Written by Jim Welsh
Macro Tides Weekly Technical Review 23 December 2019
Good News and Options Expiration
Oh, what a difference a year makes. A year ago the S&P 500 plunged as negative news spurred an increase in selling pressure which subsequently triggered additional waves of selling leading into the expiration of options and futures on December 21, 2018.
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After the S&P 500 closed below 2600 on December 14 investors who had sold put options on the S&P 500 at 2600, 2550, 2500 and lower, were forced to sell S&P 500 futures to hedge the losing put option position. The S&P 500 recorded its closing low at 2451 on Christmas Eve and intra-day low of 2347 the day after Christmas. This is an example of the tail of derivative contracts wagging the dog and accelerating the trend lower.
In 2018 the S&P 500 topped on December 3 before the plunge began, and in 2019 hit a low on December 3 prior to a non-stop move higher. After President Trump suggested he could wait until after the election to complete a trade deal with China, the S&P 500 fell to 3070 on December 3 after hitting 3154 on November 27. The S&P 500 moved above 3154 on December 12 after President Trump said a BIG DEAL was near. In addition to the positive trade news the move above 3154 began to pressure traders who had sold Call options above the S&P 500 at 3170, 3180, 3190, 3200, 3210, 3220, and higher.
As the S&P 500 climbed above the strike prices, traders were forced to buy S&P 500 futures to hedge their losing call option position. The buying of S&P 500 futures in 2019 pushed the S&P 500 higher into the December 20, 2019 expiration, just as the selling of S&P 500 futures drove it lower going into the December 21, 2018 expiration.
Seasonality, the lack of tax loss selling, and performance chasing should continue to support the S&P 500 until the end of the year. To the extent that options expiration played a role in lifting the S&P 500 last week, the S&P 500 may be vulnerable to a modest pullback beginning in January. Measures of investor sentiment are at levels that usually coincide with a correction of at least a -3% to -5%.
CNN‘s Fear & Greed Index reached 92 on December 20 which is well into the Extreme Greed zone, and the highest reading since the fourth quarter of 2017.
The S&P 500 has experienced a correction each time the Fear & Greed Index has approached or exceeded 80. The depth of each correction varied based the news of the day from 11% in the first quarter of 2018 to almost -20% in the fourth quarter of 2018. In 2019 the S&P 500 dropped -7.6% in May, -6.8% in August, -5.5% going into the low on October 7, but just -2.7% after the November 27 high.
The 10-day average of the Call / Put Ratio is higher now than at any time since January 2018, and the Option Premium Ratio has plunged to a very low level. Uniformly, sentiment is excessively bullish and expectations for economic growth have increased. High levels of bullish sentiment are a negative when looking out 2- 4 months, but in the short term the high level of bullishness keeps selling pressure low, which is further amped due to the seasonality factor going into year-end.
The S&P 500 is expected to pull back in the first quarter. The depth and pattern of the correction will determine whether the correction should be bought. Expectations are high that the global and U.S. economy will pick up steam in 2020. As I will discuss in the January Macro Tides, this expectation is reasonable but not guaranteed since it assumes consumer spending will remain strong and business investment grows much faster than it did in 2019.
The gains in the S&P 500 in 2019 were not the result of earnings growth and an expansion in the S&P 500’s Price / Earnings ratio. The entire gain in the S&P 500 in 2019 came from a 30% expansion in the S&P 500’s P/E ratio since earnings actually fell (red line in chart above). In order for the S&P 500 to advance in 2020, earnings will need to grow enough to prevent a contraction in the S&P 500’s P/E.
Treasury Bonds
The Treasury bond market is at an important inflection point from a technical and fundamental perspective. The consensus expects economic growth to improve in 2020 in the U.S. and globally which suggests there could be upward pressure on yields globally.
Last week Sweden’s central bank raised its policy rate from -0.25% to 0.0%, after holding it below 0% for 5 years. In recent months there has been more pushback in Europe against negative rates and their effectiveness, so Sweden’s action may be a sign of a tipping point.
The ECB is buying sovereign bonds which could allow it to gradually increase its policy rate from -0.50% in 2020, and attempt to cap how fast bond yields rise in response. There is a risk of a Taper Tantrum European style, if the bond market over reacts to any change in the ECB’s rate regime.
Negative global bond yields created the inverted yield curve in the U.S. last summer, and any spike higher in global yields would likely lift Treasury yields irrespective of the FOMC holding rates steady. This topic will be discussed in greater detail in the January Macro Tides as it could be a big deal.
The U.S. Treasury market has been buffeted by a lot of good news since early November but Treasury yields remain below their November 7 high, at least so far. The high for the 10-year Treasury bond last week was 1.947% compared to 1.971% on November 7. However, the 10-year Treasury yield has pushed above the red down trend line connecting prior highs. It will be more negative if the black trend connecting the yield highs at 1.903% and 1.971% is exceeded (about 2.03%).
The 30-year Treasury yield has yet to break out above the red down trend line which is currently near 2.40% and less than .03% above last week’s high at 2.376%. Should the 30-year break out above 2.40%, the black trend connecting the yield highs at 2.378% and 2.443 % is the next key level (about 2.47%). My expectation of lower Treasury rates in the first half of 2020 was predicated on the belief that a trade deal would remain elusive, even if President Trump decided not to implement the December 15 tariffs.
A trade deal does not automatically negate the potential for lower Treasury yields, but the positive psychology it has generated could cause additional selling in Treasury bonds. Since the trade deal was announced, the Treasury market has been less sensitive to negative economic news and more responsive to any report that comes in at or modestly better than expected. Reports that were weaker than expected illicit a bounce that fades, while a decent report causes more concerted selling.
Treasury Bond ETF (TLT)
Three weeks ago I recommended establishing a 65% position if TLT traded down to $137.90. After the strong employment report on December 6, Treasury yields spiked higher and TLT dropped to $137.86. TLT has continued to hold above the red trend line connecting the highs in January and March, and the lows in July and November. This is why I recommended using a close under $136.16 as a stop.
In the last 3 trade days TLT has made an intra-day low of $135.76, $135.93, and $136.00. An intra-day drop below $135.76 would be bad. A decisive close under $136.00 could open the door for a decline to $130.50. If TLT trades above $141.77 raise the stop to $137.20. TLT paid a $.218 dividend on December 19.
Dollar
After dropping from 98.54 to 96.72 last week, the Dollar bounced to 97.81 on December 23, just shy of the 61.8% retracement. Year end pressures could lift the Dollar to near 98.50 before the decline resumes. The Dollar has been expected to fall to 96.00 or lower in coming weeks.
Gold
As noted last week, Gold could still jump above $1500 in the short term but it needs to clear the trend line at $1489 first. A rally to a higher high above $1556 is not likely until Gold drops below $1446 and ideally under $1420. The expectation of a rally that does carry Gold above the August high of $1556 is predicated on the price pattern and assumes the August peak was wave 3 from the August 2018 low near $1160. The choppy trading since then is wave 4. This is why aggressive traders can buy Gold (GLD or IAU) if it trades under $1420, using a 1.5% stop on a closing basis.
Gold Stocks
The Gold stock ETF (GDX) has been trading between the red ($26.10) and black ($28.20) trend lines for more than 3 months. If Gold pops above $1500, GDX could test the September high of $29.50. If Gold does drop below $1420 and GDX trades under $25.85, traders can establish a 50% position using $25.10 as a stop.
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.
Becoming cautious in late April and July was prescient as the S&P 500 subsequently corrected by more than 5%. What I didn’t anticipate was how quickly the market would rebound after any positive Tweet 8 from President Trump, nor how the market would rise so persistently after October 7 even though no concrete signs of a trade deal appeared.
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 short position in the S&P 500 was increased from 20% to 40% on the opening of November 19 when SH opened at $24.87, and sold on November 22 when SH trading at $25.03 or higher.
If the S&P 500 does pull back in the first quarter, as the measures of investor sentiment suggest, the key technical level will be the December 3 low 3070, which is also where the red trend line connecting the January and September 2018 highs resides. If the S&P 500 retests 3070 after a down-up-down correction, it will likely continue to rally toward 3500.
If the S&P 500 falls in a 5 wave decline as it tests or breaks below 3070, it would suggest the subsequent rally will represent a shorting opportunity. Between now and early to mid January, seasonality and the consensus bullish outlook for 2020 is likely to keep selling pressure muted.
My guess is that consumers will splurge a bit on Christmas but then use the first quarter to pay down credit card debt and replenish savings, which could put a dent in first quarter GDP. Prior to the December 15 tariffs, companies may have increased their ordering above what they needed to avoid the additional tariff costs. First quarter GDP could be dragged down as companies pare their bloated inventories. And if business investment doesn’t pick up in the first quarter, the notion that manufacturing has bottomed may be questioned.
The market has been lifted by a string of good news raising expectations for 2020 and leaving an overbought and over loved market vulnerable to some profit taking in the first quarter. Of course, any hiccup before a Trade Agreement is actually signed will cause a flurry.
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.
Note: Tuesday’s market results (December 24) are not reflected in this article. It was written after the market closed Monday 23 December 2019 but an editorial delay did not publish it until now.
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