Written by Jim Welsh
Macro Tides Weekly Technical Review 16 March 2019
The importance of the 2500 level on the S&P 500 was discussed last week:
“There is one level on the S&P 500 that should provide some level of support and God help us if it doesn’t. The black trend line that connects the bear market low in March 2009, October 2011, February 2016, and December 2018 comes in between 2500 – 2550.”
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This trend line is about 8% below the close of 2746 on March 9, which raises the question of whether the S&P 500 will reach it. Given the outlook the odds favor a test of this trend line. While there is no guarantee that the current decline will stop at this trend line, the S&P 500 could at least experience a strong rally from near this trend line.”
On Friday March 13 the S&P 500 experienced one of its largest rallies in history gaining 9.3%, with 7.0% of the move coming in just the last 24 minutes of trading, after testing 2500 on March 12. The high on March 13 was right in the range cited in the March 13 Special Update sent out just before the market opened on March 13.
“If Wave 4 matches the extent of Wave 2 the S&P 500 could rally up to 2678 and possibly up to 2734, which was the intra-day low on March 9, March 10, and March 11 on the S&P 500.”
It is an understatement to say that breaking below 2500 is not good.
According to the Small Business Administration, companies with fewer than 500 workers employ roughly 60 million people, or about 47% of the private sector workforce. A 2019 report by the JPMorgan Chase Institute looked at 1.4 million small businesses and found 29% of the businesses in a typical community were unprofitable, and 47% had less than two weeks of cash liquidity.
COVID-19 can infect someone for up to 2 weeks before symptoms appear, so there is a growing consensus to enforce social distancing for at least 2 weeks. A number of state governments have mandated that many small businesses that rely on large numbers of consumers to sustain their business model either close or curb the number of hours they are open or the number of customers they serve.
The poster child for one of the most affected sectors by the behavior changes sweeping across the country is restaurants. Even before mandatory shutdowns were announced, Open Table found that online reservations, phone reservations, and walk-ins were already plunging by 40%.
Open Table has more than 60,000 restaurants on its booking platform so the results it has reported provide a broad based assessment of what’s happening. Consumer spending at restaurants and bars accounts for almost 4% of gross domestic product, so a 40% hit to restaurant revenue could alone subtract 1.6% from second quarter GDP. More than 13 million workers are employed in the restaurant sector, so up to 5 million workers could soon lose their job if restaurants pare their labor force by 40%. Unless a safety net is provided quickly to these workers, GDP will be negatively impacted as these workers cut back on their spending.
Vistage Worldwide Inc conducted their monthly survey of more than 900 businesses with $1 million to $20 million in revenue for The Wall Street Journal between March 2 and March 9. More than twice as many business owners said they expected the economy would weaken rather than improve in the coming year. On March 2 only 25% of those surveyed reported that business conditions had worsened, but by March 9 that percent had jumped to 38%, underscoring how quickly the economy was deteriorating in a matter of just 7 days.
Estimates of GDP have been ratcheting down almost daily as the magnitude of this crisis has swept across the globe and now the U.S. As I wrote in the March 12 Special Update:
“For a period of time the way of life we know is about to change in a way none of us could have imagined.”
Goldman Sachs expects GDP to contract by 5.0% in the second quarter, and then rebound smartly in the second and third quarter with growth approaching 3.0%. At this point any estimate is a guess, but Goldman’s guess seems optimistic.
Some have compared COVID-19 to natural disasters like Katrina, which is why the economy is expected to quickly bounce back. But this analogy doesn’t work. While a natural disaster destroys economic activity in the area stricken, it also leads to a surge of pent up demand as the affected area rebuilds. Sometimes the rebuilding generates more economic activity than the initial destruction.
COVID-19 is destroying economic growth but the impact is more a delay in economic activity than creating increase in pent up demand. The restaurant that loses revenue when people don’t go out to dinner will never recover the lost revenue. This loss of revenue applies to every business that provides an experience for consumers like sporting events, conferences, vacations, and a long list of other moments that can never be reclaimed.
Some of the lost demand will come back as consumers buy the car they were planning to purchase but were forced to delay due to the shutdown of the economy. Businesses will spend money that they didn’t during the slowdown once they believe the worst has passed. There will be a rebound in the economy, but no one knows just how deep the drop will be or how long the virus keeps people from any semblance of returning to ‘normal’. The best estimate is that the peak in infections could be four weeks from March 14 or as many as 12 weeks. Every week beyond 4 weeks will inflict more damage on the economy and on the psyche of American consumers.
Since the bull market began in March 2009 corporate stock buybacks have provided a floor under the S&P 500 and limited the scope of every correction. On March 16 every major bank in the U.S. announced they were stopping stock buybacks and their stocks were far weaker than the S&P 500. Given the potential abyss in economic activity facing most S&P 500 companies, the vast majority of firms will curb if not eliminate their stock buyback programs. This is what occurred in 2009 and there is no reason to believe it won’t be repeated in 2020.
Buybacks have represented a major source of demand for stocks for years and the decline in demand from this source will be missed as selling pressure is likely to remain higher than normal as reported infections soar. A potential source of supply could come from the horde of investors (millennials) who have embraced the mantra of passive investing, primarily to save a few basis points in management fees. Since 2014 the amount of money in passive ETFs has tripled as stocks continued to climb ever higher. The S&P 500 is down almost 30% and Small Caps and Emerging Markets are down even more.
Treasury bonds are up which is a help, but most Millenials probably don’t have a large allocation to Treasury’s and might own more corporate bonds that have been sinking. As the drum beat of negative news increases in coming days, the pressure on passive investors will continue to build and could reach a breaking point as more of these folks wake up at 3 am and reflect on what has transpired in less than 1 month to their 401k. There is a level that will cause this group of investors, who have never been baptized by a gut wrenching decline, to become far less passive and decide to actively sell.
The combination of less demand from corporate stock buybacks and potential supply is discomforting and suggests that the next level of support may hold as well as 2500 did. As I have said before:
“In a market like this there are no levels of support. One can look at the chart of the S&P 500 and identify price levels that previously provided support, but in the middle of a dynamic decline (panic) no one cares.”
As noted in the March 12 Special Update:
“The next level of support that is the most obvious is 4 the December 2018 low of 2347 on the S&P 500. If Congress acts over the weekend, the S&P 500 has the potential to rally at least 150 points and could extend up to 2680 – 2734. (This rally occurred on March 13.) Once this rally runs out of steam a decline to near 2350 is likely.”
The S&P 500 closed at 2386 on March 16.
Although a bounce can take hold at any time, it seems likely that 2347 will not hold as selling pressure remains extreme. On March 16, 2002 stocks made a new 52 week low and no stocks recorded a new high, while only 120 stocks managed to buck the tide by going up but 2935 fell.
The 21 day Advances minus Declines Oscillator did not make a lower low even as the S&P 500 did. This divergence may allow for a rally soon, but I wouldn’t put too much weight on this divergence given the intensity of selling pressure.
If the S&P 500 fails to hold 2347, the next potential area of support is 2250 (higher green trend line) followed by the lower green trend line at 2080. If the peak in infections is 8 to 12 weeks, instead of 4 weeks, a decline to the February 2016 low at 1810 (red horizontal trend line)can’t be ruled out, as extreme as this seems.
In 1929 the S&P 500 shed -44.6% after topping on September 7 before hitting a low on November 13. A comparable decline would bring the S&P 500 down to 1880, and if the current decline matched 1929 in time, a low would be struck on March 25. After posting a low on November 13 in 1929, the S&P 500 rallied 46.7% before topping on April 9.
The point in showing this chart and reviewing these numbers is not to suggest we’re heading toward a depression. Instead, the point is that even on the cusp of the Great Depression, the S&P 500 experienced a huge rally. Back in 1929 -1932, policy makers didn’t have tools to intervene and manipulate asset prices as modern central banks do routinely now.
Once a peak in infections occurs there is the potential of a stampede back into the market, as investors anticipate a huge rally in asset prices due to the combination of monetary and fiscal stimulus. No one will wait until signs appear that the intervention is actually working to spur economic activity. They will gladly take a leap of faith.
My guess is that today’s big drop suggests the S&P 500 is groping for the end of Wave 3 of what is likely to be a 5 wave decline. If correct, the S&P 500 could rally back toward 2711 before Wave 5 takes the S&P 500 down to a new lower low. Wave 1 brought the S&P 500 down from 3393 to 2856 or 537 points, before Wave 2 lifted the S&P 500 to 3136 after the Fed’s first emergency rate cut on March 3. Wave 3 has dropped the S&P 500 770 points in a relentless decline that may have bottomed at 2386 on March 16.
If Wave 4 is comparable to Wave 2’s rally of 280 points, Wave 4 would target 2666 on the S&P 500. After such a big decline for Wave 3, Wave 5 is often nearly as long as Wave 1. If the S&P 500 tops between 2650 – 2711, a subsequent decline of 537 points would bring the S&P 500 down to 2113 – 2174.
In the February 2 Macro Tides I provided the following assessment:
“Since there is no way of knowing whether the coronavirus will prove mild or far worse than expected, monitoring chart levels and trend lines for the S&P 500 may provide some additional guidance. 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. A 5 wave decline and break below 3100 would suggest the coronavirus will prove more deadly than currently assumed, depress global growth, and short circuit any second half rebound in the U.S.”
The S&P 500 did fall in a small 5 wave decline as it broke below 3100, which did indicate that the coronavirus would prove worse than expected. The goal at this point is to identify a large 5 wave decline in the S&P 500 since the high at 3393 in an attempt to find a tradable low that lasts more than a few hours, without being early and getting run over.
Treasury Bonds
Despite the Federal Reserve slashing the federal funds rate from 1.50% on March 2 to 0.125% on March 15, and implementing another round of Quantitative easing with $700 billion of bond purchases, Treasury yields have gone up significantly. This is not an indication that the Treasury market is discounting a rebound in economic activity as some would like to think. It is more likely a sign that investors are selling Treasury bonds since they are one of the few assets that are still up on the year. If correct, the weakness in Treasury bonds is a reflection of an asset liquidity problem. As long as this condition persists it won’t be good for the stock market.
If the economy weakens as seems likely in coming weeks (months?), Treasury yields are likely to head lower after bouncing around.
Gold
Like Treasury bonds Gold was sold since it was also one of the few assets that is up on the year. Between March 9 and March 16 Gold plunged from $1701 to $1453.
As noted in recent weeks:
“The next Gold buying opportunity may not materialize until Gold is below $1475.”
Today’s low likely marks a short term low and may set the stage for a bounce back to $1550 to $1575. If the S&P 500 falls below 2200, Gold could experience another selling wave as investors sell what they can. The next leg lower could take Gold down to $1400 – $1425 before a more significant trading low is in place.
Gold Stocks
In the February 24 WTR I thought it was time to reduce exposure to Gold stocks since GDX had rallied beyond its price target of $30.50. From GDX’s high of $31.84 on February 24 GDX has been almost cut in half after hitting a low of $16.18 on March 16. This low however is somewhat artificial since there was a pricing problem with GDX on March 13.
The correlation between Gold Stocks and the S&P 500 has been high in recent weeks, which implies additional weakness, as the S&P 500 is likely to continue to negatively impact GDX. Gold stocks may be setting up a phenomenal rally in coming months but must begin to trade better to indicate that a trading low is forming. A close below $19.00 may provide the first signs of a low since GDX’s RSI will likely show a meaningful positive divergence.
Dollar
Since falling to 94.65 on March 9 the Dollar soared to 98.80 on March 13, as the COVID-19 pandemic has over run the globe. The rebound in the Dollar opens the door to a pattern that would allow the Dollar to rally above 101 and potentially back to its January 2017 high of 103.82. Dollar strength during a period of slowing global growth is not a positive for U.S. corporations or the global economy and especially not for Emerging Markets.
Emerging Market
This move higher in the Dollar is putting pressure on Emerging Market Dollar denominated debt at a bad time, as growth in Emerging Markets is weakening. The impact is clearly seen in EM Credit Default Swaps for EM corporate debt and more worrisome EM sovereign debt.
Dollar strength in the current environment could lead to a dislocation for one or more EM countries, if these spreads continue to widen. For countries and companies that earn most of their revenue in their home currency, a decline in their currency relative to the Dollar increases the burden of their Dollar denominated debt.
According to the Bank for International Settlements, U.S. Dollar credit to “non-bank” borrowers outside the United States totaled $11.9 trillion as of June 30, 2019. The risk of a default or mini-crisis in an EM country is rising and could add to the fallout from COVID-19. As they say, sometimes when it rains it pours.
In the February 2 WTR I discussed how EEM could fall to $32.00 in coming months:
“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.”
EEM traded down to $31.59 intra-day on March 16. Given the price pattern from the high at $46.32 EEM could fall below $30.00, as EEM appears to still be in Wave 3.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
Once the S&P 500 closed beneath 3214 (the intra-day low on January 31 and February 24), which was the expectation discussed in the February 24 WTR, an intermediate peak was confirmed. The unrelenting decline that has followed has caused the MTI to drop sharply. The MTI fell below the blue horizontal line on March 11, confirming the onset of a bear market.
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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