by Jim Welsh
MacroTides Weekly Technical Review 02 March 2020
Central Bank Cavalry Rides to the Rescue – Again
With the U.S. stock market teetering on the precipice on Friday February 28 Federal Reserve Chair Jay Powell offered some soothing words 90 minutes before the close.
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“The fundamentals of the U.S. economy remain strong. However, the coronavirus poses evolving risks to economic activity. The Federal Reserve is closely monitoring developments and their implications for the economic outlook.”
As the stock market weighed Powell’s comments and whether it would tank going into the close, the tide turned and the S&P 500 zoomed 74 points in the final 12 minutes of trading – no doubt drawing comfort from the anticipated support from the Fed.
Over the weekend the Bank of Japan, Bank of Canada, and the Reserve Bank of Australia joined ranks with the Fed with promises of more central bank intervention. Equity investors may not believe monetary policy can fix every problem, but stock prices ALWAYS respond favorably to easing.
The verbal intervention by Powell and his fellow central banker Musketeers may have prevented a potential set up for a steep decline (crash?) on March 2, with a Turnaround Tuesday offering hope for at least a short term trading low. The central bank intervention changed the flow of the decline and may offer insight as to when a short term rebound high may develop. Rather than a low being set on Tuesday, it may mark a high.
High energy declines occur when investors are provided really good reasons to sell. The recent decline was the largest drop from a high in market history, so it’s not a stretch to surmise that many institutions didn’t have a chance to lower equity exposure given how quickly the plunge unfolded.
Of course, one has to assume that the positive fundamental outlook the vast majority of institutions held just 2 weeks ago has been altered by COVID-19. With so much uncertainty about the extent of the coming slowdown in growth and earnings, I’m not sure how anyone wouldn’t have a different view of the world. But investors have been trained and conditioned to buy whenever the Federal Reserve and central banks act to support asset prices. The power of herd mentality can’t be ignored no matter how irrational it may appear, especially since there isn’t a single epidemiologist on the FOMC, ECB, or BOJ.
In this case there aren’t many investors who actually believe monetary policy can address economic weakness from a non-economic source, but no one wants to left behind. Lower rates may stabilize financial markets but lower rates won’t provide consumers the courage to venture out into crowds in coming weeks, if the number of COVID-19 infections climb.
On March 1, the U.S. only tested 500 people for COVID-19, while South Korea tested 65,000. As the number of those tested for the virus increases, the number of infections and deaths in the U.S. will rise and begin to look like Italy’s experience.
The outbreak in the Seattle area hasn’t really registered since Seattle is not a major city like New York, Chicago, Los Angeles, and a dozen others. But experts think the virus may have been spreading there for up to 6 weeks before it became known, so it very likely infections will continue to rise.
As more tests are administered in major cities there is a high likelihood that infections will be found in many of those cities, which is when a generalized change in consumer behavior will become apparent and hurt the economy.
In the first half of February the stock market pretty much ignored the progression of the coronavirus and the risk it posed. Now, investors think central banks can immunize markets from a pandemic, which seems irrational given what we’ve learned about COVID-19. If the virus spreads as seems likely in coming weeks, it’s just a question of when investors will be forced to confront the impudence of central bank rate cuts. That is when the S&P 500 is likely to retest the low of 2856 on February 28, and potentially drop below it.
Since 2011 there have 5 high energy declines prior to the recent smash. A review of each may prove instructive as to whether a retest of the low on February is likely or not. A high energy decline is determined when the 5-day average of Advances minus Declines falls below -1200.
In 2011 the S&P 500 declined -18.8% after U.S. Treasury debt was downgraded from AAA to AA. During the subsequent rebound the S&P 500 recovered 50.5% of the decline before dropping -2.5% below the original low. Despite the lower low the 5-day average of Advances minus Declines posted a higher low.
In 2015 the S&P 500 lost -12.5% in a handful of days after China devalued its currency. In the bounce that followed the S&P 500 recovered 57.5% of the initial loss. After the rebound ran out of gas the S&P 3 500 dropped to within 0.3% of the initial low. During the retest the 5-day average of Advances minus Declines posted a higher low by a wide margin.
In early 2016 the S&P 500 fell -14.4% and then recovered 44.4% of the loss. The S&P 500 then undercut the original low by just 0.1%. During the retest the 5-day average of Advances minus Declines posted a higher low.
In February 2018 the S&P 500 shed -11.8% after a strong employment report spooked investors who thought it would prompt the Fed to raise interest rates. After the break the S&P 500 recovered 79.1% of the quick loss before retesting the original low. During the retest the 5-day average of Advances minus Declines posted a higher low, even as the S&P 500 dropped to within 0.8% of the first low. (chart above)
In the fourth quarter of 2018 the S&P 500 stair stepped lower dropping -20.2% from its high in October. The motivation for the heavy selling was concern that the Fed would drive the economy into a recession when the December FOMC meeting Dot Plot indicated the FOMC would hike rates 4 more times in 2019, after raising the federal funds rate at the December meeting.
Retests of the initial low after a high energy selloff occur because the reasons for the selling wave don’t evaporate over night. The swiftness of the original drop encourages investors to sell into the rebound as the news reminds them why the market sold off. In 2011, 2015, 2016, and in early 2018, the S&P 500 retested the initial low every time. There was no retest of the December 2018 low for two reasons:
1. Concerns about the economy were significantly lowered on January 4, 2019, after the December 2018 employment report showed that 304,000 new jobs had been created when it was announced.
2. On January 4, 2019 Federal Reserve Chair Jay Powell made the following comments which calmed investors who feared the FOMC was on a mindless march to raise rates in 2019. Fed Chairman Jerome Powell said mild inflation would give the central bank greater flexibility to set policy in the year ahead and that the Fed, which raised rates 4 times in 2018, wasn’t on a “pre-set” path to push its benchmark rate higher.:
“With the muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves.”
This new information about the strength of the economy and trajectory of Fed policy evaporated the reasons why the S&P 500 had declined in December, which is why there was no retest of the December 24, 2018 low.
One of the key factors that determine if a retest is likely is whether the reasons for the initial decline hang around and remind investors why selling pressure rose so intensely. In the current situation it is difficult to imagine how the reasons won’t only hang around but become worse.
The S&P 500 lost 537 points in just 7 trading days. The rally on March 2 has partially alleviated some of the oversold pressure that had built up. A 50% retracement of the initial drop would allow the S&P 500 to rally to 3125, while 61.8% rebound would target 3250. I have no idea whether the S&P 500 will reach these targets given the level of extreme emotional volatility.
My guess is that the S&P 500 is likely to spend more time in unwinding how oversold it became, which suggests the rebound period can last for a week or so. If it does consume more time, it’s likely the S&P 500 could suffer another sharp drop, before another rebound takes hold. (A classic a-b-c)
In the prior examples in which a retest did occur, the 5-day average of Advances minus Declines rebounded to the plus +677 level or higher, before the S&P 500 rolled over. As of March 2, the 5-day average of Advances minus Declines was -440, which is another reason why more time and more upside seems likely.
The key take away from the review of these prior high energy declines is that the S&P 500 will experience a retest of the low of 2855 possibly before the end of March. With this outlook selling into strength seems appropriate, and using the price targets as an opportunity to go short.
Treasury Bonds
If the S&P 500 retests or makes a new low, the 10-year Treasury yield will probably make a lower low before a more serious uptick in yields takes hold.
For months I thought that the 30-year Treasury yield could fall to the low of 1.905%. On March 2 the 30- year yield plunged to 1.612%! Until the S&P 500 bottoms, the pressure on yields to fall further will remain.
One of the reasons I thought Treasury yields would fall to historic lows was based on their chart pattern, which I’ve discussed for months:
“Since the high in November 2018 at 3.455%, the 30-year yield has been declining in what appears a 5 wave pattern. It is in wave 5 and would be completed once it falls below 1.905% at a minimum.”
Another reason was the pattern in the 10-year German Bund, which sported the same pattern. This suggested that the 10-year Bund yield would fall below the low of -0.71% it reached last summer for its wave 5 from the high in yield in January 2018.
Last summer global bond yields were pulling Treasury yields down and I expected this to repeat as Treasury yields fell to a lower low. It is interesting that Treasury yields seem to be pulling the German Bund lower. This suggests that an important low in global bond yields could develop once the German Bund does fall below -0.71%.
Treasury bond ETF (TLT)
For months the expectation was that TLT would rally above $148.67 before Treasury yields would reverse and rise for a period. As noted last week I thought TLT might have a bit more upside but that it was time to sell. TLT opened at $150.21 on February 25, and promptly proceeded to run up to $156.50 on March 2 before closing at $153.94. If the S&P 500 does retest its February 28 low, TLT will probably run up to near its high, before a more protracted period of consolidation and pullback takes hold.
Gold
Last week I thought it was a good time to reduce exposure to Gold stocks since its RSI was overbought and GDX had rallied beyond its price target of $30.50. On February 25 GDX opened at $30.48 and then plunged -16.5% to $25.43 on February 28. GDX may drop below $25.43 if the S&P 500 suffers another decline that tests the February 28 low of 2856. A drop below $25.43 might provide a buying opportunity.
Gold Stocks
Last week I thought it was a good time to reduce exposure to Gold stocks since its RSI was overbought and GDX had rallied beyond its price target of $30.50. On February 25 GDX opened at $30.48 and then plunged -16.5% to $25.43 on February 28. GDX may drop below $25.43 if the S&P 500 suffers another decline that tests the February 28 low of 2856. A drop below $25.43 might provide a buying opportunity.
Dollar
Last week I thought the Dollar was near a high and might weaken as expectations for rate cuts by the Fed increased. Despite the recent strength, the Dollar was still expected to fall below 96.36 in coming months. From a high of 99.39 on February 25, the Dollar spiked down to 97.18 before bouncing to 97.63 on March 2.
Emerging Market
As discussed last week, EEM was likely to decline below $40.50 at a minimum. EEM recorded an intraday low of $39.28 on February 28. A lower low is expected especially if the S&P 500 retests its February 28 low.
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.
After breaking below the red trend line that connects the January 2018, October 2018, and July 2018 highs near 3100, the S&P 500 rallied back to the underside of this trend line on March 2. There is a gap at 3109 and the S&P 500 may rally up to 3125. This is the 50% retracement of the 537 point decline, or the S&P 500 may simply fill the gap at 3109 before another setback takes hold.
My expectation is that COVID-19 will behave like other flu viruses and begin to fade as the temperatures rise in April and May. This suggests that after a few more weeks of bad news, and the number of infections in the U.S. and Europe spike higher, there will be a slowing in the number of infections. Ideally, the S&P 500 will retest its February 28 low of 2856 in the next few weeks as the number of new infections spirals up.
This could set up a strong rally into the summer as investors price in a global recovery due to all the stimulus provided by central banks and fiscal stimulus by China and potentially Europe.
Of course, it is possible that COVID-19 becomes a true global pandemic and the global economy suffers a more severe contraction. This is not the time to be complacent.
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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