.1% after the January 23, 2018 signal before the correction developed. It’s interesting that in 8.5 years the OPR has only fallen to near 0.50 on five other occasions which were each followed by a correction of some magnitude. Given the price pattern in the S&P 500, the coming correction could prove more substantial.
The Advance – Decline line has continued to make new highs, which is normally a positive. However, the A/D line usually has a fairly high correlation with the percentage of stocks above their 200 day average. However, since the peak in January they have diverged. As the S&P 500 was peaking in late January, the A/D line was also making a high and 68% percent of NYSE stocks were above their 200 day average.
Although the A/D line has risen impressively in recent weeks, the percent of stocks above their 200 day average has only climbed to 52% as of June 8. Honestly, I’m not sure what accounts for the disparity but my gut tells me it probably isn’t positive for the market. On November 15 the S&P 500 closed at 2565 with the percent at 53%. The S&P 500 is up 8.4% since November 15 but the percentage of stocks above their 200 day is about the same. This suggests the market’s internals are not as strong as the A/D line indicates.
If the Nasdaq 100 QQQ has traded above 175.93 and the Russell 2000 has traded above 1679.99, establishing a 15% short position is warranted, if the S&P 500 trades above 2801.90, using 2832 as a stop.
Treasury Yields
From its high of 3.115% on May 17, the 10-year yield fell to 2.759% on May 29. A 78.6% retracement would allow for the yield to retest the prior high of 3.035% before falling below 2.759%. If this pattern develops it would complete an a-b-c rally from the high at 3.115%, and potentially offer a shorting opportunity.
The 30-year Treasury yield dropped from 3.247% on May 29 to 2.954%, a decline of 29.3 basis points. It may not reach the 78.6% retracement level at 3.184% before it at least challenges the 2.954% low on May 29.
Dollar
On May 29 the Dollar traded up to 95.02 which is likely the high for wave 3. A recent survey of trader sentiment showed that the vast majority of traders were bullish, which was one reason why I thought the Dollar was ready for a pullback of 1% to 1.5%. The current dip is likely wave 4, and could bring the Dollar index down to 93.00. Once the correction is complete, the Dollar is likely to exceed the prior high at 95.02.
Gold
In the May 14 WTR, I recommended:
“Buy a 50% position in Gold or the Gold ETF GLD, if Gold trades under $1301. Increase it to 100% if Gold trades under $1285.”
On May 15 Gold traded under $1301 and the Gold ETF GLD opened at $122.82. Although Gold has traded under $1285 during night trading sessions, it has not traded under $1285 while GLD was trading. For now I’m going to rescind the recommendation to add if Gold trades under $1285 as explained below. I continue to expect Gold to rally to $1310 – $1325 at a minimum. If Gold is able to overcome this resistance, the next target would be $1360 – $1370. Gold may need even more time before a sustainable rally is capable of taking hold and lifting Gold above the heavy duty resistance at $1368.
When Gold fell below $1300 and traded down to $1282 on May 18 and May 21, it held an important trend line connecting the December 2016 low and December 2017 low. (Solid trend line on chart below) Large Speculators increased their long position from 90,957 contracts on May 22 to 115,130 contracts on May 29, as Gold held above the trend line and traded up to $1307. From a technical perspective the actions of the Large Speculators makes sense. It’s always good to take a long position near a trend line of support so the trend line can be used as a stop and limit losses.
The higher dashed trend line on the chart below was also an important trend line, since it connected the significant low in December 2016 with the important low in July 2017. In mid October of 2017 Gold fell from $1205 to $1162 and then spent the next 6 weeks holding above the higher dashed trend line. In early December Gold smashed below the higher dashed trend line and recorded a low at $1236 in December 2017. The same pattern may be shaping up now.
Large speculators bought Gold just above a trend line in May 2018, as they did in late October and the first 3 weeks of November in 2017, since they could use the higher dashed trend line as a stop. When gold broke the higher dashed trend line in December 2017, they sold their gold position as their stops were hit. The break of the higher dashed trend line increased negative sentiment and set the stage for a rally from $1236 in mid December 2017 to $1365 in January.
If the solid trend line is broken in coming weeks, Large Speculators would likely be stopped out which could set up the buying opportunity I’ve been expecting. On May 11 Gold traded up to $1325 and Silver rose to $16.81. Today Silver traded up to $16.91 but Gold has yet to get above its resistance at $1307. The divergence between Silver and Gold is not positive and supports the potential of a decline in Gold below the solid trend line that could bring gold down below $1264. Add another 25% to Gold or the Gold ETF GLD if Gold trades under $1264
Gold Stocks
The relative strength of Gold stocks to Gold has not improved which is disappointing and a bit worrisome. If Gold drops to $1262 or lower, GDX could easily drop below $21.75 and possibly down to $21.30. Sitting through that type of decline is not attractive and it could prove worse unless the relative strength of Gold stocks improves, and I’m not willing to bet on that. Per instructions provided in the May 14 WTR:
“A 50% position is recommended if GDX trades under $22.10 in coming days.”
On May 18 GDX traded under $22.10. Place a stop on this position at $22.22. If GDX trades above $23.00 raise the stop to $22.60. Sell half of the position if GDX trades above $23.24, and the remaining half if it trades above $23.40.
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 remains well below its high from January. The relative strength of Technology has weakened since the low on May 3, which is another sign that Technology may be nearing a high as the chart of the Nasdaq 100 QQQ implies.
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.
