Written by Jim Welsh
Macro Tides Weekly Technical Review 24 February 2020
Last week I noted that investors were complacent and bullish despite the impact of the COVID-19 on China’s economy and the global economy. Investors were willing to overlook the risk from the COVID-19 virus since they believe the Federal Reserve will lower rates more if necessary, and China will unleash a large fiscal stimulus program to reverse the plunge in its economic activity.
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These policy responses were forecast to limit the hit to global economic growth, which has led investors to buy every dip, even though investors don’t know how deep the economic valley will be. No one knew with certainty if COVID-19 would spread beyond China, or how quickly China will have it contained, but investors were more than willing to assume that any slowdown was likely to be limited and followed by a rebound.
Analysts were quick to compare COVID-19 with SARS (Severe Acute Respiratory Syndrome) which erupted in China in February 2003 and spread to more than two dozen countries in North America, South America, Europe, and Asia before it burned out in July 2003. By the time SARS was discovered in February 2003 though, the S&P 500 had declined 45% from 1553 in March 2000 to 850 in February 2003, and the Nasdaq Composite was down 79%.
The plunge in the Nasdaq Composite and the S&P 500 had nothing to do with SARS, and the subsequent bull market which began in March 2003 had nothing to do with the end of SARS either. But these details didn’t matter as long as strategists were able to show how much the S&P 500 rallied in the months after SARS made headlines.
Analysts were quick to down play COVID-19 since its fatality rate (2% – 3%) was far lower than that of SARS (9.6%) and cited statistics comparing the annual flu to COVID-19. According to the Centers for Disease Control, since 2010 the flu has sickened annually between 9 million – 45 million people, with 140,000 – 810,000 people so sick as to require hospitalization, and 12,000 – 61,000 deaths.
These numbers are big but lost in the discussion is the fatality rate for the annual flu is 0.1% compared to the estimated to date fatality rate of 2% – 3% for COVID-19. COVID-19 is roughly 20 times more deadly than the flu. This fact is clearly more important than the number of total flu infections and deaths.
I don’t presume to know any more than anyone else about COVID-19 but those who do know more have continued to express concern about the lack of containment in China and the potential for COVID-19 to spread around the world. As we now know the experts were right as COVID-19 has spread to Italy, South Korea, Iran, and Japan with each country reporting a large spike in the number of infections in the past week. After ignoring and dismissing what seemed to be obvious warning signs for weeks, investors took notice on February 24 and hammered the S&P 500 (-3.35%), DJIA (-3.59%), and Nasdaq 100 (-3.89%).
Wall Street analysts who compared SARS and the annual flu season to COVID-19 are now quick to note that the coming of spring causes the annual flue to run its course as temperatures rise. The expectation is that COVID-19 will behave the same. The odds do favor this outcome but is far from guaranteed since COVID-19 has already exhibited differences from SARS.
Margaret Harris, a spokeswoman for the World Health Organization (WHO), said:
“This really is a new virus and we’re learning as we go along. We’re seeing some cases that don’t have a clear epidemiological link.”
Infections are now showing up in people who haven’t traveled to China or come into contact with confirmed cases. Harris noted:
“it’s not clear how the virus is spreading.”
If the virus is spreading in ways that can’t be measured, containing it could be nearly impossible. Michael Ryan, chief of health emergencies for the WHO, said at the news conference;
“The virus may settle down into an endemic pattern of transmission, into a seasonal pattern or could accelerate into a full-blown global pandemic. At this point it is not possible to say which of those realities is going to happen.”
Even if COVID-19 fades as temperatures rise in April and May, the next four weeks will provide an ample opportunity for the number of infections and deaths to increase around the world and further disrupt supply chains. In the short run financial markets are likely to remain defensive as the news gets worse.
Many small and medium sized businesses in China could be pushed over the edge in coming weeks since they lack the liquidity to stay afloat. A survey taken on February 14 by the Chinese Association of Small and Medium Enterprises found that 30% of those surveyed would struggle to keep their doors open beyond 30 days with another 30% hitting the wall after 60 days.
Large State Owned Enterprises (SOE’s) in China have virtually unlimited access to credit from China’s state owned banks, so they are not at risk. The PBOC is certainly aware of the economic stress facing small firms and will do what it can to encourage banks to lend to small and medium sized businesses until the Chinese economy regains its footing. This action will likely prevent a widespread dislocation from a wave of bankruptcies, but won’t eliminate all the stress as some firms struggle to pay all their workers even if they survive.
If COVID-19 continues to spread around the world, the impact will vary by country. The U.S. is probably best prepared to limit the spread of COVID-19 and treat those who do become infected. This suggests that a widespread outbreak in the U.S. is a low probability. However, any increase in the number of Americans infected will cause more people to avoid crowds out of fear of contracting the virus in movie theaters, sporting events, restaurants, air travel, and travel on mass transit if possible.
This normal human reaction will be amplified around the world, which is why global economic growth will remain tepid even after the crisis phase winds down. The Federal Reserve can lower rates and China can launch a gigantic stimulus program, but monetary and fiscal stimulus won’t rewire human nature and convince everyone that it’s safe to go out into crowds for months.
Americans may be affected in a way that could be meaningful even if the virus doesn’t sweep across the U.S. China has become the dominant producer of drugs for the U.S. pharmaceutical industry, producing 95% of ibuprofen, 91% of hydrocortisone, 70% of acetaminophen, 40% of heparin, antibiotics, antidepressants, birth control pills, blood pressure medicines, cancer drugs, and countless other medications. Ninety percent of the prescription drugs consumed in the United States are generics, and the majority of them are produced overseas, mostly in India and China.
China often provides the raw ingredients for medications that may be manufactured outside of China. There are 48 drug producing firms in Wuhan province which is the epicenter of the COVID-19 outbreak in China. If staffing at these 48 firms in Wuhan doesn’t return to a normal level soon, shortages of basic medications could develop and result in Americans not being able to get the prescribed medications they need.
While only a small number of Americans might be affected, you can be sure there will be headlines highlighting the fear of those going without necessary medications, especially those whose life may be threatened. There will also be outrage that U.S. pharmaceutical companies allowed this vulnerability to occur, just so they could increase their profits. Bernie Sanders will have a field day.
China is publishing data that suggests the epidemic peaked in early February but an analysis of the data suggests the numbers coming out of China may be too perfect.
China’s Coronavirus Figures Don’t Add Up. ‘This Never Happens With Real Data.’
A statistical analysis of China’s coronavirus casualty data shows a near-perfect prediction model that data analysts say isn’t likely to naturally occur, casting doubt over the reliability of the numbers being reported to the World Health Organization. In terms of the virus data, the number of cumulative deaths reported is described by a simple mathematical formula to a very high accuracy, according to a quantitative-finance specialist who ran a regression of the data for Barron’s. A near-perfect 99.99% of variance is explained by the equation, this person said:
Put in an investing context, that variance, or socalled r-squared value, would mean that an investor could predict tomorrow’s stock price with almost perfect accuracy.
In this case, the high r-squared means there is essentially zero unexpected variability in reported cases day after day.
Melody Goodman, associate professor of biostatistics at New York University’s School of Global Public Health noted:
“I have never in my years seen an r-squared of 0.99. As a statistician, it makes me question the data.”
Real human data are never perfectly predictive when it comes to something like an epidemic, Goodman says, since there are countless ways that a person could come into contact with the virus. For context, Goodman says a “really good” r-squared, in terms of public health data, would be a 0.7. She said:
“Anything like 0.99 would make me think that someone is simulating data. It would mean you already know what is going to happen.”
Investors want to believe the situation is getting better in China but skepticism seems warranted.
Stocks
As noted last week:
“The risk that the valley is much deeper than investors realize is significant. If the experts are correct and COVID-19 cripples China’s economy and spreads as some have forecast, investors may be confronted with an unpleasant collision with reality. Fed rate cuts and Chinese stimulus may look more like a placebo than an actual cure for what is making the global economy sick. The stock market will be closely tracking the data for COVID-19. The experts believe the number of those infected and deaths will increase in the next 2-4 weeks at a minimum. Investors have assumed that the virus will be contained, so a ramp up of infections and deaths could create a small measure of doubt and lead to a modest pullback. A dip to 3215 -3250 for the S&P 500, and for the Nasdaq 100 a drop to 8960 – 9020 should be expected.”
On February 24 the S&P 500 fell to 3214 and Nasdaq 100 the dropped to 9028.
The S&P 500 posted a low of 3214.68 on January 31 before reversing and rallying to a new high on February 19 of 3393. After the S&P 500 gapped lower on February 24, the low print for the day was 3314.65 just 0.03 below the January 31 low.
This is clearly the work of algo trading, which generated buy orders as the S&P 500 neared the prior low, and why the S&P 500 subsequently bounced to 3253. A decent trading low is not likely until the S&P 500 drops below 3214 and generates more selling pressure.
Although the S&P 500 held above 3214 it did close well below the trend line connecting the low on October 3, 2019 and January 31, so the uptrend has broken down. The red 5 day moving average closed below the green 13 day moving average for the first time since the October 3.
The crossover below the 13 day average confirms that at least a short term high is in place.
As noted in the February 10 WTR:
“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.”
On February 24 only 295 stocks rose while 2700 fell, a ratio of 9.15 to 1, and suggestive of strong selling pressure. The 21 day average of advances minus declines became short term oversold on February 24, so a bounce could take hold soon. However, if COVID-19 continues to spread and the S&P 500 falls below 3214 as expected, the 21 day average of advances minus declines will probably fall to near -400 (green horizontal line) before a decent trading rally develops. Based on the pattern for the S&P 500, a bounce to 3260 or so could take hold before a decline to 3180 – 3205 leads to a more sustained rebound that could lift the S&P 500 to 3280 -3305.
More puts than calls were bought on February 24, but the 10-day average of the Call / Put ratio is still way too high to expect a solid trading low. The trading lows in early October and June didn’t form until the 10-day average of the Call / Put ratio fell to near 1.0 (green horizontal line).
From the low of 2856 on October 3, the S&P 500 rallied 537 points into the peak on February 19 at 3393. A 38.2% retracement of this rally would bring the S&P 500 down to 3188 which is why a better trading opportunity is likely after its falls below 3214. A 50% pullback of the 537 point rally targets a low at 3125, which is about where the black trend line connecting the secondary low on January 3, 2019 and the October 3 low is located. As mentioned last week:
“If the number of infections and deaths continues to grow beyond 4 weeks and the disruption to supply lines becomes more pronounced, the S&P 500 could quickly fall to 3070 – 3150, while the Nasdaq 100 tumbles to 8175 – 8445 by the end of first quarter. In the unlikely event that COVID-19 becomes a global pandemic, and these areas of support for the S&P 500 and Nasdaq 100 fail to hold, the market could get really beat up irrespective of Fed actions or massive fiscal stimulus by China.”
The federal funds rate market is pricing a 71% probability of 3 rate cuts by the FOMC before the end of 2020. Sooner or later (probably sooner) President Trump will send a barrage of Tweets telling the Fed to cut rates to offset the impact from COVID-19.
If the fallout from COVID-19 swamps global financial markets, a number of dovish FOMC members will give speeches in favor of the FOMC lowering rates if conditions warrant. Whenever these comments occur, the stock market will jump for joy so volatility is likely to remain quite high in coming weeks.
Treasury Bonds
The stock market not only responded to the spread of COVID-19 on February 24, but also to the decline in Treasury yields as was expected last week. “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 wonder if the global economy is sicker than realized.” The 10-year Treasury yield dipped to 1.352% barely above the low of 1.336% in July 2016. The RSI did not confirm the new yield low which suggests yields are near a low which may occur when the S&P 500 falls below 3214.
My expectation was that the 30-year Treasury yield could fall to the low of 1.905% fairly soon. On February 24 the 30-year yield plunged to 1.811%.
In the February 3 WTR I discussed why the 30-year Treasury yield had the potential to fall to 1.80%. “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.” Given what’s going on in the world, it is certainly possible that the 30-year Treasury yield could decline a bit more and below 1.80%. However, the risk reward going forward is not great. A rebound in Treasury yields is possible based on the RSI divergence on the 10-year Treasury yield and the red trend line for the 30-year Treasury yield.
If the outlook for Treasury yields is correct, I have thought TLT should find its way back to the high at $148.67. With the plunge in Treasury yields in the past few days, TLT traded up to $150.96 on February 24. Although TLT may have a bit more upside, it’s time to sell.
Gold
Gold didn’t pull back prior to the rally above $1609, but it did make a new high as outlined last week:
“As long as Gold holds above the January 14 low of $1534, it could spike above the high of $1609 on January 8.”
With the large decline in the stock market Gold zoomed and traded up to $1687 on February 24. Gold has a tendency to spike and then reverse as it did in January and may have done again on February 24. The expectation that Gold would rally above $1609 was based on the price pattern which suggested that the high in January was wave 3. The consolidation after the $1609 high was wave 4, which suggested a rally above $1609 was coming for wave 5. The spike to $1687 may have been all of wave 5, although its possible Gold will surpass $1687 to complete wave 5 of wave 5.
Either way the pattern suggests Gold is near an important high, and the extreme positioning in Gold concurs.
Gold Stocks
Previously:
“If Gold drops to $1553 – $1562 before February 22, GDX could be expected to drop below $27.68, and potentially test $27.20. If Gold holds above $1534 and subsequently rallies above $1609, GDX would be expected to move up to $29.66 – $29.87, and possibly $30.50.”
Unfortunately, Gold did not pullback and GDX not only rallied to $29.87 and $30.50 but up to $31.84. In fact GDX gapped up on February 24 opening at $31.76 before reaching $31.84. GDX then faded and closed at $31.05 -2.5% off the high at $31.84. It is now possible that GDX completed a large rally from the September 2018 low, since it exceeded the August 2019 high of $30.97. GDX’s RSI is overbought and GDX not only rallied as expected but exceeded its price target, which implies it’s a good time to reduce exposure to Gold stocks.
Dollar
The Dollar traded up to 99.91 last week comfortably above the price target of 99.23. After rallying for weeks since hitting a low on January 31, the Dollar fell on February 21 and February 24 even as concern about COVID-19 intensified. The Dollar may weaken as expectations for rate cuts by the Fed increase. The Dollar is nearing a high and is still expected to fall below 96.36 in coming months.
Emerging Markets
After falling to $41.88 and becoming short term over sold, EEM was expected to bounce. As noted last week, the rebound had the appearance of a corrective rally (a-b-c), so a decline below $41.88 in coming weeks was expected. On February 24 EEM fell to an intra-day low of $41.43. Whether EEM falls to $38.00 or lower will be dependent on whether China is able to contain COVID-19. At a minimum EEM is likely to decline below $40.50 if the current decline is equal to fall from $46.32 to $41.88, from the rebound high of $44.84.
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.
Investors have assumed that COVID-19 would be contained soon and growth would return to China and the global economy in short order, just as it has after prior epidemics. 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. If infections and deaths continue to increase during March, the S&P 500 has the potential to fall to 3100 – 3150.
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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