Written by Jim Welsh
Macro Tides Weekly Technical Review 08 July 2019
Although the FOMC decided not to lower the funds rate at the June 19 meeting, there was a notable shift in the FOMC Dot Plot from the March projections.
Please share this article – Go to very top of page, right hand side, for social media buttons.
As you may recall 8 FOMC members expect the federal funds rate to be unchanged until the end of 2019 with 1 member supporting a single increase. In contrast, 7 members favored 2 cuts before year end with 1 member backing a single reduction. The minutes from the June 19 meeting will be released on July 10 and will receive a great deal of scrutiny for what motivated the shift toward lower rates. The FOMC has two domestically centric mandates: maximum employment and stable prices. In the current environment the Trade War with China and the slowdown in the global economy may have received more attention and discussion at the June 19 meeting than the domestic economy.
Since that meeting there has been no resolution in the Trade War, only another postponement. The worst possible outcome at the G20 meeting was avoided for now, but FOMC members have no more certainty than on June 19. The global economy has continued to slow modestly based on the majority of economic stats since June 19. The U.S. economy received good news as 224,000 new jobs were created in June a sharp improvement from the 75,000 in May. Wage growth held steady at a decent 3.1% annual rate and is expected to rise in coming months based on forward looking labor market indicators.
Consumer spending improved during the second quarter after slowing in Q1 and should remain steady as incomes grow. Manufacturing has been the weakest sector in the U.S. and globally, with the slowdown in global trade due to tariffs being the primary driver. Business investment has been weak in the U.S. and globally as companies wait for more clarity on trade and in response to the global slowdown.
Despite the overall downtrend in global manufacturing, the U.S. ISM Manufacturing Index only fell to 51.7 in June, so it is still in expansion territory. There is a true bifurcation between manufacturing and the service sector, not just in the U.S., but in the Eurozone and China. The service sector in the U.S. comprises 85% of GDP compared to just 15% for manufacturing. In June the service sector ISM Non Manufacturing Index for the U.S. was 55.1, which is still a healthy level. The manufacturing weakness in the Eurozone has been deeper than in the U.S. with the Markit Manufacturing PMI at 47.5 in June and in contraction mode. The primary driver of the weakness has been concentrated in Germany which derives more than 45% of its GDP from exports. It has been hit harder by the trade tiff and slowdown in China. The service sector PMI for the Eurozone was 53.6 and much stronger than the manufacturing PMI. In China the Manufacturing PMI for June was 49.4 while the service sector PMI was much stronger at 54.2.
The bifurcation between manufacturing and services underscores the impact on the global economy that the Trade War has exerted and the potential to do more damage or provide a meaningful lift if a resolution is achieved. This is part of the dilemma confronting FOMC members as they assess what is the appropriate policy. In all likelihood the majority of FOMC members do not know with any degree of certainty how they will vole at the July 31 meeting. The strong employment report will not sway those who projected no change or a single increase in the funds rate to cut. For those looking to lower the funds rate by the end of the year, the employment report gives them comfort in waiting for more data. The June estimate for retail sales will be released in mid July and will provide further insight into domestic economy strength. The key determinant remains the outcome of the trade negotiations since a full-blown Trade War could tip the global economy into another sinking spell and drag the U.S. down. I think many of the FOMC members would respond forcibly to additional tariffs and support a 0.50% cut in the funds rate immediately.
The 8 doves on the FOMC know that financial conditions have eased significantly since December, which will provide the U.S. economy support in coming months. The tightening in financial conditions that developed in the fourth quarter has been completely reversed.
The decline in Treasury yields has brought mortgage rates down by more than 1.0% since December, which has spurred a modest surge in refinancing activity. This will give those homeowners a boost in their disposable income and spending.
Lower mortgage rates will make housing a bit more affordable and help more potential buyers qualify to buy. An ‘insurance’ rate cut at the July 31 meeting may not provide that much of a lift beyond what the decline in bond yields has already provided.
The FOMC has only 9 cuts to work with and an insurance rate cut doesn’t seem like the wisest move. It may be better for the FOMC to hold off until they know the outcome of the trade talks or economic data is soft enough in the U.S. to compel them to act. After the employment report, the odds of 0.50% cut in the funds rate at the July meeting fell from 25% to 2.5%, while the odds of a 0.25% reduction slipped from 100% to 97.5%.
Those expecting the FOMC to act at the July meeting are ignoring other risks. The S&P 500 is at a record high and asset prices in general are somewhat expensive. If the FOMC cuts rates, even though the U.S. economy doesn’t need it, an additional rise in stock prices could pose a stability risk. If the FOMC cuts rates in July, and by some miracle a trade deal is achieved in coming months, economic growth would pick up and could invite more criticism for the FOMC if they were subsequently forced to consider raising rates. As long as U.S. economic data remains solid, the majority of FOMC members may decide waiting is the better course of action.
Would the stock market decline if the FOMC doesn’t lower the funds rate? Yes. But some of those expecting the FOMC to act in July have forgotten that the equity market is not one of the FOMC’s mandates.
Stocks
The DJ Industrial average was expected to rally to a new all time high to complete Wave (D) of the triangle that began in January 2018. On July 3 the DJIA rallied above the October 3 high so it has completed the minimum required to finish Wave (D). Since the June 3 low, the DJIA continues to make higher highs and higher lows which is the definition of an uptrend. In order to signal that a top may be in place the DJIA would have to at least drop below the prior low of 26,465 on June 27.
Although Wave (D) in the DJIA and S&P 500 may be nearing an end, the underlying technical health of the market suggests there may be more upside. The NYSE Advance / Decline Line has made a new high driven in large part by the preponderance of interest sensitive issues that trade on the NYSE. Although the percent of stocks above their 200 days average is only moderately positive at 63%, it has made a new recovery high since the low in December (versus 62% on May 3). In a really healthy market the percent would be comfortably above 70%. Prior to the selloff in the fourth quarter, the A/D Line and the 200 day percent recorded lower highs in early October (red lines). Until this type of divergence develops, or the market averages begin to make lower lows, the upside must still be respected.
The NASDAQ Advance / Decline Line does not have nearly as much exposure to interest sensitive issues as the NYSE and it’s A/D Line looks much weaker. Even though the NASDAQ 100 did manage to post a marginal new high, the NASDAQ A/D Line shows that breadth has been narrowing significantly since last August. It is also modestly below the April high which indicates that it is continuing to weaken.
While the DJIA and S&P 500 were able to record a new all time high last week, a number of major market averages and keys sectors failed to do so. The NYSE and Russell 2000 are the broadest market averages and are well below their prior all time high, with the Russell 2000 more than 11% below its prior high. In a healthy market nearly all the averages would be making new highs together or would be far closer. Technology stocks have consistently been a leading sector and Semi-Conductors are the leading edge of technology.
The Semi-Conductor ETF (SMH) is almost 10% below its April 24 high. This has caused SMH’s Relative Strength to the S&P 500 to weaken which is not a good sign for the Semi’s or the overall market, as was the case prior to the fourth quarter drop in the market.
The DJ Transportation average is another leading and important sector and it looks ugly. The large divergence between the DJ Industrial average and Transports is setting up a Dow Theory sell signal.
The table is set for a decline of some magnitude depending on the level of selling pressure. In order to signal a short term high and potentially a completed Wave (D), the S&P 500 needs to fall below its prior low of 2912. A decline to 2820 seems likely and a test of 2730 is certainly possible if the FOMC doesn’t lower its policy rate or earnings guidance is lowered by a majority of companies. If President Trump enacts more tariffs or a military event with Iran develops, the S&P 500 could test 2650. A break of that level would open the door to a retest of the December low which is what the Megaphone pattern in the DJIA and S&P suggest is likely.
Since the January 2018 top the S&P 500 has formed a Classic ‘Megaphone’. The high in January 2018 would be labeled wave (3) from the March 2009 low. (See chart below) The decline to the low in February 2018 is wave (A), the rally to the September 2018 high is (B), and the plunge into December 2018 is (C). Last week’s high may be Wave (D). Wave E would bring the S&P 500 below the Wave (C) low in December.
I’m not ready to go short until more evidence confirms that the topping process is complete. When the S&P 500 was trading at 2877 at 7am on May 16 I lowered the exposure in the Tactical U.S. Sector Rotation Model Portfolio from 100% to 50%. I lowered exposure to 25% in the Tactical U.S. Sector Rotation program on June 11 after the S&P 500 gapped up to 2903 at the open. I lowered exposure to 5% from 25% at the close on Wednesday when the S&P 500 was 2913. I sold the 5% position in Technology ETF (XLK) shortly after the opening on July 1. The Tactical U.S. Sector Rotation Model Portfolio is now 100% in the money market.
Treasury Bonds
Last week the expectation was that Treasury yields would spike to a new low before reversing higher:
“Since spiking down to 1.975% on June 20, Treasury bond yields have been chopping sideways and may have formed a small triangle in the process. This suggests that the 10-year Treasury yield will spike below 1.975% before reversing higher.”
The 10-year Treasury yield rose from 1.943% on July 3 to 2.068% on July 5. A close above 2.07% would indicate a short term top was in place, while a close above 2.18% would suggest a potential multi-month top.
The initial increase in yields is likely to be slow since the expectations for FOMC easing are so entrenched, and positioning in the Treasury futures shows a large short position is still held by Large Speculators (green line middle panel) and Commercials (red line middle panel) are long. If positioning was more constructive I would be looking to go short.
As noted last week:
“The Treasury bond ETF is expected to rally above $133.50 as it potentially completes Wave 5 of Wave (C) and the rally from the low of $111.90 in November.”
A close below $131.30 would confirm a short term high, while a close below $130.00 would increase the odds that a multi-month top was in place.
Global Bond Yields
Global bond yields are now the lowest since 1900. Let that sink in for awhile.
Christine Lagarde has been nominated to take over the leadership of the European Central Bank (ECB) when Mario ‘Whatever it Takes’ Draghi’s term ends on October 31. At the last ECB meeting Mario indicated that the ECB would launch additional stimulus programs since inflation is below the ECB’s 2.0% target and growth has been flagging. With $13 trillion of global sovereign bonds already yielding less than 0%, what additional stimulus can the ECB hope to accomplish? Mario is from Italy so he may be reinventing the old saying reflecting central bank impotence:
‘Pushing on a string’
to
‘Pushing on a strand of Spaghetti’.
Gold
Gold experienced a sharp decline of -3.75% after trade talks were scheduled to resume as expected. After posting a short term low of $1382 on Jul 1, Gold quickly bounced to $1435 just below the high of $1438. It’s possible that the high at $1438 was wave 3 and the current correction is wave 4. If it becomes a classic a-b-c correction, Gold should dip under $1382 modestly before rallying to a new high. If this pattern unfolds a more protracted decline would follow. A scalp trade for aggressive traders could set up in the Gold ETF IAU if it trades under $13.10, with a rally above $13.75 to follow.
Gold Stocks
If GDX drops to $24.03 a rally to a higher high could unfold if Gold pulls back under $1382 and then rallies above $1438. Aggressive traders can buy GDX at $24.06 and sell above $26.25.
Dollar
I thought the Dollar could get a lift if the employment report was stronger than expected dimming the odds of a rate cut at the July 31 FOMC meeting. If the probability of a July 31 rate cut continues to fall in the next few weeks, which is the expectation, the Dollar could potentially test the 98.37 high. The Dollar is still expected to drop to 95.03 in coming months.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
The MTI generated a Bear Market Rally (BMR) buy signal on January 16, 2019 (green arrow) and climbed above the green horizontal trend line on February 26 confirming the uptrend. The progressive weakening in the technical structure of the market since late April led me to reduce exposure. When the S&P 500 was trading at 2877 at 7am on May 16 I lowered the exposure in the Tactical U.S. Sector Rotation Model Portfolio from 100% to 50%. I lowered exposure to 25% in the Tactical U.S. Sector Rotation program on June 11 after the S&P 500 gapped up to 2903 at the open.
I lowered exposure to 5% from 25% at the close on Wednesday when the S&P 500 was 2913. I sold the 5% position in Technology ETF (XLK) shortly after the opening on July 1. The Tactical U.S. Sector Rotation Model Portfolio is now 100% in the money market. .
The Megaphone pattern allowed for the S&P 500 to trade up 3000 and modestly above that big round number. The S&P 500 traded up to 2996 last week. Although it may take a few more weeks for the stock market to complete its topping process, the next big move is likely to be down not up. Should the S&P 500 close above 3020 and hold above that level, the Megaphone pattern would probably be negated, and I would have to reassess the outlook.
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.
.