Written by Jim Welsh
Macro Tides Weekly Technical Review 04 November 2109
Fed Cuts, Job Growth Surprises, New Highs
As expected the FOMC lowered the funds rate and indicated that additional cuts will depend on weaker than expected data. That certainly wasn’t the case on Friday when the October employment report was stronger than estimated and the two prior months were revised higher by 95,000.
Despite the upside surprise monthly job growth has averaged 167,000 through the first ten months of 2019 compared to 223,000 in 2018. Although better than forecast job growth was a pleasant surprise, it doesn’t alter the outlook for more gradual slowing in job growth, which has been trending lower since the end of 2018.
While Average Hourly Earnings (AHE) grew 3.0% in October, which is still decent, it has slipped from 3.4% in the fourth quarter of 2018. Weekly wages have weakened more since they are dependent on the number of overtime hours and hours worked, which have fallen.
After the yield curve inverted last spring, and the ISM Manufacturing Index dropped below 50 in August, recession fears gripped the markets especially in late August. As I have discussed in recent months, the yield curve inversion was likely an overreaction since it was due in large part to negative global bond yields and thus not comparable to prior cycles. The ISM Non-Manufacturing Index had been holding up far better and represents 85% of U.S. GDP compared to 11% for manufacturing. The ISM Non-Manufacturing Index dropped to 52.6 in September from 56.4 in August, so it will likely show an improvement for October when it is announced on November 5.
For markets the most important aspect of the employment report was that it eased concerns about a recession starting in the first quarter of 2020. If the October ISM Non-Manufacturing Index does rise it will reinforce the view that the global economy may be emerging from a mid cycle slowdown and will continue to improve in coming months. This view has gained traction since central banks have enacted 42 rate cuts representing a total of 2,070 basis points.
Financial Conditions have eased a lot since the first quarter of 2019, which will progressively provide a lift to the global economy in the first half of 2020. The one major obstacle to this constructive scenario is a resolution to the Trade War with China and whether President Trump will hit the European Union with tariffs on November 14. If the anticipated Phase I trade deal with China is derailed or tariffs are levied against the EU, the S&P 500 could quickly peel off 10% to 15%, and could ultimately find its way to the December 2018 low of 2347.
My view has been consistent: I don’t think China will agree to intellectual property restrictions demanded by the U.S. And President Trump is not likely to roll back tariffs short of a comprehensive deal, as demanded by China. On November 4 a commentary by Taoran Notes, a social media account affiliated with China’s Economic Daily, said that Beijing’s core demands – including the removal of all US tariffs – had not changed:
‘China will not fully acquiesce to key U.S. trade demands in areas such as intellectual property rights protection.’
China’s Ministry of Commerce also cast doubt on claims by President Trump that China could buy up to $40 billion to $50 billion of American agricultural products a year, noting that the peak for Chinese imports of U.S. farm goods was $29 billion in 2013. A number of weeks ago President Trump announced that China would buy agricultural products and suggested that U.S. farmers would be wise to buy more land to grow all the crops China would be buying. It seems noteworthy to me that there has been no confirmation that China has bought a single bushel of soybeans or any grain.
I think China has been employing its version of a Rope-ADope strategy in the trade talks with the U.S, with the goal of dragging them out in hopes that President Trump will eventually accept a watered down deal. If I’m wrong and a Phase I deal is achieved and President Trump gives the EU another 6 month pass, the S&P 500 could enter a blow off advance. The U.S. equity market has outperformed every other global market by a wide margin, so if the Trade War erupts anew or is expanded to include the EU, the U.S. market has the potential to fall more than any other equity market.
The budding optimism about a rebound in the global economy could be vaporized virtually overnight with weeks of gains erased in a matter of days.
The negativity surrounding trade and recession fears that were widespread in late August as the S&P 500 fell to 2822 have been replaced by optimism. A month ago CNN’s Fear and Greed Index was just 32 and signaling a high level of fear. As of Friday November 1 it has jumped to 86 which indicates Extreme Greed.
The current level of Greed is the highest since late 2017, which was followed by a sharp decline in February 2018, and September 2018 which preceded the thumping in the fourth quarter. Investors have already positioned themselves for good news and could be shocked if they don’t get it.
The positioning in VIX futures are also at an extreme level, as most investors expect volatility to fall further in coming weeks. As a result there is a record short position in the VIX futures.
Those short would need to buy VIX futures if the VIX begins to rise above the red trend line in the chart below. This could lead to a sharp increase in the VIX that could carry it above 30.0 .
Click on any chart below for large image.
The VIX did briefly break out above the red trend line in early October, but the decline in the S&P 500 was arrested after President Trump announced that a Phase I deal had been reached with China. It is interesting that the VIX rose on November 4 even though the S&P 500 rose by more than 11 points. Something similar occurred on April 26 and April 29, just before the May correction commenced, as the S&P 500 and VIX rose.
As noted last week, the level of volatility as measured by the Volatility Index (VIX) has fallen below 12.50, which is the same level that accompanied the highs in the S&P 500 in late April and late July. Corrections of -7.6% in May and -6.7% in August followed, once the VIX broke above the downward sloping trend lines.
Based on the S&P 500’s chart pattern, a rally to 3056 was expected:
“From a low of 2822 on August 5 the S&P 500 rose to 2922 on September 19. If the S&P 500 rallies an equal amount from its low of 2856 on October 3 the S&P 500 can push up to 3056. This suggests that the S&P 500 could have a bit more to run before a top is completed. If the S&P 500 rallies to 3056 it will tag the red trend line that connects the January 2018 high, the peak in September 2018, and the high on July 26.”
The S&P 500 has exceeded the 3056 target by 1% and has closed above the trend line from the January 2018 high. While it is possible that this close above the trend line represents a breakout, there is enough technical evidence to suggest it will prove temporary, unless the trade issue is resolved.
The Call/Put Ratio I use incorporates all the options traded on all the exchanges and includes the CBOE equity data, and isn’t available until 9p.m.pst. The extremely high level of equity call buying on November 4 suggests the overall Call/Put Ratio will lift the moving average closer to the red trend line and possibly above it. As noted last week:
“If the S&P 500 does manage to move up to 3056 over the next week or so, the Call/Put Ratio will probably rise above the red trend line and indicate the high level of optimism is confirming a top.”
The S&P 500’s RSI is overbought (just above 70) which suggests additional upside is likely limited. The Call / Put Ratio and RSI don’t necessarily pinpoint a top, but they do indicate that a high is near.
With the exception of the DJIA, which has recorded a new high, all of the divergences among the major market averages I discussed last week are still intact. These divergences represent potential weakness if a good reason to sell materializes.
When the S&P 500 traded up to 3040 on October 28 I purchased a 20% position in SH for my managed accounts at $25.59. SH is the 1 to 1 short S&P 500 ETF that gains in value when the S&P 500 declines. The next two weeks could prove especially tricky given the trade news that could upset or boost the S&P 500 overnight. My expectation is the S&P 500 has the potential to drop to 2830 and possibly as low as 2740 in coming months. I will be looking to add to the short position after a reversal lower and a retracement.
Dollar
The expectation was that the Dollar Index would bounce from the October 21 low at 97.15, and then drop below 97.15. The Dollar did rebound up to 98.01 before falling to 97.16 on November 1. Since it failed to make a lower low, the Dollar could rally back up to 98.01 or slightly higher, before ultimately falling below 97.15.
If the Dollar does fall below 97.15 by November 11, and complete 5 waves down from the high at 99.67, the door would be open for a larger snapback. The Dollar has benefited each time the trade dispute has deteriorated.
As noted for weeks, the positioning in Dollar futures suggests a multi-week decline is likely, irrespective of short term squiggles.
India and Emerging Market Local Currency Bonds
On September 25 India announced it was lowering its corporate tax rate from 30% to 15% for new companies opened in the next 4 years. This seems like a smart idea to attract companies that may be considering moving their supply chain out of China in coming years. In addition the Reserve Bank of India has been lowering its policy rte since mid 2018, which should also boost economic growth within India in 2020.
On September 25 I established a 10% position in the India ETF (INDA) at $33.23. Although these were the primary reasons for buying INDA, a lower Dollar was expected to act as a tailwind for Emerging Market equities in general. INDA is up 5.25%. INDA’s RSI is up to 70 so a pullback is likely. If the S&P 500 completes the expected top and appears poised for a sharp drop, I will lighten up on INDA
The Emerging Market Local Currency Bond ETF (EMLC) was also expected to benefit from a weaker Dollar, even if Treasury bond yields increased as expected. EMLC has moved up from $33.52 to $33.90 and paid out two dividends totaling $0.366, while Treasury rates have ticked higher.
Treasury Bonds
The ongoing assumption has been that the decline in global bond yields and Treasury yields remains intact. If this outlook is correct, Treasury yields will drop and make another lower low in coming months. Within that context the low yield of 1.429% in the 10-year Treasury bond was wave 3 down from the high of 3.248% last November.
The rebound since the low of 1.429% to 1.903% would be wave (a) of 7 wave 4, since the rebound in yields last week overlapped the low of 1.635%. The overlap suggests the recent 3 wave drop in yields (a, b, c in blue) was wave (b) of wave 4. This suggests that the 10-year year could rise above 1.903% to complete wave (c) of wave 4. If wave (c) of 4 is equal to wave (a) (1.903- 1.429 – .474), the 10-yar Treasury yield could reach 1.98%.
The recent trading pattern suggests that wave 4 may be forming a triangle. In this case the move up to 1.86% was wave (c) of 4, which would be followed by a drop to 1.57% – 1.62% for wave (d) of wave 4. Wave (e) of wave 4 would lift the 10-year Treasury yield to another lower high below 1.86% to complete the triangle for wave 4. Once wave 4 is complete, wave 5 from last November’s high would bring the 10- year treasury yield below 1.429%.
The 30-year Treasury yield has moved up more than the 10-year, so it is possible that while the 10-year holds below 1.903% and probably 1.860%, the 30-year may rise above 2.378%. If this divergence develops between the 10-year and 30-year, it would establish a positive divergence and be supportive of a subsequent rally.
The positioning in the Ultra Treasury bond is supportive of a rally that brings the 30-year Treasury down to test or make a lower low below 1.905%. Large Speculators (green line middle panel) have a larger short position than last November when Treasury yields peaked. If the Trade War reignites, those short will be forced to cover, which would drive bond prices higher.
Treasury Bond ETF (TLT)
If the triangle is the correct pattern, TLT shouldn’t fall below $136.54 and will not drop to the target of $133.90. As noted the 30-year may be tracing out a different pattern than the 10-year, which means we just have to see what develops in the next few weeks.
Gold In the September 23 WTR I recommended shorting Gold if it traded above $1531. Last week I noted that if Gold was about to drop under $1420, it should not rally back to $1516 anytime soon, which is why I placed a stop on the short position at $1513. Gold traded up to $1513 on October 31 triggering the stop. This opens the opportunity for Gold to rise to $1540 to $1555, which would be signaled on a move above $1517.
If Gold does rally to that range it will likely set up another short trade since positioning remains quite negative. Conversely, a close below $1480 would likely open the door for a decline to below $1456. Sooner or later Gold is expected to drop under $1420.
Gold Stocks
After bouncing off support near $26.50 five times since last July, GDX is giving subtle hints that a rally back above $30.00 may be developing. GDX has held above $26.70 and last week eked out a slightly higher high for the first time since the peak on September 4. With Gold testing $1516 and also hinting at a run higher, GDX would signal a rally above $30.00 if it can close above $27.20. Longer term the expectation is for GDX to decline below $25.50 as Gold drops below $1420.
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 to 40% on August 8 when the S&P 500 was trading at 2930 (SH $26.69). The short position was reduced to 20% on August 28 when the S&P 500 was trading at 2882 and SH was sold at $27.09. The remainder of SH was sold on September 25 at $26.03.
When the S&P 500 traded up to 3040 on October 28 I purchased a 20% position in SH for my managed accounts at $25.59. SH is the 1 to 1 short S&P 500 ETF that gains in value when the S&P 500 declines. 11 My expectation is the S&P 500 has the potential to drop to 2830 and possibly as low as 2740 in coming months.
The Major Trend Indicator has now made a third lower high since late April. However, if the MTI is able to climb above the July, it would indicate more strength than I expected.
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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