Written by Jim Welsh
Macro Tides Weekly Technical Review 13 August 2018
In the August monthly issue of Macro Tides I noted that the stock market has been supported by a lack of selling pressure since the consensus outlook is for continued economic growth and good earnings. Second quarter corporate earnings have been good (up 23.5% according to Thomson Reuters), with the majority of companies meeting or beating estimates.
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The tranquility of the overall stock market is potentially masking an underlying vulnerability if a good reason to sell materializes. The vulnerability is evident in the gradual erosion in the market’s internal strength. As I have discussed for weeks, a little more than half (54% on August 7) of NYSE stocks have been above their 200 day average compared to 68% in January, even as the S&P 500 was less than 0.4% below its January peak.
The lack of broad participation has also been evident in the percent of stocks that have made a new 52 week high in the past 21 trading days. On August 7 just 1.61% of NYSE stocks made a new 52 week high compared to 2.61% in mid June and 6.92% in January. On Friday August 10, there were more stocks making a new 52 week low on the NYSE and Nasdaq just 3 days after the S&P 500 flirted with a new high on August 7 and the Nasdaq composite came within 0.13% of a new high on August 9.
According to Bloomberg, six stocks, (FMAANG) Facebook, Microsoft, Amazon, Apple, Netflix, Google) accounted for 98% of the gain in the S&P 500 through July. The stock market is more vulnerable to an increase in selling pressure since its internal strength is so concentrated and not broad based.
In the August Macro Tides I discussed two issues that could increase selling pressure: more trade trouble with China and a slowdown in U.S. economic growth in the second half of 2018. The more significant is additional trade friction with China which is likely to come to a head by mid September. To date, China has shown no inclination to play nice in the trade sand box. President Trump has announced more tariffs on another $16 billion of imports from China will begin on August 23. If China responds quickly with additional tariffs the stock market will have another opportunity to recognize that the trade dispute with China may continue to ramp up into a trade war.
A new risk to the tranquility of the stock market appeared on Friday after President Trumped increased tariffs on steel and aluminum produced in Turkey. This led to a 15%+ plunge in Turkey’s currency and stock market. Since July 2017, the value of Turkey’s currency (Lira) has been cut in half. This has ignited a bout of inflation which reached 16% in July.
When a currency experiences a free fall, the normal game plan is for the central bank to raise domestic interest rates to keep money from flowing out of the afflicted country or to impose capital controls to prevent outflows. Argentina’s currency has been falling since mid April and its central bank raised its policy rate to 40.0% to stem the tide of money flowing out. Today, Argentina raised their policy rate to 45.0% as its currency came under renewed pressure in the wake of Turkey’s devaluation on Friday.
The president of Turkey has prohibited the central bank from increasing rates to stabilize the Lira. Instead, Turkey’s central bank lowered the reserve ratio for its banks freeing up $6 billion that can lent to stimulate the economy. This step is not likely to provide enough support and the central bank will be forced to raise rates significantly maybe by the end of this week or impose capital controls.
The currency crisis in Turkey sparked memories and concerns about the Asian crisis that was sparked by a large decline in Thailand’s currency in July 1997. This ripple eventually spread to South Korea and Indonesia. Turkey’s problem is that it has $198 billion in dollar denominated debt that has been lent to corporations. Most of those companies’ revenue is in Lira which means the cost of servicing their debt has increased as much as the Lira has fallen versus the Dollar. In coming months some of loans are not going to repaid which is going to hurt the banks that extended the loans.
A number of large European banks have exposure with most of the loans held by banks in Spain (5.3% of GDP), France, and Italy. If Turkey is going to become a more serious problem it will likely show up in the European bank stocks that have exposure. My guess is that the ECB will do whatever it takes to contain the risk from loans to Turkey from having a broader impact on the EU banking system.
In some respects Turkey is joining a developing problem that has already hit Argentina, Russia whose currency is down 20% since March, and Iran whose currency has lost 80% of its value since January. But the most likely impact is the shock wave from Turkey will disrupt emerging market economies somewhat. This may weigh on EM growth in the second half of 2018 and shave growth a bit in the European Union. Growth in the U.S. is already set up to slow to near 3.0% in the second half of 2018 from 4.1% in Q2. Any slowdown in EM and the EU will act as a modest headwind for growth in the U.S. The consensus seems to believe that the U.S. economy is so strong that it is immune from just about anything and decoupling from Turkey is a no-brainer. This seems to reflect a high level of complacency.
For months there were no reasons to sell, and coupled with stock buybacks by the largest cap stocks, the market was able to hold up even as the majority of stocks went nowhere. According to Goldman Sachs, 13% of annual buybacks occur in August so they could continue to help levitate the market. However, if the trade dispute with China escalates, buybacks won’t keep the S&P 500 from closing below 2788, which should open the door for the expected pullback to 2700.
During 2017 volatility was historically low and a huge short position developed in the VIX. When the market broke down in early February and the VIX rose above 17.0 on February 2, those short the VIX were forced to buy the VIX. This buying pushed the VIX higher and caused even more of those who were short the VIX to cover. This caused the VIX to reach 50.3 on February 6. The losses created by the sudden surge in the VIX unleashed selling in the overall stock market as margin calls spread like a wild fire. It’s taken 6 months for the S&P 500 to laboriously climb back to the January peak which has pushed the VIX down.
On August 9 the VIX fell to 10.17 but closed at 14.78 on August 13 an increase of 45% in less than 3 days. This could meaningful in coming days since the short position in the VIX has been steadily building for months and is now about 65% as large as it was in January. In other words, there is fuel for another brush fire which could be set off if the S&P 500 closes under 2788. A close below 2690 could ignite another selling wave.
Click on any chart below for large image.
Gold – Wrong or Just Way Too Early?
In the July 30 Weekly Technical Review (WTR) I said:
“If the Dollar spikes above 95.65, Gold may dip under the July 19 low of $1212 and could breach $1200 briefly.”
In the August 6 WTR I expected the Dollar to climb above 95.65:
“The Dollar is still expected to exceed its July 19 high of 95.65 before a high is recorded.”
After President Trump tweeted that he was increasing the tariffs on Turkey before markets opened on August 10, the Dollar jumped to 96.45 and Gold dipped to $1206. On August 13 the Dollar ticked up to 96.52 but Gold broke down hard falling to $1192, which surprised me after Gold’s decent showing on Friday. In light of today’s weakness, the question is whether anything has changed?
My expectation of a good rally in Gold has been built on the positioning in Gold futures and the extremely low level of Gold bulls which have been under 10% for 3 almost weeks. On August 7 Large Speculators held 12,688 contracts long down from 120,240 on June 12.
Managed Money were long 55,502 contracts on June 12, but are now short -66,116 contracts.
Since June 12, Large Speculators have sold -107,552 contracts and Managed Money has liquidated -121,618 contracts. This selling pressure has been pushing the price of Gold down for the past two months.
This positioning is the most bullish since December 2015 and the second most constructive positioning since 2001.
As noted, President Erdogan of Turkey has told the Turkish central bank that he does not want it to raise interest rates to support the currency since higher rates will hurt the domestic economy, which is going to be under significant pressure from servicing its corporate Dollar denominated debt. There is a chance that some of the selling pressure in Gold today August 13 came from Turkey’s central bank. By selling Gold, it would have money to buy the Lira with purchases funded from its Gold sales. Given the weakness in the currencies of Russia and Iran, it is certainly possible that both countries may have sold Gold in the past two months to prop up their currency.
When Gold closed at $1248 on June 28, its RSI was 20.1 and 24.7 when Gold closed at $1222 on July 19. On August 13 Gold closed at $1192.60 but the RSI was 26.8 so there is a modest momentum nonconfirmation with the prior lows.
Most of my subscribers have been following my analysis for years and you know that this trade is the worst trade I’ve had in a long time. Based on positioning, sentiment, and how oversold Gold has become, a good rally is coming. It’s too early to determine whether I’m just wrong on this trade or whether I was just way too early.
At some point it will make sense to add to this position but only when momentum has clearly turned positive. Lost in the shuffle on August 10 was news that the Consumer Price Index rose to 2.9% in July and the core CPI reached 2.3% the highest since 2008. Had tariffs not been increased on Turkey the major news story of the day would have been about inflation which probably would have given Gold a lift.
Gold Stocks
Gold stocks are going to remain under pressure until Gold reverses higher. GDX gapped lower on August 13 and in the process left a gap from the low on August 10 at $20.51. GDX’s RSI fell to 25.6 on August 13, which is the most oversold GDX has been since July 2015. It is likely that GDX will bounce and then make a lower closing low that allows the RSI to record a positive divergence.
A rally to $21.10 will be the first indication that a low is beginning to form. Market averages occasionally leave gaps between the high and low of two consecutive trading days. It is rare for a gap not to be closed eventually. In May and July of 2017 I discussed the gap GDX had left on December 23, 2016 at $20.43. GDX traded down to $20.89 in May 2017 and $20.99 in July. There is a chance GDX may finally fill the gap at $19.43 before a bottom takes hold.
From GDX’s high on January 25 at $24.86, GDX dropped $4.03 to an intra-day low of $20.83 on February 9. An equal decline of $4.03 from the high of $23.30 on April 18 would target $19.27 while an equal decline from the July 9 high of $22.93 would target $18.90. Even if this lower target is reached, GDX is likely to retrace 50% of the total decline which would allow it to rally to $22.50 – $23.00 before the end of 2018. Given the positioning and sentiment in Gold, a more robust rally by GDX is certainly possible.
Dollar
The Dollar was expected to exceed its July 19 high of 95.65 before a high was recorded. After the tariffs were increased on Turkey the Dollar spiked higher and reached 96.52 on August 13. Positioning and sentiment indicate the long Dollar trade is crowded. A close below 95.50 would be the first indication that a top may be in place, while a close below 94.90 would be more emphatic. Despite the new high in the Dollar its RSI is well below the level it reached in late May, which is another sign that a top appears to be forming.
Euro
The Euro was expected to fall below the June 21 low of 1.15089 which was why the Dollar was forecast to exceed its 95.65 high. Euro has fallen sharply since August 9. The instructions were to establish a 50% long position in FXE if it declined below $110.55. After closing at $110.54 on August 9, FXE gapped lower on August 10 as the Euro fell sharply and closed today at $109.24. The Euro appears to be finishing a 5 wave decline down from its February high. A rally that retraces 50% of the decline would lift FXE to near $114.00.
Treasury Yields
As discussed last week, Large and Small Speculators along with Managed Money have established a record short position in Treasury bond contracts in the 5-year, 10-year, and Ultra Long bond futures. In total 1.438 million Treasury contracts have been sold short and at some point will be bought to close out the positions. Despite news that inflation picked up in July bond yields finished lower on August 13 than on August 9 before the Turkey and inflation news hit on August 10. If the economy loses some steam in the second half of 2018, investors who are short could be pressured to cover some of the short positions, which would help push Treasury yields lower, rather than higher. This suggests that the 10- year Treasury yield could test the March low of 2.715% and possibly the 2017 high of 2.63% in coming months.
The 30-year Treasury may fall below the July 6 low of 2.925%. If it does, it would complete the potential Head and Shoulders top that has been forming since the February high at 3.221% and allow for a decline to 2.66%. (Head 3.24% – Neckline at 2.95% = .29% subtracted from the Neckline at 2.95%) The only way this develops is if the trade war escalates and expectation the Fed will not increase rates at its December meeting. The equity market could decline sharply in anticipation of a slowdown in the economy.
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 which is still in effect.
The MTI remains well below its high from January. A close below 2690 would suggest a meaningful top had been completed.
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.
