Written by Jim Welsh
Macro Tides Weekly Technical Review 22 July 2019
GDP Report for Q2 and FOMC Impact
The Commerce Department will report its first estimate of second quarter GDP on Thursday. Estimates vary but the consensus is GDP will have grown 1.8% in Q2 down from 3.1% in Q1. The slowdown will be noted as further justification for the FOMC to lower the federal funds rate by at least 0.25% on July 31. Although expectations for a 0.50% cut have dropped from 50%, the odds that the FOMC will make a splash and lower the funds rate by 0.50% are still at 25%. That’s not likely.
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On the surface the GDP report will certainly make it appear that the economy slowed materially in the second quarter. However, after reviewing the details one could make the case that the economy may actually have strengthened.
As the graphic above shows, trade and inventory accumulation added 1.7% to first quarter GDP, while consumer spending and consumption only adder 0.6%. Inventories were built up in the first quarter to potentially avoid tariffs and to replenish inventory after a strong holiday season. Production increased in Q1 as companies filled orders adding to GDP. Once the surge in inventory building runs its course, production is scaled back as new orders decline. This is likely what occurred in the second quarter and why the decline in inventories is estimated to have shaved -1.3% from GDP.
Trade added 1.0% to Q1 GDP as imports fell and exports rose in anticipation and in response to tariffs. Import volume rebounded in the second quarter subtracting from domestic GDP since the goods imported are produced overseas. Exports of US goods and services fell in the second quarter which further lowered domestic GDP. These estimates are from Capital Economics.
Consumption represents almost 70% of US GDP so consumption data provides a more consistent assessment of the economy’s health, since trade and inventory fluctuations can create false impressions about underlying strength. Clearly, GDP growth in the first quarter was overstated and the second quarter was not as weak as the GDP report will suggest.
The GDP report will be the last major data point the FOMC will receive before their meeting on July 30- 31. In his testimony before Congress Chair Powell virtually promised the financial markets that the FOMC will lower the funds rate on the July 31 meeting. Since his appearance the only question in most minds is whether the cut will be 0.25% or 0.50%.
In a CNBC interview on Friday July 22 Boston Fed President Rosengren provided his thorough analysis of the economy and threw a bucket of cold water on the expectation for a 0.50% cut. Rosengren doesn’t believe the economy needs a rate cut. He noted the strong employment and Retail Sales reports as evidence the economy is humming along. He acknowledged that inflation as measured by the core PCE was 1.6% and below the FOMC’s inflation target of 2.0%, but noted that the Dallas Fed Trimmed Mean Inflation rate was 2.0%. Rosengren also mentioned that the FOMC had to be careful about asset valuations and be careful not to take actions that could boost them too high and create a problem down the road when they fell back to earth.
I’m providing a portion of the text from Rosengren’s CNBC interview since he touches on many of the points I’ve made in recent weeks as why a rate cut doesn’t make sense given the healthy state of the economy, inflation, asset values, and the fact that the FOMC has only 9 easing bullets in its arsenal:
“My own view on the economy is that the economy is doing actually quite well. So, in terms– we’re not really having an economic slowdown. If you take it back to the middle of June and think about where we were in the middle of June, most of the data’s come in pretty good. So, we had the G20, and while it wasn’t a perfect outcome, it was certainly a good outcome that we didn’t have further disruption in trade. If you look at the employment report, the June employment report was quite strong, much stronger than May. If you average over the last three months, a little bit over 170,000 payroll employment. That’s a strong employment result for the economy. If you look at inflation, the CPI came in stronger than people expected. My own expectation is when we get the GDP report at the end of this week that core inflation is going to look pretty good and very consistent with what we’re seeing with the Dallas Trimmed Mean, which is right at 2%. And finally, if you look at consumption, the consumption data has been quite strong. That’s 70% of the economy. And that’s quite consistent, I think, with getting an overall GDP report. We’ll see next Friday what we actually get, but I’m expecting something around 2%, which is a pretty good outcome.”
In his Congressional testimony Powell emphasized the high level of uncertainty was one reason why a rate cut was warranted. Rosengren acknowledged there is always uncertainty but various market indicators of uncertainty are low:
“One is uncertainty. So, uncertainty about what? If you look at the VIX, the VIX is not particularly elevated– so that’s telling you that the stock market’s not particularly volatile relative to its history. If you look at credit spreads, credit spreads aren’t particularly elevated. If you thought we were about to go into a recession, normally you see those spreads widen. If you look at forecasting uncertainty and look at the Survey of Professional Forecasters, they’re not particularly wide. They haven’t changed dramatically – showing a concern of a recession. So, by those measures of uncertainty, we’re not seeing substantial uncertainty. In terms of insurance and what you’re taking insurance out against, I would say that insurance is something that we normally take out when the stock market declines very substantially.”
The media is ablaze with the notion of an insurance rate cut but Rosengren discussed when an insurance cut was triggered by events in the past and the current environment doesn’t measure up to prior events:
“Think of 9/11, think of LTCM in 1998, think of October ’87, those were all instances where we made the argument that we were taking out insurance. They were all periods where financial markets had moved very substantially, but we hadn’t gotten economic data that indicated a slowdown, and so we did take out insurance around those three instances. As you just pointed out, the stock market is close to highs. The unemployment rate is close to a 50-year low. So, I think there are financial stability concerns. It’s not costless to take out insurance. You pay a premium for the insurance. And one of the ways that you think about that cost is what you’re doing to financial stability. So, financial stability can come in many different respects, but certainly a period where asset prices are elevated, you should be a little concerned about actually heating up those asset prices. If you think about leveraged loans and think about the corporate sector, we have taken on a lot of leverage over this course of this recovery and there are some concerns that when we have the next downturn, that could result in an amplification of that downturn. So, we have to think about some of the collateral effects of taking out that insurance. So, we need to think about the potential costs. I agree with the overall view that, if we are going into what is clearly a downturn, you want to act aggressively. And the reason for that is because we don’t have that much room before we hit zero interest rates.”
Although the economy has slowed compared to last year, it is still growing faster than the FOMC’s long term non-inflationary rate of 1.8%:
“We were growing around 3% last year. We’re talking about more like 2% growth. 2% growth is definitely less than 3%, but it’s still a little bit stronger than we– what we think the potential for the economy is. So, given that the economy is quite strong, given that I do think that inflation is going to be very close to 2%, and given that the growth in the economy is satisfactory– I think that’s an environment where you don’t have to take a lot of action.”
It is important to note that Rosengren is not a lone wolf on the FOMC and there are a number of other FOMC members who share his assessment of the economy. Years ago the FOMC embarked on a course to provide more clarity through more communication of policy goals and intentions. The expectation was that better communication would dampen volatility in the financial markets and prove beneficial for the economy. I’m not sure the FOMC has succeeded.
For this reason alone the FOMC will after a lengthy debate decide to lower the funds rate by 0.25%, since not doing so would prove disruptive to financial markets. The only question is how the FOMC crafts a statement that dampens expectations of additional cuts, which Rosengren and other like minded FOMC members may want for their vote to lower the funds rate at the July 31 meeting.
Stocks
Last week I noted that the NYSE Advance / Decline Line was above the trend line from the low on June 3, as was the percent of stocks above their 200 day average (chart below). 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). My expectation is that something similar could develop in coming weeks 4 before the market would be more vulnerable to a decline.
As discussed last week, interest sensitive stocks were beginning to weaken and which had 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 interest sensitive sectors have continued to underperform and the NYSE Advance / Decline Line modestly broke below the trend line from the low on June 3, as has the percent of stocks above their 200 day average. The break of similar trend lines occurred just before the -7.2% drop in May.
Click on any chart below for large image.
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%).
For the first time since last September the percent of Bulls in the weekly Investors Intelligence survey exceeded the percent of Bears by more than 40%
Sentiment indicators often provide early warning signs of an impending top so another run to a new high by the S&P 500 can’t be ruled out.
Of the 10 S&P 500 sectors only Consumer Staples, Consumer Discretionary, and Technology are outperforming the S&P 500. This indicates that 7 of the 10 sectors are underperforming the S&P 500 which is another sign that leadership is getting increasingly narrow. Even within the 3 sectors that are doing well, Amazon represents 23.4% of Consumer Discretionary (XLY), Proctor & Gamble, Pepsi, and Coca-Cola comprise 36.5% of Consumer Staples (XLP), while Microsoft and Apple make up 36% of Technology (XLK).
The S&P 500 and the DJIA have done what was needed to minimally complete Wave (D) of the Megaphone triangle from the Wave (3) high in January 2018. There are enough technical and sentiment warning signs to suggest that a pullback to 2800 is coming and possibly 2730 (Key Support), even if the Megaphone pattern is ultimately invalidated.
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 has been 100% in the money market since July 1.
I will look to establish a 25% short position in the S&P 500 through the purchase of the 1 to 1 inverse ETF SH, when the S&P 500 is above 2995.
Treasury Bonds
Sentiment toward Treasury bonds is overwhelmingly bullish which normally would make me bearish. However, positioning in the 10-year Treasury bond futures suggests that lower yields are still possible.
The other catalyst that could trigger another decline in yields is a sharp decline in the S&P 500, if President Trump enacts more tariffs. Since the G20 meeting on June 28 nothing of substance has developed. China has not announced that it is buying more grains and the US is not likely to drop its demand that China implement laws making the theft of intellectual property in China illegal. While it is certainly possible that another round of negotiations is announced, I am doubtful they will lead to a resolution. The question then becomes how patient will President Trump be if there is no real progress? I have no idea but he hasn’t given the impression that he is a patient man.
Positioning is not as extreme as it was in early 2017 or last fall when a record net short position suggested that bond yields were primed for a decline (Chart above). But the net short position is still large enough to fuel a further rally in bond prices and lower yields in coming weeks. In addition, there was a net long position when bond yields bottomed in mid 2016 and August 2017, and the current positioning is nowhere near those levels. This suggests that the 10-year yield is likely to fall below the recent low of 1.943% before bond yields reverse higher.
If this assessment if correct, the Treasury ETF (TLT) will rally above $134.29 to complete wave 5 and potentially finish the rally from the November low of $111.90.
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% or whatever lower low is achieved. 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.
Gold
Last week I wrote
“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.”
Gold traded down to $1300.34 overnight on July 17 before rebounding. This is one of the advantages of trading futures since they trade virtually 24 hours a day, while the Gold ETFs only trade with liquidity during the day.
Aggressive traders were advised to sell 33% of the position if Gold traded above $1438, 33% above $1448 and 33% above $1458, using a $10 stop once Gold trades above $1438. Gold traded up to $1450.65 so 33% was sold at $1438, 33% at $1448, and the remaining 33% sold at $1540, $10 below the high.
Gold has a tendency to spike into highs and sentiment last week reached a fever pitch with much Gold talk on CNBC and advisors recommending Gold for many reasons. Longer term I think Gold is going to trade higher but in the short run it is likely to consolidate and probably pullback to $1383 at a minimum.
In addition to sentiment long positioning by speculators in Gold futures has almost reached the levels in July 2016, and exceeded September 2017 and January 2018 levels, when Gold topped just above $1350. Compare the current positioning to last fall when Gold traded under $1170 and in December 2015 when no one wanted Gold and it was on sale under $1060.
Gold Stocks
Last week I noted that the relative strength of the Gold stocks to Gold continued to strengthen which suggested higher prices were likely especially if Gold traded above $1438 as expected:
“The Gold stock ETF (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.”
Although the relative strength of the Gold stocks continues to strengthen, GDX’s RSI did negatively diverge as GDX soared to higher highs. After Gold and GDX peaked in the summer of 2016, GDX rebounded to $28.70 and $28.56 before subsequently plunging to under $19.00 in December 2016. The area near those two highs would be expected to provide resistance and likely cap the current rally. If Gold does drop toward $1383 or lower, GDX could easily fall by 15% since it is really extended.
Dollar
The ECB meets on Thursday July 25 and is likely to signal that more accommodation is coming and may provide details on how it will proceed. This sets the Euro up for a potential period of weakness which would give the Dollar a lift. If this proves correct, a bout of Dollar strength would provide an excuse for Gold to correct. As noted earlier, the first estimate of US GDP for the second quarter will be released on the same day. If it comes in much under 1.8% it might modestly weaken the Dollar. My guess is specific details from the ECB will hurt the Euro more than a soft GDP report will pressure the Dollar. In terms of the Dollar’s chart I would apply a highly technical term to describe its pattern since last November – unintelligible.
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 has been 100% in the money market since July 1.
I will look to establish a 25% short position in the S&P 500 through the purchase of the 1 to 1 inverse ETF SH, when the S&P 500 is above 2995.
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 3018 on July 15. Although it may take a bit more time for the stock market to complete its topping process, the next big move is likely to be down not up. As noted there are enough technical and sentiment warning signs to suggest that a pullback to 2800 is coming and possibly 2730 (Key Support), even if the Megaphone pattern is ultimately invalidated.
Should the S&P 500 close above 3030 and hold above that level 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.
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