Written by Jim Welsh
Weekly Technical Review 10 February 2020.
As the S&P 500 was making a new high on February 6, 227 stocks in the S&P 500 were actually down year to date. The mega cap stocks (Microsoft, Apple, Amazon, Facebook, and Alphabet Class A&C) comprised 18.1% of the S&P 500 as of February 7 and have enabled the S&P 500 to make a new high. As long as these 5 stocks continue to attract money from momentum investors, the S&P 500 can make marginal new highs and help the overall market hold up.
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In the early 1970’s the investment phrase ‘Nifty Fifty’ was used to describe the popular strategy of simply buying the 50 stocks investors determined to be immune and indispensible and were known as “one-decision” stocks. All any investor had to do was decide to buy them.
During the 1973-1974 bear market the Nifty Fifty stocks lost more than the DJIA which tumbled 45%. Many of the Nifty Fifty have been bought out or merged with other companies and a few went out of business, i.e. Polaroid and S.S. Kresge.
Investors have become far more efficient and today only have to make the decision to buy the ‘Fav Five’. If one wants to add a little spice, Tesla and Netflix could be added to make it the ‘Stellar Seven’.
For the first time since the low on October 3, the Advance / Decline failed to make a higher high on February 8 and February 10, which shows that the breadth of the market is lagging. The percent of stocks above their 200 day average fell from 72% on January 17 to 65% on February 5. When the S&P 500 posted its new high on February 6, more stocks ended the day lower than up (1408 – 1508) and the percent above their 200 day average dipped from 65% to 64%.
While the rebound from the January 31 low of 3215 has been impressive, the internal strength of the market has continued to deteriorate, as measured by the 21 day average of Advances minus Declines. This type of weakness is usually seen just before a correction. The difference now is that a small number of stocks carry so much weight in the S&P 500 and also have a big psychological impact on traders. As long as the Fav Five are bought on every dip and subsequently rally to a new high, traders will take that as an all clear sign for the overall market as well.
Bullish sentiment, as measured by the Call / Put ratio, has remained high as investors view the action in the stock market as a sign that nothing can derail the rally. This seems to lead to an interpretation of any negative news in a positive way.
According to Evercore, a highly respected research firm, China’s economy may not grow at all in the first quarter as the virus disrupts production, supply chains, and keeps China’s growing middle class indoors. Supposedly, this bad news is actually good news since the Chinese government will launch a vigorous fiscal stimulus program, so any GDP lost in the first quarter will be made up later on. The current convulsion in growth is nothing more than a minor speed bump, so buy the dip!
Large Chinese firms have almost unlimited access to credit through China’s state owned banks. With growth evaporating, big firms can either tap lines of credit with their banks or take out new loans to tide them over, all with the blessing of the Communist party. Small firms in China do not have easy access to bank credit and a large number could go out of business, if the disruption continues for any length of time.
One reason lending to small firms has lagged is the non-performing loan ratio for small businesses was 5.9% in May 2019 compared to just 1.4% on loans to large companies. China will attempt to make credit available to small firms but an increase in bankruptcies is still likely.
The timing of the coronavirus outbreak is compounding the slowdown China was experiencing from the tariff war with the U.S. Many companies large and small were struggling with slower GDP growth that was well below the official growth of 6.1%. While lending to large firms by state owned banks will help large companies weather the coronavirus slowdown, it will make a big problem even bigger.
Since the financial crisis, China’s Total debt as a percent of GDP has soared and grown far faster than GDP. This indicates that each new dollar of debt is generating less growth and is unsustainable in the long term. Most of the increase in debt has been concentrated in corporate borrowing, which has climbed to almost 160% of GDP from less than 100% in 2007.
The U.S. stock market was heartened by the opening of some of the companies on February 10 that had been closed due to the coronavirus. The headline probably is more positive than the reality, as every employee may not return to work until they are more convinced it is safe to do. Many firms will be forced to deal with a disruption of their supply chains as they try to ramp up production, which will lead to more delays. Apple could be the trigger if their iPhone production is slowed materially and guidance is lowered.
The S&P 500 recorded a new closing high on February 10 but its RSI is well below 70 (63.0) and its high of 77.0 on January 17. Normally, the magnitude of the RSI divergence would signal an important top. But that’s not likely until the Fav Five falter.
I noted last week that the level of 3244 had developed as a short term support area.
“As long as 3244 holds the S&P 500 has the potential to rally above 3293 to complete an a-b-c corrective rebound from the low of 3234.50 on January 27.”
I did not however expect the S&P 500 to rally to a new high.
Based on the analysis provided in the January 21 WTR that indicated the S&P 500 might top at 3336, I recommended establishing a 20% short position in the S&P 500 via the ETF (SH) as long as the S&P 500 was trading above 3320, using a stop of 3370. The S&P 500 traded above 3320 on January 21, 22, 23 and 24 topping at 3337 on January 22. SH could have been purchased at $23.35 or lower. In the February 3 WTR I recommended increasing the short position to 40% if the S&P 500 traded above 3293, and to lower the stop to a close above 3324. SH was trading at $23.53 when the S&P 500 traded above 3293. The S&P 500 closed above 3324 on February 5 and SH closed at $23.23.
The S&P 500 Equal Weight Index is democratic since each company is treated the same and each has the same weighting of 0.2% as the other 499 companies. Apple and Microsoft, which make up almost 10% of the regular S&P 500, are no more important than Gap, Inc which has a weighting of 0.0139%. The Fav Five contributes 18.1% to the daily change in the S&P 500 compared to the bottom 300 companies which only add 16.8%.
Since mid December the Equal Weight S&P 500 has gone up in value, but compared to the heavily cap weighted regular S&P 500, the relative strength of the Equal Weight has been falling like a rock.
When the Fav Five correct (and as hard as it is to imagine they will), all the stocks that have been weakening since mid December aren’t likely to be rejuvenated. The concentration of money in the Fav Five and complacency they’ve inspired has reached the goofy stage. When the turn lower comes, it could be violent as traders all try exit at the same time.
The relative strength of the Equal S&P peaked in mid September while the mega cap Fav Five have traded almost vertically. There is a good chance that Algorithmic trading has played a significant role in how the mega cap stocks have traded. I saw this posted last week and thought it was spot on and funny:
‘Every time the market hits an all-time high an Algo gets its wings.’
On February 10 another Algo got their wings.
Treasury Bonds
In the February 3 WTR I noted that the RSI for the 10-year Treasury bond was below 26.0 indicating that the decline in the yield has become over done:
“This suggests that yields can tick-up in the short term, but the longer term down trend remains intact.”
The 10-year yield jumped from 1.522% on February 3 to 1.668% on February 6, before falling to 1.547% on February 10. Since December 31 the 10-year yield has dropped from 1.919% to 1.547%, even as the S&P 500 rallied 3.7%. The low yield for the 10-year Treasury last summer was 1.429%, as global bond yields were plunging and the prospects for a trade deal with China were dim. If the 10-year yield approaches 1.429%, stock investors may begin to notice and begin to wonder if the global economy is sicker than realized.
The pattern in the 30-year Treasury has followed the path of the 10-year. The 30-year yield jumped from 1.992% on February 3 to 2.141% three days later, only to fall to 2.020% on February 10.
Longer term the expectation remains that the 30-year Treasury yield can fall to the low of 1.905% by mid-year, and may get there before the end of the first quarter. The red trend line (chart below) connecting the low in January 2015 at 2.26% and the low of 2.106% in July 2016 suggests the 30-year yield could fall to 1.80% or lower if it tags the trend line.
Since the high in November 2018 at 3.455%, the 30-year yield has been declining in what appears a 5 wave pattern (green numbers). It is in wave 5 and would be completed once it falls below 1.905% at a minimum. If correct it suggests a major turning point could develop once this pattern is complete, that would lead to a significant rise in Treasury yields.
Treasury Bond ETF (TLT)
As discussed previously:
“The correction that has developed since the high of $148.67 wave (3) may still be wave (4) from the November 2 low of $111.90. If correct, TLT would have the potential to rally above $148.67 in coming months.”
As discussed last week:
“TLT rallied to $145.99 on January 31 and its RSI is a bit over 70, so a brief pullback is possible.”
TLT quickly fell to $141.90 before resuming its rally.
Gold
Although Gold may attempt another rally slightly above $1600, the pattern suggests Gold will fall below $1536 before any meaningful rally can take hold. A decline to near $1450 can’t be ruled out.
Gold Stocks
Last week GDX fell to $27.77 but the expectation remains that GDX will fall below $27.68, and potentially near $27.10.
Dollar
The Dollar traded above 98.54 on February 10, which was not expected. The Dollar’s RSI is above 70 and an equal rally (a=c) from the low at 96.36 on December 31 would target 99.23. The Dollar is still expected to fall below 96.36 in coming months.
Emerging Market
After tracing out a 5 wave decline, the Emerging Market ETF EEM had become short term oversold and was expected to bounce to $43.50 or so. On February 5 EEM traded up to $44.47 before closing at $43.93. On February 6 EEM jumped to $44.34 and then faded and closed at $43.97. Closing so far below the intra-day highs on February 5 and 6 is not healthy trading action and suggests selling pressure increased as EEM tried to rally.
The long term price pattern in the Emerging Market ETF (EEM) suggests that EEM could drop to $38.00 or so to complete a big A-B-C correction since the high of $51.76 in January 2018. If the Wave (C) decline from $46.32 is equal to the Wave (A) drop (51.76 – 37.35 = 14.41) EEM could fall to $32.00 (46.32- 14.41). If the global economy slows more than expected a decline to $38.00 seems plausible. The only way a decline to $32.00 occurs is if the global economy is admitted to the ER. No worries though. Central banks will cut rates repeatedly.
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, 2019 confirming the uptrend.
The January 2018, October 2018, and July 2018 highs are connected by the red trend line. The breakout above this trend line in early November was significant. Often, markets retest a breakout level before either negating the breakout or resuming the uptrend. The sharp 3-day drop from 3154 on November 27 to 3070 on December 3 was a retest.
The excessive persistent bullishness and concentration in mega cap stocks, and dependence of their continued strength, suggests a correction is coming that brings the S&P 500 below 3215 at a minimum. The key will be the form of the pullback and how quickly bullish sentiment dissipates.
If the S&P 500 retests 3100 after a down-up-down correction, it will likely continue to rally toward 3500 and higher. If the S&P 500 falls in a 5 wave decline as it tests or breaks below 3100, it would suggest the subsequent rally will represent a shorting opportunity.
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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