Written by Jim Welsh
Macro Tides Weekly Technical Review 03 December 2018
Equity and bond traders thought the Federal Reserve was committed to increasing the federal funds rate in December and three times in 2019. This view was based on the dot plot published after the September FOMC meeting.
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Even though the FOMC expects GDP growth to slow to 2.5% next year, the dot plot indicated that the majority of FOMC members expected to increase the federal funds rate in December and three more times in 2019. The misconception by investors was in thinking FOMC members would be married to the dot plot rather than to incoming data on the economy and inflation. As I emphasized last week:
“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.”
This is just common sense and should have been understood by all market participants. Knowing that the markets had the wrong perception I expected markets to react with surprise if Powell stated the obvious. The market took off after Powell said:
“There is no preset policy path. We will be paying very close attention to what incoming economic and financial data are telling us.”
The S&P 500 rallied from 2685 just before the text of his speech was released to 2759 on Friday November 30 a gain of 2.4%.
Click on any chart below for large image.
Investors believe Powell and the FOMC have changed their tune and may not increase rates 3 times in 2019. Just as investors were formerly incorrect in believing the Fed would blindly raise rates three times in 2019, they may now also be wrong in assuming the Fed won’t raise rates 3 times in 2019. In fact investors are now pricing in only 1 rate increase in 2019. With oil prices down about 30% the expectation is that inflation will fall in 2019.
The Fed’s preferred inflation measure is the core Personal Consumption Expenditures Index (PCE) which excludes energy and food. The Fed wasn’t that worried when oil rallied from $50 a barrel to $76 a barrel, and they won’t be swayed now that it has fallen back to $50 a barrel.
The New York Fed’s Underlying Inflation Gauge (UIG blue line) includes 105 economic and market indicators and suggests that inflation pressures will intensify during 2019 and climb to 2.7% in 2020. The labor market is tight with the unemployment rate at a 49 year low as Powell noted in his speech. The labor market is so tight it now takes a record 31 days for companies to fill an open position compared to 26 days in 2006.
The Bureau of Labor Statistics Wage Growth Diffusion Index estimates that Average Hourly Earnings will continue to rise as 2019 unfolds and reach an annual rate of 4.0% by the end of 2020.
If the UIG is correct and inflation trends higher in the first half of 2019, the unemployment rate trends lower, and Average Hourly Earnings press upward, the financial markets will learn that the Fed’s ‘new found flexibility’ isn’t restricted to fewer rate hikes in 2019. It is certainly possible that the market’s expectation that the high for the federal funds rate in this cycle will not be 2.75%, but may be as high as 3.25%. If tax refunds prove larger than most taxpayers expect, the economy could catch a second wind in the second quarter and elevate concerns that the Fed may be forced to raise the federal funds rate above the neutral rate.
It will take more than one economic report to raise doubts about the pace of rate hikes in 2019. The first wake-up call could come as soon as this Friday when the November employment report is 
released. The forecast is for 180,000 new jobs in November which would be down from the October increase of 250,000. There is a good chance the October number will be revised lower. While Wall Street will view any number less than 180,000 as good news since it gives the Fed more leeway, the Federal Reserve will see it differently. For the economy to absorb new entrants into the labor market, only 75,000 jobs need to be created. The Fed would view anything above 75,000 jobs as further shrinking slack from the labor market. If the unemployment rate dips from 3.7% to 3.6%, the financial markets will know that the Fed will think the labor market is another step closer beyond full employment and likely to exert upward pressure on wages. The most attention may be directed at the change in Average Hourly Earnings (AHE). If wages grow by $0.03 AHE will be up 3.0%, 3.1% ifwages grow $0.07 and 3.2% if AHE are up $0.08.
Needless to say a 3.2% print would get the attention of financial markets and remind them that there may be more than 1 rate increase in 2019 and the first may occur in March rather than June.
Stocks
Last week I thought the S&P 500 had the potential to rally above 2815 based on its pattern and technical indicators. The rally from 2603 to 2815 may have been wave A of a counter trend rally, with the decline to 2631 on November 23 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.
There were two conditions that were required for a rally above 2815 to develop:
“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. 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.”
The S&P 500 gapped higher on December 3 after it was announced that the U.S. and China had agreed to postpone for 90 days the increase in tariffs from 10% to 25% on January 1, 2019. The 90 day period will allow for further negotiations. The devil is always in the details and the details of intellectual property rights, forced technology transfers, and industrial espionage require China to alter their way of doing business. I’m skeptical China will meet the U.S. halfway on these issues. The real nitty gritty of whether the 90 day window will generate substantive progress and resolution won’t come into view until the Ides of March. In the next month or two President Trump will likely emphasize that progress is being made and won’t be bashful in Tweeting this view.
The S&P 500’s high on December 3 was 2800. Although it’s possible that wave C ended at 2800, it is more likely the S&P 500 will exceed the November 8 high of 2815 before wave C ends. The decline from 4 2940 to 2603 was likely the initial decline within the context of a larger decline that could bring the S&P 500 down to 2300 sometime in 2019 (1). In the November 5 WTR I made the following recommendation:
“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.”
The S&P 500 traded up to 2815 on November 8 triggering both positions. In the November 19 WTR I recommended covering half of the position if the S&P 500 traded under 2650 which it did on November 20. In the November 26 WTR I rescinded the recommendation to cover the remaining 25% short position in the S&P 500 at 2681 in the Special Update on November 26. I wanted to maintain a small short position just in case Powell didn’t tell the market what it wanted to hear:
“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.”
The S&P 500 rallied above 2730 on November 28 after Powell’s speech. If the S&P 500 is able to punch above 2815 it may run up to 2845 which is where wave A and wave C would be equal. Increase the short position to 75% if the S&P 500 trades above 2830, using a stop of 2880 on the whole position.
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. The Dollar has strengthened whenever the tariff issue flared up. Sentiment is also wildly bullish the Dollar. All this suggests the Dollar is a crowded long trade and ripe for at least a decent correction.
Although the Dollar may hold up through the end of the year due to global banks wanting to hold dollars, it is primed for a correction. Technically, the Dollar’s RSI negatively diverged when the Dollar made a new closing high on November 12. The expectation is that the Dollar will fall back to the late September low under 94.00 in coming months. The first sign that the correction may starting will be a close below 96.40 and the rising uptrend line.
Gold
Gold’s relative strength to the Dollar has been improving and should the Dollar decline to 94.00 in coming months, Gold would seem poised 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 may be forming an inverse head and shoulders since mid October, with the neckline designated by the horizontal trend line at $1240. A close above $1240 would target a rally to $1275 based on the width of the inverse head and shoulders.
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 $21.50. If Gold pushes up to $1350, GDX could rally to $23.00 (green down trend line), especially if its relative strength to Gold improves as Gold rallies.
Treasury Yields
Since late September the huge short position held by Large Speculators has shrunk from -756,316 contracts to -284,223 contracts as of November 27, which was the day before Powell’s speech. The 10- year Treasury yield has fallen from 3.075% on November 28 to 2.986% on December 3 likely spurred by additional short covering by Large Speculators. The RSI on the 10-year Treasury yield is almost as overdone as it was on May 29 when the yield bottomed at 2.759%. The bond market may have misinterpreted Powell’s since the FOMC’s bias is to raise rates unless incoming data is weaker than expected. The first upward adjustment in yields could appear if the employment report on December 7 is stronger than expected.
The 30-year Treasury yield has fallen from 3.350% on November 28 to 3.272% on December 3. 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%.
If inflation rises in 2019 and the FOMC increases the federal funds rate more than two times in 2019, establishing a short position Treasury bond by buying an inverse Treasury ETF could prove profitable. A 50% position can be established if the 1 to 1 inverse Treasury ETF TBF trades below $23.50, using a close below $23.25 as a stop. TBF looks like it broke out in early September when it moved above the declining black trend line, and is merely ‘testing’ the breakout. Aggressive traders can purchase the 2 to 1 inverse Treasury ETF TBT below $38.40 using a close below $37.88 as a stop.
Crude Oil-WTI
Saudi Arabia and Russia are likely to agree on production cuts at the OPEC Summit meeting on December 6 which should help stabilize crude oil prices and then enable a rally to ensue. Saudi Arabia depends on oil revenue to fund 80% of its government budget while Russia derives 50% of government revenues from its oil production. Failure to cut production would likely be followed by a decline to $45.00 a barrel or lower.
Two weeks ago 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 and $9.33 on November 28, so it was not filled. Use a close below $9.38 which is the 78.6% retracement of the rally from $9.30 to $9.85 as a stop. AMLP yields about 8.5%.
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. Half of the position was covered when the S&P 500 traded under 2650 and SH was trading at $29.97.
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. 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.
