Written by Jim Welsh
Macro Tides Weekly Technical Review 15 October 2018
The expectation last week was for the S&P 500 to bounce possibly up to 2900 – 2910 and then decline:
“From its high of 2941 the S&P 500 fell 79 points. A 50% to 61.9% retracement would allow the S&P 500 to rally to 2900 to 2910, which seems likely. My guess is that the coming rebound is a bounce that relieves the short term oversold condition that has developed and is subsequently followed by another sell off.
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“If the S&P 500 rallies to 2910 and an equal decline of 79 points follows, it would bring the S&P 500 down to near 2830, and possibly a test of 2800 (the blue horizontal trend line at 2796). The S&P 500’s 200-day average is at 2765 and rising about 5 points per week. Given the weakness in the underlying market, a test of the 200-day average cannot be ruled out.”
The S&P 500 did bounce on October 9 but was only able to rally to 2895 before rolling over. The weakness of the rebound was another indication of the market’s underlying weakness which has been the main topic in recent weeks.
For a number of weeks I noted that the short position in VIX futures had risen to where it was in January 2018, just before the VIX soared in early February forcing those short the VIX to cover. The fallout from the scramble to cover shorts drove the VIX in just 3 days from 13.47 on February 1 to 50.30 on February 6, contributing to the 8.5% decline in the S&P 500. As noted in the October 1 WTR:
“Should a decent reason to sell materialize, a quick sharp decline is possible, especially since there is a large short position in the VIX.”
In the three days following last week’s October 8 WTR, the S&P 500 fell from 2884 to an intra-day low of 2710 on October 11, a drop of 6.0%. The S&P 500 undercut the 200-day average at 2765 (red moving average) on October 11, closed 1.5 points above it on Friday, and below it on October 15.
Click on any chart below for large image.
Based on any technical indicator the S&P 500 and overall market is quite oversold. The S&P 500’s RSI fell to 16.2 on October 11 (RSI on above chart). The 21 day percent of net Advances minus Declines dropped to -19.7%, a relatively rare occurrence and well below the threshold of -15.0% (green horizontal line). This is only the fourth time this indicator has become so oversold since November 2014. In the three prior times, the S&P 500 enjoyed a decent counter trend rally (3 weeks, 2 weeks, 6 weeks), before falling again to test the initial low in September 2015, February 2016, and March 2018.The percent did approach -15.0% in November 2016 just before the election. Since the November 2016 sell off wasn’t prompted by economic news, the potential of a retest wasn’t necessary.
The initial decline in August 2015 was instigated by China’s devaluation of the Yuan and in January 2016 the market fell as the plunge in oil prices intensified and concerns about the global economy mounted.
In February, the S&P 500 plunged after the January 2018 employment report showed wages growing more than expected which led to a sharp increase in Treasury bond yields.
A retest developed in these three instances, since the concerns that prompted the initial decline lingered and led to another bout of selling pressure. Once the stock market perceived Trump’s election as a good thing, there was no need for a retest.
When the S&P 500 retested the prior lows in September 2015, February 2016, and
March 2018, the 21 day percent of net Advances minus Declines recorded a far less oversold percent. This suggested that the downside momentum was lessening since fewer stocks were participating during the retest (green line connecting the initial low and retest low).
The pattern in 21 day percent of net Advances minus Declines suggests that a decent rebound in the S&P 500 is coming that could last a few weeks and be followed by a subsequent decline that tests 2710.
Although the sharp selloff last week shook up investors, the Call/ Put Ratio suggests sentiment has not become negative enough to support and sustain an intermediate rally. The Call/Put Ratio compares the number of calls purchased each day to the number of puts traded. When investors are bullish, they buy far more calls than puts and the C/P Ratio climbs well above 1.0. After discussing the fragmentation between the major market averages in the September 24 WTR, I noted that despite technical negative investors were more bullish than in June, which was not a healthy sign:
“The Call/Put ratio indicates that investors were more bullish last week than in June, even though a number of major market averages failed to confirm the new highs in the S&P 500 and momentum and measures of the market’s internal strength were weaker.”
The C/P ratio was one piece of technical evidence suggesting that the market was becoming vulnerable to a decline.
Near a market low, investors become negative and buy more puts than calls, pushing the C/P Ratio below 1.0. At the lows in August and September 2015, January 2016, and in March 2018, as the S&P 500 was retesting the February low, the C/P Ratio fell below 1.0. The C/P Ratio also fell below 1.0 in June 2016 at the Brexit low, just before the election in November 2016, and in August 2018.
As of Friday October 12, the C/P Ratio was 103.8, which suggests the S&P 500 may fall to near 2710 soon (on Tuesday October 16 or 17), which causes the C/P Ratio to fall below 1.0. That would provide a good back drop for a choppy volatile rally that carries the S&P 500 up to 2800 – 2825 before the subsequent retest decline commences.
The Trading Index (TRIN, ARMS Index) measures the amount of buying and selling pressure (volume) relative to market breadth (advances and declines). Near market highs, or the onset of a consolidation after a large advance, the TRIN will fall well below 1.0, as it did in January 2018 and recently.
When selling pressure becomes overloaded, the TRIN rises above 1.0. At a minimum, the 10-day average (black line) will rise above 1.3, and at intermediate bottoms the 21 day average (red line) will also get above 1.30 (above chart). The Trading Index is not perfect but does a better job of identifying lows in the market than highs. In August-September 2015, January 2016, April 2017, and March 2018, both the 10 day and 21 day moving average of TRIN rose above 1.30.
As of Friday October 12, both were below 1.0, which is hardly an endorsement that a trading low was formed last week. The TRIN indicator increases the likelihood that the S&P 500 will test lasts weeks low in coming weeks.
The short term pattern (30 minute) in the S&P 500 suggests that the S&P 500 will test or fall below 2710 on October 16 or 17 for wave 5 from the high at 2841. Once this 5th wave occurs, the S&P 500 may begin the rebound up to 2800 – 2825. Aggressive traders can buy the S&P 500 ETF (SPY) if the S&P 500 trades under 2713, using 2685 as an initial stop. Sell 33% if the S&P trades up to 2770, 33% at 2790, and the final third at 2812. If the S&P does trigger the trade use a trailing 1.1% trailing stop until the S&P 500 achieves the prices targets.
The Option Premium Ratio jumped last week to levels not seen since August – September 2015 and January – February 2016 and as such is supportive of a retracement rally to 2800 – 2825.
Just because the S&P 500 experienced successful retests in September 2015, February 2016, and March 2018, one shouldn’t assume that the next retest will automatically be successful. As discussed at length in the October Macro Tides, there are a number of reasons why 2019 could prove challenging for the stock market, so I won’t review them. One of main props under the market has been the expectation that corporate earnings will remain robust into 2019, so there was no need to worry about the market until early next year at the earliest. As noted last week:
“Institutional investors are not going to be net sellers of stock, if they believe the economy and earnings are going to improve in coming quarters which has certainly been the mindset. However, this complacency may be challenged when Q3 earnings are reported and companies offer guidance for the next 6 months that may not be as rosy as expected. In recent weeks the number of companies providing negative guidance has outpaced those providing a positive outlook by the widest margin since 2010. There are reasons to believe this trend may continue and may accelerate since more companies are facing more headwinds.”
According to FactSet, 24 companies have offered guidance and a high number of them have referenced a number of reasons why coming quarters may prove more difficult. If this trend continues, the market may not find as much support from future guidance, even if Q3 earnings hit the mark.
Federal Reserve
If incoming economic data shows that the U.S. economy is slowing a bit or companies sound more cautious about the next two quarters, the Dollar may weaken a bit as investors’ surmise the Federal Reserve will hold off on raising rates at their December meeting. Equity investors would love to think the Fed might either not raise rates in December or announce a holding period after a December increase. Not raising rates in December is a very low probability outcome based on comments Fed Chair Powell has made in recent weeks, as well as a number of FOMC members. The bottom line is Powell is no Janet Yellen and is unlikely to come to the stock market’s rescue if the S&P falls by 10%.
Dollar
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 is likely to exceed the August 15 high of 96.98. Last week I thought the Dollar would pullback to 95.20. In fact the Dollar dipped to 94.95.
The biggest problem facing the Dollar in the short term is positioning. There are still too many traders expecting the Dollar to zoom higher, which suggests the correction since the high of 96.98 may last longer and include a dip under the September 21 low of 93.81.
A correction that takes up more time and losses a bit more ground may be necessary to shake out some of the Dollar bulls, before an assault on 96.98 begins.
Emerging Markets
The Emerging Markets ETF (EEM) became oversold at last week’s low and briefly fell below the lower channel line. If the S&P 500 manages to bounce to 2800 – 2825, EEM has the potential to rally up to $41.50 – $42.00 and near the red horizontal line. If the S&P 500 subsequently retests last week’s low in a few weeks, EEM may provide a buying opportunity for a trade as it retests its low. As discussed in recent weeks, there are a number of fundamental headwinds facing EM so this is a sector that for now is not a buy and hold candidate.
Treasury Yields
As noted last week, the Treasury bond market was deeply oversold and the short position in Treasury bond futures remained at a near record level. In coming weeks, I thought Treasury yields had the potential to drop back to near their ‘breakout’ levels of 3.15% and 3.25%, even if they are headed higher.
As the stock market sold off sharply into its low on October 11, the 10-year Treasury yield fell to 3.127%. If the stock market rebounds as expected, Treasury yields may test their recent highs. If the 10- year does not push above (3.248%), the 10-year has the potential to drop to 3.05%, if the S&P 500 subsequently retests 2710.
If the 30-year does not push above (3.424%) during a stock market rally, the 30-year has the potential to drop to 3.25%, if the S&P 500 subsequently retests 2710.
In the October 1 WTR I recommended buying TLT based on a positive divergence:
“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.”
Last week I thought TLT could rally to $115.00, if Treasury yields retested their breakout levels.
“This should allow TLT to rally to $115.00 or higher. Selling above $115.00 is recommended.”
On October 11, TLT traded up to $115.15. TLT has the potential to rally up to $116.50 – $117.00 (red trend line), if the S&P 500 tests 2710.
Gold
As discussed in recent weeks, Gold continued to hold above the support trend line connecting the low in July 2015 and December 2016, which is just above $1180. I thought Gold could rally above $1214 to complete wave c of wave 4 (as noted on the chart of GLD below). Gold did rally above $1214 on October 11. The irony in this move is that it occurred on the same day the Consumer Price Index came in below expectations, which is obviously counter intuitive.
As I discussed for months, the positioning in Gold futures was extreme with Large Speculators, Managed Accounts, and Hedge funds holding a record short position. On a day that should have rewarded them with Gold falling due to lower inflation, Gold rallied almost $30.00. Imagine how much Gold might rally if it received supportive news!
For the first time weakness in the stock market attracted buying interest in Gold and Gold stocks. If this correlation persists, Gold and the Gold stocks may pullback if the S&P 500 does manage to rally to 2800 or higher. It would be a good sign if Gold doesn’t pullback much during any rally in the stock market. If the S&P 500 does subsequently retest 2700, Gold may be able to push above $1240. The recent strength does not eliminate the risk of a retest of $1160, but it does lower the probability of a retest.
The outlook would become far more positive if Gold were able to close above $1236 and then hold above $1190. Any close below $1180 would promptly lead to a test of $1161 and maintain the potential of a decline to near $1120. Positioning in Gold futures suggests that a major rally is coming to above $1300 and possibly above $1400 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 rallied 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.”
On October 15, GLD rallied up to $116.53, which might have completed wave 4 from the January peak. If GLD trades up to near the blue trend line sell 16% of GLD at $117.70. Given how constructive the positioning is in Gold futures, Gold may just blow through $1240, so selling is a risk. But the pattern from the January high is still intact as is the risk of a meaningful retracement.
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 the last two weeks, there was a potential inverted head and shoulders pattern forming in GDX. As long as GDX held above $18.00, a convincing close above $19.15 would lead to a move up to $19.48 and possibly above $20.00.
GDX broke out above $19.15 on October 11, and traded up to $20.39 on October 15. Sell 16% of GDX if it closes the gap at $20.51 created on August 11. If Gold pushes up above $1240 and then corrects down to $1190, GDX may pullback to under $19.30 and test the high of $19.23 on October 3. If this pattern unfolds it will allows us the opportunity to add to GDX.
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. For most of 2018, Financials have been one of the top recommended sectors based on the expectation that higher Treasury yields and a wider yield curve would propel the Financials higher. Last week the Financials fell to a new 2018 low, below the lows in June.
The rally in Utilities has prompted some to suggest that the Utilities are telling them yields aren’t headed much higher. Maybe. More likely, money is flowing into Utilities as some money managers become more defensive. Last week Treasury yields fell and so di the Utilities (chart below).
I think the economy is going to slow more than expected in 2019 as discussed at length in the October Macro Tides. For now, the breakout in bond yields must be respected.
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.
