Written by Jim Welsh
Macro Tides Weekly Technical Review 08 June 2020
At the beginning of 2020 the majority of investors thought the economy would be good and were bullish the stock market and positioned for more upside. COVID-19 upset that outlook when the economy was effectively shut down, the S&P 500 lost 35% forcing large institutional investors and hedge fund investors to adjust their positioning to the new economic reality which wasn’t pretty.
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Investors increased cash positions and hedge funds ramped up their short positions in anticipation of horrendous economic data. The data has been horrible (I’ll get to the employment report) but the stock market has just lodged its biggest rally in 50 days in history. The disconnect between the stock market and the economy has never been so wide. What gives?
As discussed in the June Macro Tides the Federal Reserve and Congress took actions which effectively changed psychology:
“This is simply not rational.
What changed though is psychology which is often more powerful than rational economic analysis. The unprecedented and historic actions by the Federal Reserve changed psychology, with the Fed indicating that it would begin buying high yield and municipal bonds, and allow the Treasury to leverage its Fed’s balance sheet as the Treasury funded a number of programs.
The speedy action by Congress to supplement the lost wages of 40 million unemployed workers was a necessary safety net that allowed those most affected to keep food on the table and a roof over their head. The timing of the Fed actions came at critical moments when devastating economic news could have elicited another wave of selling in the stock market.”
In the May 18 WTR I quoted three well known and respected investment pros. Scott Minerd from Guggenheim, David Tepper founder of Appaloosa Management, and Stanley Druckenmiller, and while each had their own reasons for caution they all thought the market was overvalued. As Druckenmiller said on May 12 in a speech at the Economic Club of New York,
“The risk-reward for equity is maybe as bad as I’ve seen it in my career. I don’t see why anybody would change their behavior because there’s a viral drug out there.”
This was a reference to Gilead Science’s drug “remdesivir”. He did concede that one of the wild cards was the Fed:
“The wild card here is the Fed can always step up their (asset) purchases.”
Stanley Druckenmiller was on CNBC on June 6 and was about as honest as a person could be:
“Well I’ve been humbled many times in my career, and I’m sure I’ll be many times in the future. And the last three weeks certainly fits that category. I would also say I underestimated how many red lines, and how far, the Fed would go.”
In June 2018 I stated that the Fed would expand its balance sheet to $10 trillion in the next recession, so the historic expansion in the Fed’s balance sheet was not a surprise. The Fed’s decision to buy high yield corporate debt and municipal bonds and extend lending to small firms through the Treasury was unprecedented, crossed red lines, and was a surprise.
What did surprise me was the market’s willingness to assume the Fed’s actions would address every economic problem and alleviate all the economic fallout. As laid out in the June Macro Tides there is good reason to expect the recovery to be weaker than expected in the second half of 2020.
However, the mindset is such that it may not matter, as long as market participants believe the Fed will simply do more. At the end of the day the market is the market and I have been humbled on numerous occasions over the past 40 years. I have always tried to learn from these experiences and this will be no exception.
I thought the S&P 500 would break above its 200 day average at 2999 but not exceed the trend line connecting the highs of January 2018, September 2018, and July 2019 at 3110. Supporting this conclusion was the high level of optimism as measured by the Call / Put ratio, the expected increase of COVID-19 infections in the first half of June, and the trend line resistance at 1450 on the Russell 2000.
All of those factors were blown out of the water when the Labor Department reported that 2.5 million jobs were added in May, rather than the 8 million that were forecast to be lost by economists. The discrepancy between the estimate and actual jobs was easily the largest in history. There were a number of factors that contributed to the miss.
Given the reason for the huge increase in lost jobs in March and April, the Labor Department struggled with how to define the different categories since a mandated shutdown had never occurred. The BLS discovered that it had undercounted the number of unemployed workers in March by 1.4 million, which meant the unemployment rate was 19.7% in April and above 16.0% in May, rather than the 13.3% reported. The Payroll Protection Program also played a role as companies rehired furloughed workers once they received their funds.
The Retail and Leisure and Hospitality sectors were hit hard with -2.3 million Retail jobs lost in April and -7.5 million in Leisure and Hospitality. As firms prepared to open in the last half of May more than 1.5 million of workers from these sectors were rehired. There were also big swings in Education and Health Services and Professional and Business Services that amounted to more than 5 million jobs.
The Labor Department will be making large revisions to prior data and will probably continue to struggle in quantifying the shifts that are coming in the future as more of the economy opens.
It should be noted that 500,000 state and local government jobs were lost in May, which will weigh on state budgets starting on July 1, 2020. Republicans will be resistant to additional deficit spending given the drop in the Unemployment Rate and want to wait to see if the improvement in the labor market continues.
The Democrats will take the other side and want to provide money for states and extend the weekly Bonus unemployment money, which will expire on July 31.
I think the Republicans will come around and agree to another stimulus package since it is needed as noted in the June Macro Tides:
“A recent white paper from the Becker Friedman Institute at the University of Chicago, entitled COVID-19 Is Also a Reallocation Shock, estimates that many of the laid off workers who expect their unemployment status to be temporary will actually become permanent.
“Looking through history at previous recessions, often these temporary layoffs unfortunately turn out to be permanent. Our best guess is something like 60% of the employment reduction is going to be temporary, and 40% is going to be permanent. These findings suggest that 10 million workers or more won’t be rehired in a timely manner. The unemployment rate could remain above 10% at the end of 2020. This is another reason why a strong recovery in the second half of this year is unlikely. It is also why Congress will pass another bill that extends the $600 a week Bonus unemployment payment beyond July 31, but hopefully include a provision that the payment will end if employers offer a worker their job back.”
The amount of the weekly Bonus unemployment check will likely be reduced from $600, but for the bottom 40% of workers the money is needed. Workers in the bottom quintile of the wage distribution experienced a 35% employment decline, while those in the top quintile experienced only a 9% decline.
The workers in the bottom quintile are less likely to be rehired in a timely manner and are more vulnerable since they lack the savings and wherewithal to keep making mortgage or rent payments and putting enough food on the table for their family. If Congress fails to pass an extension of the Bonus unemployment payments, there is a risk the rebound in the economy will slow. More obvious is that neither party wants to be responsible for hurting a large group of American workers just before an election.
The Federal Reserve and Congress will continue to provide a safety net for the economy, but until there is a vaccine the recovery is going to painfully labored after an initial bounce from reopening. Job growth will occur in the next few months but millions of workers won’t be rehired and an increase in white collar job losses is coming as larger firms adjust to less revenue.
The reality is no restaurant can survive if occupancy is less than 75%, and many small businesses will struggle to keep their doors open if their revenue is less than 80% of pre COVID-19 levels.
There is a wave of real estate bankruptcies coming in 2021 as store owners seek relief on their lease payment and thousands of stores disappear. With more workers working from home, many companies won’t need as much office space. This will take time to unfold but commercial real estate will come under pressure in 2021 and 2022. The question is how soon will this reality impinge on the stock market’s rosy outlook and will it matter to the stock market once it does.
Stocks
Positioning played a big role in the selloff in March and potentially a larger role in the rebound. With the economic news so downbeat the majority of institutional investors were reluctant to jump back into the market after raising cash in March. Hedge funds were really whipsawed by the big decline and subsequent unrelenting rally. They slashed their exposure in March and have now dramatically increased exposure in May.
Enormous short positions were built in those sectors hit the hardest and least likely to rebound quickly, including airlines stocks, cruise ships, hotels, and casinos. Many stocks in these sectors were down by 75% or more and were expected to remain dead in the water until a vaccine made travel possible. On June 4 the CEO of American Airlines indicated that their load factor in July (airline jargon for how many passengers are on each plane) might only be down 45% from July 2019. American Airlines stock rose from $11.85 at the close on June 3 to an intraday high of $22.80 on June 5 a modest long term gain of 92% in less than 2 days. Without a doubt there was a big short position in American Airlines and many of the other travel related stocks that soared in the past week.
The initial rally off the March 23 low was concentrated in the shelter in place stocks that benefited from COVID-19. The rally off the May 14 low has relied on the economically sensitive stocks like airlines, banks, and small caps. The first rally lasted from March 23 to April 29 and 27 trading days. An equal rally in time from the May 14 low would target a high on June 22.
The initial rally in the Russell 2000 was 407 points, but it was choppy as each leg lower after a rally overlapped the prior high. This suggests it is possibly a corrective move up which is why the label is Wave A. After a 3 wave pullback, an equal rally of 407 points from the May 14 low of 1181 would bring the Russell 2000 up to 1588, or about +3% from today’s close of 1537.
If sentiment was excessively bullish last week it is crazy over the top bullish now after the employment report convinced people the V- shaped recovery in the stock market was correctly forecasting a V-shaped recovery in the economy.
Small option traders typically trade less than 10 contracts. With time on their hands small option traders have been very busy and buying call options in anticipation of higher prices at a record pace. In the old days technicians would track odd lot short sales to gauge whether the ‘little guy’ was too bearish or too bullish. Based on option activity the ‘little guy’ is fully committed to the long side.
The total Call / Put ratio reached its highest level in many years on Friday and likely higher today. One has to go back to September 2012 after which the S&P 500 fell -8.8%. A similar high reading in March 2012 was followed by a drop of -9.6%. In April 2010 the S&P 500 fell -16.7% after the Flash Crash unnerved investors in May 2010. The current economic environment is unlike these prior instances, but the level of enthusiasm is comparable and reflects people getting too bullish and emotional buying.
The 21 day Advances minus Declines oscillator has reached a historically high level which reflects the rally in the beaten down and cyclically sensitive stocks. Such a high level is positive in the near term and projects more strength. It also is the result of emotional buying which is rarely a good thing.
The high Call / Put ratio suggests the market is in the zip code of a high, while the strong 21 day Advances minus Declines oscillator indicates the market is likely to hold up for awhile and move a bit higher. Normally, the market averages won’t hit a price peak until the 21 day Advances minus Declines oscillator records a lower high. This outlook supports the potential for the rally to continue until June 22.
Although the market averages are likely to press higher in the next two weeks, it is more likely that the S&P 500 will fall back to 3100 at a minimum. Chasing the market is probably not a good idea after so much good news and price appreciation.
Treasury Bonds
Last week the European Union announced it would issue $750 billion in Euro bonds to support those countries most impacted by COVID-19, although it may be weeks before it is officially approved. Germany announced plans to stimulate its economy with $75 – $85 billion in spending. These two announcements caused European bond yields to jump and raised expectations for the global economy. Technical selling was triggered in the U.S. Treasury market after the 10-year and 30-year Treasury bonds broke below support. This caused additional selling as stops were hit. This was not expected.
The Treasury bond market is at an important crossroad. The decline pushed the RSI for the 10-year and 30-year up to 70 which means both have become oversold. The next rally in bond prices should bring yields below the trend line they just broke above. Otherwise the potential for a decline to near the low yields in March will not develop. In that scenario bond yields will come down but record a higher low.
The Fed meets on Wednesday and may reveal its plans for targeting interest rates as it did during World War II to cap any rise in rates. Powell may reference the strong jobs report which stocks may not like.
Gold and Silver
Gold is still expected to work its way lower. A close below last week’s low of $1672 should lead to more selling, which should drop its RSI below 35. Silver’s RSI recorded a divergence as Silver push to a higher high two weeks ago. This should set up a decline to $16.75 at a minimum. Bullish sentiment toward Silver is still high so a deeper correction is possible.
Gold Stocks
The relative strength of the Gold stocks to Gold is rolling over and a dip below the red and blue moving averages would add support to the expectation of a deeper correction in GDX. A close below $32.20 would likely be followed by a decline to $29.75.
Dollar
The Dollar is near a trading low and is poised to rally. The strength of the next rally will reveal a lot and not only about the Dollar. The Dollar’s RSI is oversold so a decent bounce is coming soon.
The price pattern suggests the Dollar may be close to completing an a-b-c decline from the high at 102.99 on March 20. Wave a carried the Dollar from 102.99 to a low of 98.29 on March 30. Wave b took the form of a triangle with the high of the triangle being 100.93. If wave c is equal to wave a, the Dollar would fall 4.70 points and reach 96.23. After hitting a low of 94.65 on March 9 the Dollar rallied 8.34 points. The 78.6% retracement of the 8.34 rally targets a low at 96.43. Since the high of wave e within the triangle 8 for wave b, the Dollar appears to be in wave 5 of wave c and should fall below 96.44 to complete all of wave c.
The synergy of all these price targets and pattern in the Dollar opens the door for a rally of 8.34 points from the coming low. If this occurs the Dollar will rally above the January 2017 high of 103.82. At a minimum the Dollar should retrace 61.8% of the drop from 102.99 or more than 4.0%.Traders can buy the Dollar below 96.44 or UUP below 26.10 using a 1% stop.
Even if the Dollar only rallies 4.0%, it will likely put downward pressure on Gold, Silver, and Gold stocks. On balance it would likely be a positive for Treasury bonds and negative for stocks. If the next rally is only a retracement rally, the Dollar would be set up for a larger decline, which would be supportive of the precious metals, stocks, and a head wind for Treasury bonds.
Bottom line is that the Dollar could have a big influence on how these other markets trade in the next few weeks or months.
Emerging Market
The Emerging Market ETF EEM rallied from $36.50 on May 22 to $38.60 on June 1 and above the resistance level of $37.90. If the Dollar rallies in coming weeks, EEM is expected to retest the breakout level of $37.90.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
The MTI generated a Bear Market Rally (BMR) buy signal when it crossed above the red moving average on April 16 when the S&P 500 closed at 2800. A new bull market was confirmed on June 4 when the WTI rose above the green horizontal line. Although the MTI may confirm the probability of a bull market, it doesn’t preclude a correction, which the Call / Put ratio suggests is likely once the near term momentum wanes. The confirmation of a bull market increases the probabilities that a move to an all time high in the S&P 500 is likely after a correction.
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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