by Jim Welsh
Macro Tides Weekly Technical Review 22 June 2020
Profit margins come under pressure during periods of recession as revenues fall faster than companies can lower costs. There is a built in reluctance to lay off experienced workers as companies depend on them to execute the company’s game plan. Since a ‘normal’ recession evolves over time, CEO’s wait until the recession is clearly evident. This time firms reacted more quickly than they have in the past.
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The speed of the Pandemic and the shutdown of the economy by the government erased any doubts about the recession, which is why companies were quick to lay off workers, especially those most directly affected, i.e. everything related to travel and restaurants. Despite the speedy reaction in lowering headcount, profit margins will narrow for most firms as revenues remain below January 2020 levels.
The S&P 500 has continued to hold up even though profit margins have fallen, which is a break from the historical pattern. During the 2001 – 2002 bear market the S&P 500 was led lower by the decline in profit margins. The same result followed in 2008 – 2009 with the only difference being the depth of the fall in profit margins and the 57% smash in the S&P 500. Investors have been willing to ignore the plunge in profit margins in 2020 due to the actions by the Federal Reserve and Congress to support the economy. The Fed and Congress are attempting to build a bridge that can extend from where the economy was in January 2020 to whenever a vaccine is developed. This is a health crisis which is very much different than every other recession in the past 100 years. On April 9 the Fed announced that it would begin buying corporate bonds through the purchase of corporate bond ETFs. There is no question this intervention was needed and its impact has been huge, as the collapse in spreads indicates (chart below). Corporations have been able to sell a record amount of bonds in the first 5 months of 2020.
One would think that this level of financing means that the Fed’s primary corporate bond market mission was accomplished. In addition the spread between investment grade corporate bonds and Treasury bonds has never been so narrow. Even though the economy is not in great shape, investors are willing buy corporate bonds at yields that offer little in additional income.
However, the Fed announced that it would extend its corporate bond purchases to include individual company bonds on June 16. In the context of the corporate bond market this move was unnecessary, but it followed a 1,800 point plunge in the DJIA on June 11 which left the stock market a bit wobbly. The real goal then wasn’t to help the corporate bond market but to give the stock market a lift. The Fed succeeded as the S&P 500 rallied about 2% on the new news, which was actually old news since the original announcement was on April 9.
Positioning and sentiment are at levels that have coincided with at least a short term high in the S&P 500. The allocation to equities by members of the National Association of Active Investment Managers (NAAIM) approached 90% last week. During 2019 this level of exposure coincided with a modest correction of 5% to 7%, as well as the larger declines in late 2018 and in March 2020.
The Call / Put ratio is above the level (red horizontal line bottom panel) that has preceded the same corrections telegraphed by the NAAIM allocation level. (April 2019, July 2019, January & February 2020).
A number of the major market averages are hovering just above their rising trend line from the March 23 low. In addition, the 5 day moving average (red MA) for a number of the averages is holding just above the 13 day moving average (green MA).
It won’t take much weakness to bring the DJIA, Transportations, and Russell 2000 below their rising trend line and convincingly pull the 5 day average (red) below the 13 day average (13) and provide definitive sell signals. The Nasdaq 100 (QQQ) which is dominated by the Mega cap stocks is the furthest away from breaking below its rising trend line and having its 5 day average drop below the 13 day average. The QQQ’s recorded a new closing high on June 22, but its RSI is far below the prior RSI level (76.8) and under 70 (67.4). This was expected as noted in the June 16 WTR:
“Since the Nasdaq 100 has been the leading average there is a decent chance the Nasdaq 100 can make a new high in the next week. If the Nasdaq 100 does make a new high its RSI could post a lower high, which would represent another negative divergence.”
The table is set for a top soon and will be confirmed once the major averages close below their rising trend lines and the 5 day moving averages fall below the 13 day average. The depth of any correction will be dictated by the degree of weakness in the Nasdaq 100.
Dollar
Two weeks ago a well known economist Steven Roach published an article in Bloomberg, warning that a big decline in the Dollar is coming:
“A crash in the dollar is coming. The era of the U.S. dollar’s ‘exorbitant privilege’ as the world’s primary reserve currency is coming to an end.”
Even though Roach doesn’t expect a crash for a year, or two, or more, bearishness toward the Dollar has picked up noticeably. Positioning against the Dollar is nearing levels that were coincident with a major low in the Dollar in February 2018. This suggests that the Dollar index is unlikely to fall below 95.00.
In the June 8 WTR I recommended buying the Dollar index below 96.44 and the Dollar ETF UUP under 96.10. These positions were triggered on June 9. Use a close below 95.00 as a stop on both positions. The Dollar index is expected to rally to 98.80 and potentially above 101.00.
Gold
After chopping sideways for the past two months, Gold is likely to post a modest new high. Positioning is still negative so this move to a new high is more likely the end of the rally off the March low.
Silver
Silver refused to break below its rising trend line and seems poised to make a new high. If it does Silver’s RSI is likely to post a lower high and generate a negative divergence. Much like Gold this move up is likely the end of the rally from the low in March and not the beginning of a new advance. A rally in the Dollar in coming weeks would provide an excuse for profit taking in Gold and Silver.
Treasury Yields
Treasury yields have refused to go up even though the stock market has traded higher on supposedly good economic data and Fed policy actions. Given the level of bullish sentiment in the stock market and high expectations for the economy, I think the bond market has probably got it right. I still expect Treasury bond yields to fall in coming weeks, with the 10-year Treasury yield dipping below 0.543%. A drop in Treasury yields will likely occur as the stock market declines.
The 30-year Treasury yield is expected to fall to below 1.126%.
The Treasury ETF TLT is expected to rally above 172.15, which was the high on April 21.
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 has confirmed the probability of a bull market, it doesn’t preclude a correction. A review of the major averages suggests that a correction could be right around the corner.
However, until the major averages close below their rising trend lines, the concentration in the Mega cap stocks can continue to pull the S&P 500 higher. The FAMANG stocks now represent 24% of the S&P 500, almost triple the level in 2013.
Investors have been willing to put their Trust in the Fed irrespective of the expected increase in COVID-19 cases and only tentative signs that the economy will mount a V-shaped recovery. The June employment report may play a role as I will discuss next week. The stock market may also get a wakeup call if a city or state rolls back the opening of their economy due to the big increase in COVID-19 cases in their city or state.
Despite the recent rallies in the Energy stocks and Financials (banks) over the past month, the relative strength ranking of the sectors continues to favor Technology and Health Care.
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