Written by Jim Welsh
Macro Tides Weekly Technical Review 09 September 2018
Last week the DJIA slipped -0.2% as the S&P 500 fell -1.0% and the Nasdaq Composite dropped -2.6%. Last week’s weakness carried through trading today. Since the close on September 4, Apple has peeled off -4.3% and Amazon has given up -4.9%. During the same period the Nasdaq 100 has only lost -2.15% even though Facebook, Netflix, Microsoft and Google were all lower.
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As noted last week,
“Since late July Apple is up 15.7% while Amazon has gained 13.1%, which has enabled the Nasdaq 100 to overcome the weakness in Facebook and Google, and the volatility in Netflix. The strength in Apple and Amazon are masking the fracture that is developing within FAAMNG. If and when Apple and Amazon experience a bout of profit taking, the Nasdaq 100 won’t be saved by Facebook, Google, or Netflix.”
A Money Flow analysis by Bank of America Merrill Lynch illustrates just how crowded and extreme the Technology trade has become since October last year compared to the prior 8 years. The recent peak in money flow into Technology is more than 4 times as large as the highs in 2011 and 2014. Flows have begun to reverse and the recent price weakness is likely to spur more selling in the short term.
The FAAMNG stocks (Facebook, Amazon, Apple, Microsoft, Neflix, Google) have a higher capitalization than the bottom 290 stocks in the S&P 500 and comprise 15.0% of the S&P 500. If these six stocks trend lower in coming weeks, it will be difficult for the S&P 500 to breakout above the trend line that has defined the channel it has been trading in since April.
The lower boundry of the channel comes in just under 2800 which reinforces the importance of that price level. The S&P 500 traded just above 2790 from July 17 until August 15 when the it traded down to 2802 before rallying to a new high on August 29.
As noted last week, since early June, the S&P 500 has experienced a pullback each time the RSI has approached 70 or modestly exceeded 70. The S&P 500 fell after the RSI became overbought in late July and after August 7, so the drop last week simply follows this pattern.
As the S&P 500 was making a new all-time high in late August, the Net 21 day percent of Advancing minus Declining stocks posted a modestly lower high compared to the highs in early June and July. This indicates that fewer stocks were participating in the charge to a new high. The percent fell slightly below the lows it reached when the S&P 500 corrected in early May, late June, and mid August. The lower high and lower low in the percent hints at underlying weakness.
The S&P 500 has rallied each time the percent has fallen below 0% since early May, so a bounce in the next few days is expected. My guess is that the cracks appearing in the FAAMNG stocks increases the odds that this bounce will run out of steam before a new high is achieved and be followed by another leg lower.
Click on any chart thatr follows for large image
The S&P 500 was 4.5% higher on August 29 than it was in mid June when the S&P 500 traded up to 2791. The 21 day average of New Highs minus New Lows was 2.19% on August 29 versus 2.61% on June 12. This is another indication that fewer stocks were participating when the S&P 500 posted its new high and a reflection of the impact of the FAAMNG stocks on the cap weighted S&P 500.
The NYSE remains below its breakout level of 13,040 and the percent of stocks above their 200-day average was 50% on September 7, even though the S&P 500 is less than 2% from its all-time high.
The expectation remains that the S&P 500 is vulnerable to a pullback of 3% to 5%. As long as the S&P 500 holds above 2790, the short term trend is up. A close below 2790 would open the door for a decline to 2720 – 2750 which encompasses the low in the second half of June and the 200-day average (red line 2732).
If the S&P 500 is going to fall to the lower targets, it could be a sharp decline given the positioning in VIX futures. As previously discussed, a large short position in VIX futures has developed that is comparable to the position that existed prior to the hard and quick decline in early February.
In the chart above, the green line in the middle panel (Large Speculators) and blue line in the bottom panel (Asset Managers) shows that these traders are betting that volatility will remain low or continue to decline in coming months. If instead it rises, they will be forced to buy back their short positions which will push the Volatility Index (VIX) higher. In early February the covering of VIX shorts caused the VIX to almost triple in less than 2 weeks, which caused selling to spread to the overall market.
As I wrote last week:
“Sooner or later a trigger will appear, whether it comes from the employment report or something else. A close above 15.02 would raise the odds that a period of volatility was commencing.”
On Friday the VIX traded as high as 15.63 but closed at 14.88 after higher wages in the employment report initially spooked the market. The next time the VIX trades above 15.00 it will close above 15.02 and signal a wave of volatility has begun that could bring the S&P 500 down to 2730 or lower.
In last week’s Investors Intelligence survey the percent of Bulls reached 60.0% and exceeded the percent of Bears by more than 40%. In 2017 this didn’t matter much since a reason to sell never materialized. That is not the case now as there are a number of reasons why selling pressure might pick up before Halloween. The economy is in good shape so the risk of a classic bear market is low. That doesn’t mean the market is immune to a quick painful correction of 15% or more, even though the economy didn’t get close to a recession in 1987, 1998, 2011, or 2015-2016.
The stock market is expensive and the Goldman Sachs Bull/Bear Market Risk Indicator is higher now than it was in 2007 or 2000.
Triggers That Could Close the Gap between U.S. Equities and the Rest of the World
The U.S. stock market has performed well based on the better economic growth compared to the rest of the world and the expectation the growth will continue at a healthy pace, and a surge in stock buybacks. If the US does slow, will the US stock market continue to positively diverge from the majority of equity markets around the world or close the gap by falling?
The performance spread between the S&P 500 and Emerging Markets has never been wider. Emerging Market equities as measured by the EM ETF EEM are down 20% from their January peak while the S&P 500 has managed to squeak out a new all-time high. Numerous EM currencies have experienced significant declines since the beginning of 2018, as U.S. rates rose and the Dollar strengthened.
Fed Chair Powell’s Jackson Hole speech on August 24 reinforced the expectation the Fed will continue to increase rates. Emerging market currencies and equity markets have come under renewed selling pressure after Powell’s speech. Currency weakness has set off a negative domino effect within a growing number of EM countries.
Countries that import a large share of their basic needs are vulnerable to an increase in inflation when their currency declines versus the Dollar. Raw materials like oil, agricultural products, and industrial metals are priced Dollars. A decline of 10% in a country’s currency against the Dollar automatically increases import costs by 10% adding to inflation pressures. In 2018 there are a host of countries whose currency has fallen by 20% or more. The JP Morgan Emerging Market Currency Index is down about 16% since peaking in January. This shows how widespread the weakness in EM currencies has been.
Central banks either increase interest rates, or use foreign currency reserves to support their currency through purchases of their currency. If their currency is really weak both measures of support may be required. Although higher interest rates may help stabilize the currency, higher rates damage the domestic economy which adds to the current level negativity. After maintaining an easy monetary policy stance since 2012, EM Central Banks have been tightening policy in response to the weakness in their currencies and higher inflation.
The sell-off in Emerging Market bonds and stocks has already lasted longer than any other ‘crisis’ since the European debt crisis in 2011. The longer this lasts the odds of it spreading and becoming a contagion rise. The concern about the potential of contagion is apparent in the spike in Google searches using the word ‘contagion’. The consensus is that the odds of a EM contagion developing are small since the GDP of the countries involved so far is small when compared to global GDP. That assessment is probably correct. But it doesn’t allow for another unrelated problem appearing that has nothing to do with EM countries but could cause a spillover effect.
Italy will present its budget to the European Union on October 15 and it will exceed the EU’s 3.0% of GDP deficit rule by a wide margin. Italy’s budget deficit could approach 7.0% and create a confrontation with the EU. Italian support for remaining in the Euro is above 50% but is the lowest of any country within the European Union. In mid May a draft by Italy’s coalition government was leaked that outlined plans to ask the EU to revise Italy’s EU budget contributions and debt relief of almost $300 billion from the European Central Bank. The draft also proposed an ‘opt-out’ mechanism which would allow a country to leave the European Union in an ‘agreed manner’ if there is ‘clear popular will’ to do so. None of these suggestions will be acceptable to the EU, so it will depend on how hard Italy wants to push their agenda. After the ‘draft’ was leaked, the spread between German 10-year bund yields and the Italian 10-year government bond yield spiked from 1.4% to almost 3.0%.
There is a high level of complacency toward the trade negotiations with China, even though there is no indication that China will acquiesce to any of the American demands. Whether the U.S. stock market will continue to ignore this issue is doubtful, if it begins to spill over into the emerging market disequilibrium. I doubt China will sell U.S. Treasury bonds since any sales will devalue some of the $1.2 trillion they own. On the other hand, allowing its currency to devalue against the Dollar would offset a portion of the tariffs and help China’s export competiveness with the rest of the world. If China does allow its currency to trade above 7.0 to 1, it would resurrect unpleasant memories of August 2015.
Dollar
The Dollar strengthened after the August employment report on Friday September 7 showed that wage growth accelerated to 2.9%. This boosted the odds that the Fed would increase the Fed funds rate in September and December. On Monday September 10, the Dollar gave back most of its gains which suggests the correction in the Dollar has further to go. A pullback to 93.20 to 93.75 is likely in coming weeks. The positioning in the Dollar continues to show the long Dollar trade is still crowded.
Euro
A 50% long position was established in the Euro ETF FXE when it declined below $110.55. Sell half of the position at $112.85 and the other half at $113.95. Use a stop of $110.32 on the position. If half of the position is sold at $112.85 increase the stop on the remaining half to $111.50.
Emerging Markets
On August 21 I recommended the Emerging Markets ETF (EEM), which closed at $42.93 after trading between $42.80 and $43.11 in the hours after I sent out the Special Update. On August 30 I recommended selling EEM since the risk of contagion was higher than it was on August 21. At the time of the August 30 email, EEM was trading at $43.14 and closed at $42.95. On September 10 EEM closed at $41.14 which is a new 2018 low and more than 4% lower than on August 30.
Treasury
Yields The positioning in Treasury futures suggests that too many traders are expecting yields to rise well above the highs in mid May. Yields did rise after the employment report showed that wage growth accelerated to 2.9% in August from 2.7% in July. Inflation may put additional pressure on yields when the PPI is reported on Wednesday and CPI on Thursday.
Since the low of 2.759%, the 10-year Treasury yield may be forming a triangle that would allow the yield to climb to 3.03% or so to finish wave e. If the yield pushes much beyond 3.03%, the triangle pattern could give way to a full blown test of the mid May high. If the triangle pattern is correct, 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 trading pattern since last week has lowered the potential of a Head and Shoulders formation in the 30-year Treasury bond yield. In the short run, the 30-year Treasury yield may rise to 3.18% as part of an a-b-c rebound from the low at 2.925%. If this pattern develops, the 30-year Treasury yield could still subsequently fall below 2.925%, especially if the economy slows, the EM problems become more severe, or Italy unsettles the EU.
A 50% long position was established on September 4 when TLT traded below $120.30. The change in the 30-year Treasury yield pattern suggests TLT could fall to 117.50 (red trend line) before a good rally develops. Sell TLT at the opening on September 11.
Gold – Major Bottom Forming
In the last 20 years the Commercials have never had a long position in Gold. Their positioning is being driven by the record short position held by Large Speculators, Small Speculators, and Managed Money. Gold actually recorded its trading low on August 16 at $1160.75 but these traders have increased their short position even though Gold has rallied.
A record short position has also developed in Silver. Silver recorded a lower low last week, while Gold traded above $1190 well above the low at $1161. This is an intra-market divergence and as long as Gold remains above the August 16 low, this is another positive for the metals complex in addition to the record setting short positioning.
From the high in January, Gold appears to have traced out a 3 wave decline into the low in mid August. The bounce since the low at $1161 does not look impulsive since it was an up, down, up pattern. The initial rally carried from $1161 to $1214 or $43. An equal rally from the low of $1189 on September 4 would target a move up to $1232, which is just below where Gold broke down on July 9 (black horizontal line).
If Gold does rally above $1230 it is likely wave 4 from the January high. After wave 4 is complete Gold could retest the $1161 low, or fall to $1123 which is the December 2016 low before the bottoming process is complete.
Looking out over the next 6 to 12 months and longer, Gold is likely forming a major bottom even as this process extends in time. Longer term, Gold is likely to trade above $1300 before the end of 2018 and above $1400 sometime in 2019.
I recommended buying the Gold ETF GLD in three steps and the average purchase price for the entire GLD position is $120.84. If Gold rallies above $1230, GLD could trade above $116.50. Sell 33% of the position, if GLD trades above $116.50. If this pattern analysis is correct, GLD could subsequently fall below $111.00 in wave 5 and possibly as low at $107.00 which is why selling a portion at $116.50 makes sense. It may be easier to add to this position if wave 5 develops.
Gold Stocks
The Gold stock ETF GDX rallied from $12.40 in January 2016 to $31.79 in August 2016. A 78.6% retracement of this rally could bring GDX down to $16.55. The relative strength of the Gold stocks has been abysmal, so this extreme downside target can’t be dismissed until the Gold stocks start trading better. GDX has made a lower low than on August 16, and the RSI is still recording a positive divergence. If Gold rallies above $1230, the Gold stocks are so compressed that a rally to above $19.00 could occur in just a few days. The average cost for the recommended position in GDX is $21.62. Sell 33% of the position if GDX trades above $19.00.
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.
Although the MTI remains well below its high from January, it rose to 3.22 today. Readings above 3.0 in a bull market suggest the risk of a meaningful correction greater than 7% are low.
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.
