Written by Jim Welsh
Macro Tides Weekly Technical Review 15 July 2019
Good News, New Highs, and an Approaching Top in Stocks
The stock market has been the beneficiary of a string of good news in recent weeks. President Trump and President Xi agreed to restart trade negotiations at the G20 meeting on June 30. Concerns about the strength of the US economy dissipated after the June employment report on July 5 indicated that job growth rose to 224,000 from 75,000 in May.
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Last week Fed Chairman Jay Powell made it a good news trifecta when he made it clear on July 10 that the majority of FOMC members believe the case for lowering rates has strengthened since their last meeting on June 19. I thought Chairman Powell would have been more non committal in his semi-annual statement and testimony Congress.
Investors have seized upon Powell’s virtual confirmation of a cut in the funds rate on July 31 to also mean the FOMC is now committed to a series of rate cuts in coming months. There are numerous good reasons why a cut at the July 31 meeting was not a slam dunk which I have discussed in recent weeks. I think the FOMC is data dependent and unless the US economy shows more signs of slowing further in coming months, it will take more than global slowing, trade uncertainty, and a modest shortfall in core inflation to get additional cuts.
The FOMC estimates that the long run non-inflationary growth rate of the US economy based on labor market growth and the increase in productivity.
Labor market growth is determined by the number of 25 to 54 year old workers entering the labor market. Since 2006 the labor market has grown 0.5% annually, which is expected to nudge up to 0.6% through 2026. Even with that almost negligible improvement, labor market growth is half as strong as it was from 1996 to 2006. Although productivity has shown signs in 2019 that it is awakening from a long slumber, it only averaged 1.3% in the past decade.
Combining the figures for labor market growth and productivity suggests that potential GDP in coming years is 1.8%, which matches the FOMC’s current estimate of 1.8%… The tax incentives passed last year are likely to result in 2 a higher rate of productivity in coming years, which could lift potential GDP to modestly above 2.0%. This is why skepticism of President Trump’s claim that GDP will grow by 3.0% or higher in the next decade due to his policies is warranted. This assessment isn’t political, simply based on the math that underlies GDP growth.
An output gap is created when GDP growth contracts during a recession as the chart below illustrates. As a recovery takes hold the output gap is progressively closed as the unemployment rate falls and production capacity is utilized.
It took many years to close the output gap created by the Great Recession in 2008. In the prior 7 business cycles shown, the Federal Reserve raised rates once the output gap was closed in anticipation of higher inflation. For many reasons, inflation does not pose the same threat as it did in the prior 7 business cycles, so additional rate hikes are unnecessary until that changes. Conversely, the Federal Reserve has never lowered rates with a negative output gap since additional monetary accommodation was unwarranted.
Stocks
Hedge funds are ‘sophisticated’ trend followers who typically jump on a trend when it is nearing an end. They lowered their exposure to underweight last summer, but were forced to unwind that trade and go long when the S&P 500 continued to go up. The peak in their exposure was coincident with the top in the S&P 500 in early October.
They cut exposure as the S&P 500 plunged in the fourth quarter and then were slow to jump on the new uptrend until just before the May dip. All the good news in recent weeks has made them believers and hedge fund exposure is now the highest since just before the correction last year.
Click on any chart below for large image.
The short term trend is still positive. The NYSE Advance / Decline Line is above the trend line from the low on June 3, as is the percent of stocks above their 200 day average (above chart). During last August and September the A/D Line began to weaken and recorded a lower high as the S&P 500 made a new high in late September (red line).
One of the dynamics that has pushed the A/D line higher has been the decline in Treasury yields which lifted Utility, Real Estate, Consumer Staples stocks, as well as all the corporate and municipal bond funds on the NYSE. Last week Treasury bonds gave the first indication that yields may be nearing a low. Interest sensitive stocks were weak and caused the A/D Line to underperform. If this trend persists as I expect, the seeds are being sown for the A/D line to negatively diverge with the S&P 500 in coming weeks as it did last fall.
The NASDAQ Composite may be providing a better picture of the underlying weakness in the market since bond funds do not trade as part of its A/D Line. The strength in the NASDAQ 100 and Composite averages compared to the NASDAQ A/D Line illustrates how big capitalization NASDAQ issues like Amazon, Google, and Microsoft have pulled the averages higher even as the majority of stocks flounder.
Despite the new high in the NASDAQ 100 its RSI is posting lower highs (red line). Although the negative divergence isn’t quite as pronounced as it was last fall, it will take on more significance if the NASDAQ 100 reverses lower before the RSI can make a higher high.
The narrowing of market breadth is also evident in the percent of NASDAQ issues that are making a new 52 week high. In January 2018 8.1% of NASDAQ issues posted a 52 week high. By June it dropped to 5.1% and was 2.8% in early September. In early May 2019 it was 1.56% and on July 12 was just 1.25%. This is another confirmation that the overall stock market has been in a consolidation / corrective period since the January 2018 high, as indicated by the Megaphone pattern in the S&P 500.
The good news in recent weeks has led more investors to purchase Call options as they expect prices to keep marching higher. The 10-day average of the Call/Put Ratio (CPR) has been holding above the red horizontal trend line for more than 2 weeks. Each time the CPR has climbed above the red trend line since January 2018, a top and correction followed shortly thereafter. With the exception of the signal in June 2018, each correction has been meaningful (at least -7.2%).
As we enter second quarter earnings season it’s interesting to see how much earnings for 2019 have been lowered especially compared to estimates for 2020. Up until October 2018 estimates for 2019 and 2020 were connected at the hip but have diverged significantly ever since.
This begs the question. Will guidance from companies during this earnings season for the remainder of 2019 provide the confidence analysts will need to maintain their 2020 estimates? Sooner or later my guess is that estimates for 2020 are going to come down and make the S&P 500 look more expensive.
The S&P 500 and the DJIA have done what was needed to complete Wave (D) to complete the Megaphone triangle from the Wave (3) high in January 2018. There are enough technical warning signs to suggest that a pullback to 2800 is coming and possibly 2730 (Key Support), even if the Megaphone pattern is invalidated.
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
In coming months I expect the 10-year Treasury yield to correct some portion of the decline of the high of 3.24% last November to 1.94% reached last week. A 50% retracement would target a rise to 2.6% while a 61.8% retracement would lift the 10-year yield to 2.75%.
Last week I noted,
“A close above 2.18% would suggest a potential multi-month top.”
From the low of 1.943%, the 10-year yield jumped to 2.148% before falling to 2.092% on July 15. Until the 10-year rises above 2.148% in coming days or closes above 2.18%, the 10-year Treasury yield retains the potential to fall below 1.943%. Another drop in yields is certainly possible if additional tariffs are enacted and the S&P 500 drops quickly to 2730 or lower. If Treasury yields do drop to a lower low, I will look to go short long term Treasury bonds through the purchase of the inverse Treasury ETF TBF.
As noted last week,
“The A close below $131.30 in the Treasury bond ETF (TLT) would confirm a short term high, while a close below $130.00 would increase the odds that a multi-month top was in place.”
TLT traded down to $129.68 but didn’t close below $130.00. As long as it holds above last week’s low, TLT has the potential to rally to a new high before a multi-month is in place.
Gold
Gold is likely to rally to a new high in coming weeks. The correction since it peaked at $1438 appears to be wave 4 from the May low, which indicates that a wave 5 rally to a new high is right around the corner. Although Gold could still drop below $1382 before the rally kicks in, I would suggest buying the Gold ETFs IAU or GLD if Gold trades under $1402 and add to the position if it does trade under $1385. This is a scalp trade for aggressive traders. If executed, sell 33% of the position if Gold trades above $1438, 33% above $1448 and 33% above $1458, using a $10 stop once Gold trades above $1438.
Gold Stocks
The relative strength of the Gold stocks to Gold continues to strengthen. GDX did not pull back and is now too extended to recommend a long position even though it likely to trade higher if Gold does post a new high above $1438 in coming weeks.
Dollar
The Dollar slumped after Powell’s Congressional testimony. Other than a few weeks in January the Dollar Index has traded in a band of 1% above and below 97.00 since last November! The Dollar is still expected to drop to 95.03 in coming months, although the sideways chop of the past 9 months would allow for another stab to a modest new high.
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 3014 on July 15. 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, t I would have to reassess the outlook. As noted There are enough technical warning signs to suggest that a pullback to 2800 is coming and possibly 2730 (Key Support), even if the Megaphone pattern is invalidated.
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.
