Written by Jim Welsh
Macro Tides Technical Review 26 November 2018
CNBC’s Jim Cramer has been on another “They know nothing” rant about the Federal Reserve since early October after Chair Powell said “We’re a long way from neutral at this point.” In August 2007 Cramer correctly noted that the Federal Reserve did not realize how much liquidity was evaporating within the financial system and the risk it represented to Wall Street investment firms. It became public knowledge that a number of FOMC members had laughed at Cramer’s outburst during a FOMC meeting.
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But Cramer had the last laugh since he was proven right, which is why in recent weeks he’s been saying – Cramer 1, Fed 0.
Cramer has equated the current Fed’s pattern of increasing the federal funds rate once a quarter to the FOMC increasing the federal funds rate at 17 consecutive meetings starting in June 2004. His criticism is that the FOMC is being just as robotic now as it was in the prior cycle and risks tipping the economy into recession.
I think Cramer’s criticism is overdone and somewhat self serving since it’s provided the opportunity to repeatedly reference and show his “They know nothing” clip from August 2007.
The FOMC has been increasing the federal funds rate at half the pace it did in the prior cycle since December 2016. As Powell noted in his PBS interview with Judy Woodruff on October 3:
“Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”
When the federal funds rate reached 5.25% in July 2006, the core Consumer Price Index (CPI) was 2.7%. The real federal funds rate after subtracting inflation was +2.55% in 2006 compared to 0.0% now, so policy is clearly accommodative.
As discussed at length in the November Macro Tides, the Federal Reserve believes it is not appropriate for the federal funds rate to be 0% and below the neutral rate given the current health and growth rate of the U.S. economy. The neutral interest rate is the rate at which monetary policy is neither accommodative nor restrictive, and where growth and inflation are both at their natural rate on a stable basis. The FOMC has acknowledged that it does not know precisely where the neutral level for the federal funds rate is, but the dot plot provided by the members of the FOMC at the FOMC’s September meeting indicates where they think it is:
“The doves on the FOMC think it is 2.75% and the hawks think it is 3.0%. The median rate was 2.9% which mathematically indicates that there are 1 or 2 more members who believe its 3.0%, rather than 2.75%. The median average would have been 2.875% if the two camps 2 were equal. The important point is that even the doves support two more increases in the federal funds rate.”
The dot plot also indicates that the majority of FOMC members expect to increase the federal funds rate in December and three more times in 2019, even though the FOMC expects GDP growth to slow to 2.5% next year. Cramer thinks the FOMC will increase rates according to the dot plot irrespective of incoming data. I think he’s wrong. Cramer has also said the Fed should raise rates in December and then communicate that it is pausing for awhile. I don’t think that’s likely.
Fed Chair Jerome Powell will be speaking at the Economic Club in New York on Wednesday November 28 at 12 p.m. e.s.t. It would be an understatement to say investors will be hanging on to every word and vocal inflection for clues about Fed policy. Here’s my guess as to what Powell may say.
Powell comes across as a guy who is well grounded and a proponent of common sense. To that end he is likely to reiterate why the FOMC has been on and likely to continue on the path of gradual rate increases. This gives him the opportunity to rebut Trump without dropping to Trump’s level of rhetoric. Powell will note that even though the economy is expected to slow in 2019 to 2.5%, that pace of growth would still be above the Fed’s long term estimate of the economy’s growth potential of less than 2.0%.
Click on any chart below for large image.
Inflation pressures will build as long as GDP growth is above the economy’s long run growth potential. Powell will acknowledge the strong employment gains in recent months, even as the unemployment rate is near a 50 year low. He will point to the modest improvement in wage growth to 3.1% and the likelihood wage growth could accelerate as unemployment continues to fall. He may repeat comments he made recently about the FOMC’s goals:
“Our goals will be to extend the recovery … and to keep unemployment low and inflation low. So that’s how we’re going to think about it.”
He is likely to discuss the risks to the Fed’s expected path for inflation and economic growth in 2019. If inflationary pressures emerge and begin to lift inflation faster than the FOMC projects, the Fed will respond accordingly. Conversely, if anything threatens economic growth and indicates GDP growth will be less than 2.5% in 2019, the FOMC will take that into account. Whether he specifically mentions the trade negotiations with China or the potential flare up with Italy is not important. What is far more important is Powell acknowledging that the FOMC will not be a slave to the dot plot projections, but will instead respond if inflation or economic growth changes relative to the Fed’s projections.
If Powell were playing golf his speech would be seen as hitting the tee shot right down the middle of the fairway. But investors are likely to see it as opening the door to the possibility that the FOMC won’t increase the federal funds rate 3 times in 2019. With the recent plunge in oil prices, no one is going to take the threat of an upside inflation surprise too seriously. They will gladly infer from the drop in oil prices that the slowdown in the global economy is for real and will cause the Fed to abandon the dot plot inference of 3 rate hikes in 2019. Investors simply want to hear that it may be possible, which could be all that’s necessary to move a number of markets meaningfully.
The chart patterns in the Dollar, Gold, and the S&P 500 suggest that investors are more likely to hear what they want to hear, which could lead to a decline in the Dollar, and rally in Gold and the S&P 500. The FOMC is not likely to be as robotic about 2019 rate increases as Cramer thinks
Dollar
Large Speculators continue to hold very big short positions in the Euro, Yen, Australian dollar and the majority of other foreign currencies. These short positions represent a de facto long position in the Dollar since they will profit if the Dollar rises against these currencies. Sentiment is also wildly bullish the Dollar as global investors expect the Federal Reserve to continue to raise rates.
This suggests the Dollar is a crowded long trade and ripe for at least a decent correction. Technically, the Dollar’s RSI negatively diverged when the Dollar made a new closing high on November 12, which illustrates a loss of upside momentum and is normally a precursor to a price correction. The expectation is that the Dollar will fall back to the late September low under 94.00 in coming months.
Gold
As the Dollar bottomed at 93.81 in late September, Gold recorded a trading low of $1181. The Dollar rallied to 97.66 on November 13, just as Gold posted a short term low of $1196.31. Even though the Dollar made a higher high than in late October, Gold was able to hold well above its trading low of $1181 in late September. This indicates that Gold’s relative strength to the Dollar is improving. Should the Dollar decline to 94.00 in coming months, Gold would seem primed for a solid rally. Gold is expected to rally above $1300 in the first quarter and could approach $1350. Sentiment toward Gold is negative which suggests a rally would surprise most investors.
Gold Stocks
If Gold rallies above $1300 in the first quarter, the Gold Stock ETF GDX would be expected to test the red horizontal trend line near $21.15. If Gold pushes up to $1350, GDX could rally to $23.00, especially if its relative strength to Gold improves as Gold rallies.
Stocks
The S&P 500 has the potential to rally above 2815 based on its pattern and technical indicators. The decline from 2940 to 2603 was the initial decline within the context of a larger decline that could bring the S&P 500 down to 2300 sometime in 2019 (1). The rally from 2603 to 2815 may have been wave A of a counter trend rally, with the decline to 2631 last week representing wave B of this upward correction. If this pattern analysis is correct, the S&P 500 has the potential to rally above 2815 in wave C before the down trend resumes.
Even though the S&P 500 didn’t fully test the intra-day low of 2603 last week, it did test the closing low of 2641 on Friday when the S&P 500 closed at 2632. The 21 day percent of Advances minus Declines was far less oversold on Friday, which suggests selling pressure may have been exhausted in the short term. The same positive divergence developed as the S&P 500 retested the initial trading low in late March, February 2016, and September 2015.
Sentiment has also become overly bearish in the short term. The National Association of Active Investment Managers (NAAIM) have cut their equity exposure to 30.15%. Although it was down to 20% in February 2016, the current reading is supportive of a rally in the short term.
The Option Premium Ratio has jumped to levels consistent with a decent rally, as occurred in September 2015 and February 2016. The Call Put Ratio has improved but not as much as in September 2015 or in February 2016.
In order the S&P 500 to rally above 2815 investors will have to perceive Powell’s speech as an indication that the Fed may prove more dovish than previously expected. And, the market will have to believe that the meeting between President Trump and President Xi could lead to a resolution. A photo op with both presidents smiling and words pledging additional talks probably wouldn’t be enough to convince investors, after so many false starts. President Trump will have to offer a postponement of the proposed increase in tariffs on January 1 for 30 days or more as a gesture of good will.
If investors believe the Fed will be more dovish after Powell’s speech and trade talks might lead to a de-escalation in the trade war with China, the S&P 500 could exceed 2815 quickly. While I expect investors to misinterpret Powell’s speech as being more dovish than he intends, I doubt anything substantive with China is likely for many months. That’s why it will take more than President Trump declaring that China wants a deal to move the market meaningfully. If possible, Trump will try to pump up the market, since he equates success with a higher stock market.
The odds the S&P 500 can rally above 2815 are low, even if of everything falls into place so. A rebound is more likely to fail below 2750 before the decline resumes. In the November 5 WTR I recommended shorting the S&P 500:
“A 25% short position in an inverse S&P 500 ETF (SH) can be established if the S&P 500 trades up to 2790 and increased to 50% if the S&P 500 trades up to 2805, using 2865 as a stop.”
Half of this position was covered when the S&P 500 fell below 2650 on November 20. I am rescinding the recommendation to cover the remaining 25% short position in the S&P 500 at 2681 in the Special Update on November 26. Instead, use the 25% that was covered when the S&P 500 traded below 2650 to add to the short position if the S&P 500 rallies above 2730. If the S&P 500 trades above 2815 increase the short position to 75%, using s stop of 2880 on the whole position.
Crude Oil-WTI
After discussing why the decline in crude oil was due in part to the unwinding of a long crude/short natural gas trade, I concluded with the following assessment:
“While there may be more unwinding to come that could provide more volatility in WTI Crude Oil and Natural Gas prices, most of the damage is likely done.”
On Friday January WTI Crude Oil traded down to $50.10 before rebounding to $52.25 on November 26. Saudi Arabia can use the depth of the decline as leverage in getting other producers to reduce production at the next OPEC meeting. If correct, WTI Crude Oil can rebound to the upper $50’s in coming months, and potentially $60.00 which is 38.2% of the decline.
Last week I recommended a 33% position in the Alerian Master Limited Partnership ETF (AMLP) if it traded down to $9.56. I suggested increasing it to 66% if AMLP traded under $9.30. AMLP traded down to $9.31 on November 20 and 23, so the second order was not filled. Use a close below $9.10 as a stop.
Treasury Yields
Last week I thought the 10-year Treasury yield could approach 3.03% before resuming the upward trend to 3.28% or higher. On November 23, the 10-year Treasury fell to 3.032% and I expect yields to make a new high. From the low of 1.32% in July 2016, the 10-year Treasury yield increased to 2.62% in March 2017, an increase of 1.30%. From the September 2017 low of 2.037%, an equal rise of 1.30% suggests the potential for the 10-year Treasury yield to climb to 3.33% before the potential of another trading low is possible.
Last week I thought the 30-year yield could dip to 3.30% before reversing higher. On November 23 the 30-year Treasury yield fell to 3.278%, and is now likely headed higher. If wave 1 from 2.925% and wave 5 are equal, the 30-year Treasury yield can rise to 3.52%, slightly above the green trend line connecting the May high (3.247%) and the early October high at 3.424%.
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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. Past performance may not be indicative of future results.
The MTI has weakened significantly since early October. The U.S Sector Rotation Portfolio was moved 33% into cash/money market at 2738.30 on November 6, 66% into cash/money market when the S&P 500 opened at 2774.13 on November 7, and moved 100% into cash/money market fund as the S&P 500 moved above 2800. The average exit price was 2770.81. The U.S Sector Rotation Portfolio established a 33% short position in an inverse S&P 500 ETF (SH) at $28.35, when the S&P 500 traded above 2800.
The MTI fell below the blue horizontal trend line last week so the probability of a bear market has increased. This alone does not preclude the potential of the S&P 500 experiencing a bear market rally in coming weeks. But the MTI signal is one reason why I favor looking for the opportunity to go short rather than trying to play a counter trend bounce from the long side.
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.
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