Written by Jim Welsh
Macro Tides Weekly Technical Review 19 August 2019
When the yield on the 10-year Treasury bond dipped below the 2-year Treasury yield on August 14, equity investors reacted by selling stocks aggressively. The S&P 500 and DJIA both finished down nearly 3.0% as dire warnings were sounded about the recession implication from the yield curve inversion.
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Across every form of media a chart illustrating how a 2- 10 yield curve inversion had preceded a recession going back decades was provided any nervous investor. Yikes! Lost in all the headlines were a number of factors that suggest taking a deep breath before heading into the storm bunker.
The average lead time between an inversion and the onset of a recession has been 19 months, so expecting a recession soon is unrealistic.
That may disappoint some of the democrats running for president since they wouldn’t mind if a recession appeared just before the primary season next year, although none would admit it publically. Most of the analysis provided in the media blindly assumes the current environment is comparable with prior economic cycles since World War II. Although it might take a few seconds of constructive thinking to notice just how different the current environment is from previous cycles, the need for an attention grabbing headline is too irresistible.
Two major central banks have set their policy rates below 0%, which has never occurred before, let alone since World War II. The ECB’s policy rate is -0.40%, while the Bank of Japan is a bit more stingy with its policy rate at -0.10%. With economic activity slowing in Europe, the ECB has pledged to bring out a big bazooka when it meets on September 12. This inspired expectations that the ECB would push its policy further below -0.40%, but more importantly restart its Quantitative Easing program. This led to a rush of buyers into the European bond market knowing that come September the ECB will back stop their purchases. The German 10-year Bund subsequently fell to a -0.71% which dragged bond yields lower around the world.
Almost $15 trillion of bonds now trade with a negative yield. The gravitational 2 downward pull of global bond yields pushed the 10-year Treasury down to 1.475% on August 15 and briefly below the 2-year Treasury yield. For anyone to ignore what’s happening in the global bond market, and the role it has played in contributing to the inverted yield curve in the U.S., is naïve. If Roger Maris’s home run record of 61 was tagged with an asterisk, this inversion deserves one as well.
Historically, inverted yield curves developed in the U.S. after the Federal Reserve had either increased the federal funds rate so much that it was above the 10-year Treasury yield, or restricted the availability of credit. The federal funds rate was a modest 2.40% before the FOMC lowered it to 2.15% at the July 31 meeting. Clearly, the FOMC did not increase the funds rate enough to cause the inversion. Money is not tight as just about anyone with a heart beat can borrow money, so credit availability is not a problem. In fact the Senior Loan Survey by the Federal Reserve conducted in July and released on August 5 indicated that banks were still quite accommodating for large and medium sized companies, and had loosened credit standards for small companies.
Prior to the 2001 recession and the financial crisis, banks increased lending standards significantly before those recessions began.
As previously discussed the widespread weakness in manufacturing in the U.S. and globally is expected to slowly infect the relatively healthy service sector in coming months. As discussed last week and in recent You Tube videos, I have outlined why the weakness in manufacturing is likely to begin to infect services. The spread between the ISM Manufacturing Indexes (red) around the world and their Service counterpart (blue) have diverged significantly, so the spread is now wider than at any time since 1998.
Either Manufacturing will strengthen in coming months or Services will soften, which is what seems far more likely. As the Trade War drags on a slowdown in Services was increasingly likely. Last week the US ISM Non Manufacturing (Services) Index for July fell to 53.7 from 55.5 in June. This drop was before President Trump announced another 10% tariff on the next $300 billion in Chinese imports. The escalation in tariffs slated for September 1 will only hasten the process.
Consumer spending was unusually strong in the second quarter and due for a modest retrenchment in the third quarter. The coming natural pullback in consumer spending could prove deeper if job growth slows in coming months and the decline in overtime and total hours worked already evident in the past 6 months continues as I expect. Credit availability and a still healthy consumer suggests the U.S. economy will slow in coming months, but the warning from the inverted yield curve is early and probably wrong given the unusual dynamics leading to the inversion.
While a recession is unlikely, corporate earnings may flirt with a recession or at least fall far short of the 11% increase expected in 2020. Companies that derive more than 50% of their revenue outside the U.S. experienced an -11.1% decline in earnings in Q2, while those with more than 50% of their sales in just the U.S. saw their earnings rise by 6.6%.
If the U.S. economy slows more in coming months even those companies concentrated in the U.S. will feel a profit squeeze.
Stocks
Even though investors may be over reacting to the yield curve inversion, that does not mean the S&P 500 can’t suffer a larger decline. As discussed in an August 16 video, the S&P 500 is likely to drop below the important support created by the recent lows of 2822 August 5, 2825 August 7, and 2825 on August 15.
From its high of 3028 on July 26 the S&P 500 fell 206 points to a low of 2822. The 50% retracement of the 206 point loss would target 2925 while the 61.8% retracement would allow the S&P 500 to reach 2949. As the correction in the fourth quarter unfolded last year, the S&P 500 rebounded back to a previous retracement peak twice when it reached 2815 and 2800. The most recent rebound carried the S&P 500 to 2943 so a rally to near that price level does not negate the expected downside potential.
Click on any chart below for large image.
Although bullish sentiment has pulled back in response to the recent selloff, sentiment has not dropped to levels associated with an intermediate low. According to Mark Hulbert’s assessment of equity exposure of short term market timers, exposure fell below -20 in December as the market was bottoming. This meant these short term timers had actually established a net short position underscoring just how negative they had become. The current reading is +7.
The rally of the past 3 days has eliminated a modest short term oversold condition that was reached as the S&P 500 fell to 2825 on August 17. The 21 day average of Advances minus Decline oscillator has rebounded to a level very similar to the levels reached last October and November during those retracement rallies. (red arrows) Strong rallies within a downtrend are common and serve the purpose of relieving an oversold condition and preventing sentiment from reaching extremes.
The initial decline from the high of 3028 was 206 points. An equal decline of 206 points from the high at 2943 would target 2737. This target would be adjusted should the S&P 500 rally above it. A decline to 2737 would bring the S&P 500 down to near the lows on March 7 (2722) and June 3 (2729) as noted by the blue trend line (Chart above). The green trend connects the February, April, October and November 2018 lows and is near 2755. A decline to 2730 to 2760 is possible before another rally takes hold.
Major support for the S&P 500 is near 2640. If the S&P 500 closes below 2600 it could make a beeline for the December low of 2347, which is what the Megaphone pattern suggests is possible. The outlook for a decline would be called into question is the S&P 500 moved above 2984 which is the 78.6% retracement of the 206 point decline from the 3028 high.
Treasury Bonds
Last week the expectation was for Treasury yields to fall to a new low before bouncing higher:
“The pattern suggests that the 10-year yield will fall below last week’s low of 1.595% before bouncing up toward 1.80% for wave 4 from last November. After that bounce the yield would be expected to drop further in wave 5 and could approach the 2016 low of 1.33%.”
The 10-year Treasury yield fell to 1.475% on August 15 before bouncing to 1.618% on August 19. As long as the 10-year Treasury yield does not close above 1.80%, the expectation is that the 10-year Treasury yield will fall below 1.475% before a multi-month low in Treasury yields develops. Another decline in yields would likely be prompted by a drop in the S&P 500 below the recent lows just above 2820.
Dollar
Last week the expectation was that another spike higher in the Dollar was possible and would be signaled if the Dollar rose above 97.86. The cash Dollar Index did exceed 97.86 on August 14 so a rally above 98.93 is likely. Dollar strength appears to be playing a role in weakness in the stock market, so a new high would probably pressure the S&P 500 and contribute to a decline below 2820. The Dollar is expected to fall as economists lower their GDP estimates for the U.S. in coming months. A drop to 95.00 seems likely.
Gold
As long as Gold holds above $1480, the odds favor one more rally that carries Gold to a higher high. However, momentum, and positioning are flashing a bright Yellow Caution sign. Last November the percent of Bulls was less than 10% and now are above 90%. If Gold does rally to a higher high, a more pronounced correction is likely that could quickly bring Gold down to $1380 – $1400
Gold Stocks
If Gold does rally to a higher high, GDX is likely to exceed $30.00, as long as GDX does not close below $27.22. GDX’s RSI has fallen from a high of 87 on June 24 when GDX closed at $26.17, to 55 when GDX was trading at $28.35 on August 19. This is a display of underlying strength since GDX has managed to move higher even as its RSI corrects.
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.
I established a 25% short position in the S&P 500 through the purchase of the 1 to 1 inverse ETF SH on July 23, when the S&P 500 traded above 2995 (SH $26.09). The short position was increased on August 8 when the S&P 500 was trading at 2930 (SH $26.69).
The anticipated decline has begun which should include a test of 2760 – 2730 at a minimum, and potentially to the December low of 2350 based on the Megaphone pattern.
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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