Written by Jim Welsh
Macro Tides Weekly Technical Review 01 October 2018
I didn’t think the Fed would drop the word ‘accommodative’ at its September meeting, since it might be misinterpreted by financial markets into thinking the Fed was close to the end of its rate hiking regime. Indeed, in the minutes after the announcement a number of TV commentators suggested as much.
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After asked about the removal in the post meeting press conference, it didn’t take long for Fed Chair Jerome Powell to set everybody straight:
“It wasn’t because policy’s not accommodative. It is still accommodative.”
Powell explained that the word had outlived its usefulness as a signal to the markets of what the Fed was trying to achieve. As I discussed in the September Macro Tides and in last week’s WTR:
“The federal funds rate will rise to 2.16% after the Federal Reserve increases it .25% at their September 26 meeting. The headline CPI was 2.9% in July and the core CPI was 2.3%. The real federal funds rate will still be negative, which means monetary policy will remain accommodative after the September hike. Historically, the federal funds rate has had a real return of 2.0%.”
FOMC members repeated their expectation of raising the federal funds rate in December and 3 times in 2019 according to the dot plot. The FOMC under Chair Powell is definitely miserly with words, especially compared to the last few years under Bernanke. Part of this is driven by where monetary policy is today compared to 2012, as the Fed was explaining QE3 and preparing the markets for the end of QE in late 2014.
Click on any chart below for large image.
But the use of fewer words may be intentional with the FOMC choosing to hold its cards a bit closer to the vest as it approaches the neutral level of the federal funds rate. During the press conference Powell explained that the Fed doesn’t have a precise understanding of what policy would be accommodative. This suggests the Fed doesn’t know with any degree of certainty what the neutral rate is at any given point in time. It’s possible the Fed will know it when it sees it, much like the Supreme Court’s definition of pornography.
While productivity is expected to increase after Trump’s supply-side tax cuts, the actual level of improvement is uncertain. After being asked about the trade negotiations Powell said:
“It a concern. It’s a risk. You could see prices moving up.”
A propelled-by-tariffs rise in inflation would force the Fed into a difficult decision of how aggressively it should respond, since high tariffs would also be expected to weaken economic growth. More than anything, with so much uncertainty surrounding the appropriate neutral rate, future productivity growth, and trade tariffs, the take away from the press conference is that the Fed will be increasingly dependent on data and events that can’t be added to a dot plot. In this kind of environment, the less said the better, which is why FOMC members are likely to become more circumspect. This might increase the level of uncertainty and volatility in the financial markets.
However, the Fed may not view that as a bad thing, since the last two recessions were not preceded by a bout of cyclical inflation, but excesses in valuations in the financial markets as noted recently by Powell and Brainerd.
Dollar
Since peaking in mid August, the Dollar was expected to decline to 93.20 to 93.75. At its low on September 21, the Dollar had fallen to 93.81. It has rebounded smartly after the currency market decided the removal of the word accommodative was not dovish and the dot plot carried more weight.
From its February low, the Dollar Index rallied in a clear 5 wave pattern. This suggests that irrespective of any near term squiggles, the Dollar will eventually exceed the August 15 high of 96.98. If the September 21 low marks the end of the correction, and the next rally in the Dollar equals the 8.72 point move up from February, the Dollar would reach 102.54.
The long positioning in the Dollar (solid line) is near its January 2017 level which coincided with a top. This is why there is still a good chance the Dollar will fall below 93.81 before the next meaningful rally takes hold. The 50% retracement of the rally from 88.25 to 96.98 is 92.61.
Euro
A 50% long position was established in the Euro ETF FXE when it declined below $110.55 on August 9. The initial instructions were to sell half of the position at $112.85 and the remaining half at the open on September 25. I thought the reversal on September 24 made it likely that FXE would fall to $111.50, so booking the additional small profit made sense. On September 25, FXE opened at $112.85, so the whole position was sold at $112.85. The decision to sell the second half at the open on September 25 proved fortuitous since FXE traded below $111.50 on September 27 as expected.
Treasury Yields
Two weeks ago I wanted to wait until the short term trading pattern cleared up, and last week thought that yields could come down a bit in the short term as bond prices bounced to alleviate the oversold condition that had developed. Bond yields did dip a bit after the Fed meeting but popped on October 1 after the trade deal with Canada was announced. Still think a buying opportunity may develop if the 10- year yield exceeds the May high of 3.115%.
The short position in 10-year Treasury bond futures remains ridiculously extreme and historically huge! A significant decline in Treasury yields is possible, and only needs a fundamental reason to trigger a robust round of short covering. Until a sign that economic growth is about to slow, patience is warranted.
The yield on the 30-year Treasury bond exceeded its mid May high of 3.247% on September 19 when it traded up to 3.248%. There is a chance it could approach or exceed 3.30% by a small margin before a reversal lower takes hold.
The RSI for the Treasury bond ETF (TLT) dropped to 27.3 on September 19 indicating that bonds were oversold and due a bounce. TLT pushed up to $117.91 after the low of $116.19 on September 19. On October 1 TLT posted a lower closing low than on September 19, but its RSI registered a positive divergence (green line on RSI), just as it did in February and May prior to rallying. Establish a 50% position in TLT if it trades down to $115.70. This is likely more of a scalp trade, unless questions arise about economic growth. TLT recorded an intra-day low of $114.88 on June 26, 2015 which may be tested.
Emerging Markets
The RSI for the Emerging Markets ETF (EEM) fell below 35 on September 10 so it was modestly oversold. The recent bounce has alleviated this. In the past two weeks there have been a number of stories suggesting that EM stocks are undervalued compared to the S&P 500. That’s certainly true. But there are challenges facing EM, including the potential of another rally in the Dollar and the rise in oil prices. The JP Morgan Emerging Market Currency Index has fallen by more than 12% since April.
When the currency devaluation is added to the 23% increase in the price of oil in 2018, many EM countries have seen their oil costs soar by 35% or more. Inflation is rising rapidly and forcing many EM central banks to increase rates which will slow growth in 2019.
Even after the recent bounce, EEM continues to make lower lows and lower highs which is the definition of a downtrend. Any strength in the Dollar or further rally in oil could push EEM lower and potentially bring EEM below $38.50 (just above black horizontal line) and create a buying opportunity.
Gold – Patience Required
Gold’s bounce since the mid August 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. I thought Gold had the potential to rally up to $1231. Needless to say the trading action has been less than inspiring as Gold hasn’t been able to rally above $1214 even as the Dollar corrected. This reinforces the view that the move up from the mid August low of $1161 is likely wave 4 from the high in January. In the short term, Gold could still rally above $1214 to complete wave c of wave 4 (as noted on the chart of GLD below).
The outlook would become far more positive if Gold were able to close above $1236 and then hold above $1206. If Gold does not accomplish this, a failed rally above $1214 suggests 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. Large Speculators and Managed Money have the largest short position in history, while the Commercials are net long for the first time in 20 years. 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. 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 does develop.
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 improved, but this extreme downside target can’t be dismissed. The average cost for the recommended position in GDX is $21.62.
Two weeks ago I recommended selling 33% of the position if GDX traded above $19.00. GDX traded above $19.00 on September 20 and September 24.
As noted last week, there is a potential inverted head and shoulders pattern forming in GDX. So far it has continued to hold above $18.00 to keep that hope alive. A convincing close above $19.15 would at least lead to a move up to $19.48 and possibly above $20.00. Sell 16% of GDX if it closes the gap at $20.51 created on August 11. If Gold does test $1161 or falls to $1123, I will recommend adding to the GDX position.
In late July Vanguard announced it was renaming its $2.4 billion precious metals fund and lowering the funds exposure to gold stocks from 80% to 25%. This transition would entail the sale of more than $1.2 billion of gold stocks. Gold stocks hit an air pocket in August which was probably due in part to selling by Vanguard into a weak gold market. This view was reinforced by the improvement in the relative strength of GDX to Gold since mid September which is when Vanguard expected to finish the transition.
Stocks
The fragmentation discussed the last two weeks has continued. Although the S&P 500 exceeded it August 29 high, the Russell 2000, Nasdaq Composite, and NYSE Composite remain below their prior highs. The Nasdaq 100 managed to exceed its August 30 high by $0.01 on October 1 before closing 0.72% from the intra-day high. The longer these divergences persist, the more meaningful they become. The Russell 2000 has been especially weak and recorded a daily reversal on October 1.
Higher interest rates are causing interest sensitive stocks to fall which is contributing to weakness in the NYSE Advance / Decline line, which is showing signs of faltering for the first time in many months.
The Nasdaq Advance / Decline is showing the same weakness.
The S&P 500 came within 0.2% of a new all-time high on October 1, but the percent of stocks making a new 52 week high during the past 21 days is comfortably below 0%.
The last time the percent of stocks making a new 52 week high was below 0% with the S&P 500 within 2.5% of its high was in mid June 2015 (red arrow). The fact that this is occurring so close to the all time high is extraordinary.
On Friday the percent of stocks above their 200 day aveage was 49% compared to 56% in late August and 68% in January.
In June 2015 there were signs that the market’s internal strength was weakening. The percent of stocks making a new 52 week high fell below 0% and the percent of stocks above their 200 day average slipped below 50% (red arrow chart of NYSE below). When China devalued its currency by 3% in mid August, it caused selling pressure to spike. Since the market’s internal strength was weak, the S&P 500 plunged 10% in just 4 trading days. The percent of bulls in the Investors Intelligence survey last week rose to 60.6% an unusually high level. This indicates that bullish sentiment is high even though the internal health of the market has been weakening for weeks. Should a decent reason to sell materialize, a quick sharp decline is possible, especially since there is a large short position in the VIX.
Until a reason to sell shows up, the market can continue to do what it’s been doing. In the past 5 trading days the S&P 500 has closed in the lower half of its daily trading range, which is another sign of distribution.
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 climbed above 3.0 as the S&P 500 posted its all-time high on August 29. 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.
Not being invested in the weakest sectors at the bottom is just as important as being invested in the top four sectors.
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.
