Written by Jim Welsh
Macro Tides Weekly Technical Review 31 December 2018
After the Rally in S&P 500 Ends Soon, New Lows Expected
As explained below in this week’s review, now is not the time to make new commitments to stocks.
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Last week I discussed why the S&P 500 was nearing the end of wave 3 which would be followed by a rally of 150 – 200 S&P points:
“The TRIN readings and the Call/Put Ratio suggest the S&P 500 is in the zip code and close to finishing wave 3 soon. After wave 4 carries the S&P 500 up by 150 – 200 points, a decline to a lower low is likely to follow in wave 5.”
The S&P 500 recorded a trading low on December 26 at 2347 and promptly rallied 173 points to a high of 2520 on Friday December 28. Although the S&P 500 may push modestly above 2520 in the next few days, the S&P 500 is expected to fall below 2347 sometime in January.
The 21 day Net percent of Advancing stocks minus Declining stocks closed at -29.1 on December 24 (orange horizontal line), one of the lowest readings since the 1987 crash, 1998 Long Term Capital Management selloff, September 2001 after 9/11, July 2002, financial crisis in 2008, and downgrade of U.S. Treasury debt in 2011. In each case the S&P 500 experienced a rally and then a subsequent decline to a lower low that recorded a less oversold reading on the 21 day Net percent of Advancing stocks minus Declining stocks.
Click on any chart below for large image.
In the January 2019 issue of Macro Tides (out tomorrow), I discuss why a recession is unlikely in 2019 and compared the recent decline to those experienced in 1987, 1998, and 2011. In those prior declines the S&P 500 fell by 20.0% or more but the economy did not enter a recession. These prior declines reinforce that it is possible for the S&P 500 to suffer a meaningful decline without a recession. Investors who believe markets discount the future have inferred that the stock market is ‘telling’ them the economy is weak and may enter a recession before the end of 2019. Based on what is known today the odds of a recession beginning in the next 6 months is less than 20%. That could certainly change if the trade and tariff dispute with China becomes an all out trade war.
The technical pattern of prior high energy selloffs indicates that the S&P 500 is likely to decline below 2347 whether a recession develops later in 2019 or not. In each case the initial momentum low was followed by a rally and subsequent decline to a lower low usually within 3 months.
Although the 21 day Net percent of Advancing stocks minus Declining stocks did not drop below -25.0% (orange horizontal line) in August 2015 or January 2016, the pattern in the oscillator and S&P 500 were the same as in the prior occurrences in 1987, 1990, 1998, 2002, 2008-2009, and 2011.
The odds certainly favor another decline in the S&P 500 below 2347 before a more significant and protracted rally can take hold.
At the open on January 2 establish a 33% short position by purchasing the 1 to 1 inverse S&P 500 ETF SH as long as the S&P 500 is above 2470 and increase it to 66% if the S&P 500 trades above 2520. Cover half of the position if the S&P 500 drops below 2347.
The intensity of the drop into December 24 creates the possibility that the 2347 low was wave 3 of 3 and the rally off 2347 is wave 4 of 3. The implication is the same in the short term – the S&P 500 will fall below 2347. The difference in this pattern is that after a decline below 2347, the S&P 500 would rally at least back to 2520 for wave 4 from the high at 2940. The S&P 500 would then be expected to decline to yet another lower low before the pattern from the high at 2940 is complete.
From its low in February 2016 at 1810 to the September 2018 high of 2940, the S&P 500 rallied 1130 points. A 50% retracement would target 2375 which was exceeded on December 24. The 61.8% retracement is 2242. The red trend line connecting the March 2009 low with subsequent lows in October 2011 and February 2016 comes in near 2300.
At what S&P 500 level should cash be committed?
Irrespective of how this decline finishes the expectation is that once a low is in place the S&P 500 is likely to retrace at least 50% of the decline from 2940. If wave 5 bottoms at 2300, the S&P 500 would rebound to 2620 if the retracement is 50%, and to 2695 if it is 61.8% of the 640 point decline from 2940. If the low turns out to be 2200, the 50% retracement would lift the S&P 500 back to 2570 and to 2657 if it is 61.8% of the 740 point drop from 2940.
Since it is not possible to know whether the low will be 2300 or 2200 or even 2100, the 50% retracement levels should be above 2347 irrespective of the precise low. This suggests that if the S&P 500 does fall below 2347 some amount of cash should be committed since the S&P 500 is likely to trade above that entry point in the first half of 2019. I will do my best to identify an entry point if the S&P 500 does approach 2347, but conceptually this is the framework to use.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
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 on November 7. Half of the position was covered when the S&P 500 traded under 2650 and SH was trading at $29.97.
When the S&P 500 exceeded 2730 on November 28, the 25% that was sold when the S&P 500 traded under 2650 was bought with SH trading at $29.03. This position was closed at the open on December 11 when SH opened at $29.60. The 16.5% position established on November 7 when SH was trading at $28.35 was closed on December 20 when SH was trading at $31.81.
The MTI fell below the blue horizontal trend line on November 21 so the probability of a bear market increased. The MTI signal is one reason why I have favored looking for the opportunity to go short rather than trying to play a counter trend bounce from the long side. That may change once the S&P 500 appears to have completed 5 waves down from the September peak.
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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