Written by Jim Welsh
Macro Tides Weekly Technical Review 08 February 2021
A Fundamental Bull Market or Speculative Binge
A fundamental bull market is supported by broad based economic growth which spurs solid growth in worker’s wages and organic growth in corporate revenue and cash flow. The steady increase in economic activity lifts the stock market but the market’s valuation is below the 75th percentile of historical valuations. A fundamentally driven bull market is not dependent on the economy needing an extraordinary amount of fiscal stimulus to avoid a recession and surge in bankruptcies
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If the economy is experiencing broad based growth it is not dependent on monetary accommodation to artificially depress interest rates to justify excessive valuations. The market’s current valuation based on numerous historical benchmarks is in the top 3% of all measurements going back 100 years. Stock market capitalization as percent of GDP (Warren Buffett’s favorite valuation metric) has just hit the highest level ever.
This valuation would be understandable if the U.S. was in the middle of a broad based expansion that was lifting wage growth and providing corporations the confidence to boost business investment.
The Pandemic has created a hole in the U.S. economy that has left 10 million workers still without a job, after the January 2021 employment report was released on February 5. Some analysts were heartened by the decline in the U-3 Unemployment Rate from 6.7% to 6.3%. On the surface this certainly appears to be good news until the math underneath the calculation is reviewed. The Unemployment rate compares the number of people who are out of work to the labor force, which includes those working but also those who are unemployed but actively looking for a job. In January 406,000 people were so discouraged they quit looking for work. With the labor market denominator lowered by 406,000, the unemployment rate was lowered to 6.3%, and would fall to 0% if every unemployed worker stopped looking for a job.
As discussed in the June Macro Tides, research of prior recessions showed that a high percentage of workers who thought their unemployment status would be temporary wound up being permanently laid off:
“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. According to Nicholas Bloom an economics professor at Stanford University and one of the co-authors of the white paper,
“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.”
This analysis appears prescient as just over 40% of temporary layoffs have become permanent. This may change for the better if the vaccines are effective enough to allow the most affected industries to mostly reopen. Of the 9.9 million fewer jobs in January 2021 compared to a year ago, 37% of them are in three industries – restaurants, hotels, large gatherings amusement parks, sports
A market sporting a historically high valuation built on an economy that is not experiencing broad based growth are indications of a speculative binge, but the clincher is psychology and the behavior of investors. As the world moves to address climate change it is only natural that those sectors that will turn hope into reality do well. The value of solar power stocks have soared five-fold and electric vehicle stocks are up six-fold, after spending 3 years doing very little.
Initial public offerings (IPO’s) have been a big hit in the past 9 months spurring demand for firms coming to market without having earned a penny. The percentage of IPO’s with negative earnings is as high as it was in the dot.com bubble. Investors have forked over more than $65 billion to Special Purpose Acquisition Company (SPAC). These entities raise money to acquire public companies without defining goals or limits, which is why they are also known as ‘blank check’ companies.
Since August the 10-year Treasury yield has climbed from 0.50% to 1.18%, but Junk bond yields have been falling and set a new low last week. Investors are so sure about the coming economic boom they are less concerned about the containment of the Pandemic and more concerned about chasing the higher yields offered by less than pristine firms. Junk bonds often trade in lock step with equities so the record low in junk bond yields is another sign of speculation.
In recent weeks novice investors have congregated in Reddit chat rooms and collectively choosing to buy stocks with large short positions through the broker / dealer Robinhood. Their actions caused shares of GameStop, AMC, Koss, and others to soar.
I have no doubt professional traders with Wall Street firms like Goldman Sachs jumped in to take advantage of the volatility, which is why the volume traded in these stocks rose to levels that Robinhood traders couldn’t generate. Most of these plays have already crashed with many down more than 80% from their inflated highs.
The willingness to buy stocks just because they were going up is pure speculation. Since 1985 the most shorted stocks have consistently underperformed the Russell 3000 by an average of -6.9% annually, other than a few brief periods of outperformance. In the past few months this group has outperformed the Russell 3000 by 147% compared to prior episodes of 19% and 9%.
The number of new retail accounts opened since last March is comfortably above 10 million and many of these new investors have gravitated to trading Call options. Using Call options increases the leverage a small investor can implement to bet on their favorite stocks. One yardstick to measure the activity of small option traders is to quantify the number trades of Call option Buys on individual stocks that are less than 10 contracts. Since April of last year the volume of Call option Buys has increased 900%.
For those who are more conservative and not comfortable in trading Call options that expire in two weeks as 50% of the volume indicates, there is always good old fashion margin. Investors are able to leverage their capital by 100% if they use 50% margin and many have chosen this route. In the last 9 months margin debt has increased by more than 60% the largest increase ever.
The only other instances that margin debt soared by more than 50% in the prior nine months was in late 1999 and in 2007, which were followed by learning experiences.
The initial Call infatuation was concentrated on the Mega Cap FAMANG stocks last summer which ended when the Nasdaq 100 topped on September 2.
After Pfizer announced its vaccine on November 9, these stocks were briefly out of favor only to be embraced in early January. After correcting in late January as Mega Cap stocks were sold to meet margin calls on disastrous short positions, Call buying has resumed in the FAMANG stocks. The huge buying of Call options has forced dealers to buy the underlying stocks which has propelled the Nasdaq 100 to a new high and pulled the S&P 500 up too.
The economy is on the mend and vaccine distribution is improving which provides the back drop supporting the buy-the-dip mentality no matter how shallow. There is no doubt that the bull market that began in March 2020 after a 35% plunge has evolved into a speculative binge that has further to run.
The expectation was that the S&P 500 would experience a sharp decline that would bring it down to 3550 before a subsequent rally took the S&P 500 above 4000:
“The low on Friday January 29 on the S&P 500 was 3694 and the expectation is that the S&P 500 will close below 3694 which should lead to more selling. The S&P 500 is expected to drop to near 3550, which would retrace 50% of the rally from the low of 3234 and high of 3871. After the coming correction, the S&P 500 is expected to rally above 4000.”
Rather than continuing to correct the S&P 500 immediately zoomed to a new high which was not the expectation.
The pullback into the low on January 29 when the S&P 500 fell to 3694 turned out to be an a-bc correction, which is best labeled wave 4 (chart below). The rally to a new high could be wave 5 from the low of 3234 on October 30. Despite the new price high the RSI for the S&P 500 is recording a negative divergence and is below its prior high and 70.
The same RSI negative divergence is in place for the Nasdaq 100 (QQQ), and the price pattern also supports the wave 5 interpretation.
If the chart analysis for the S&P 500 and Nasdaq 100 is correct, these averages should top this week and begin to correct with the initial target being the January 29 lows. However, in the middle of a speculative binge the market can continue to trade higher until a point of exhaustion is reached. Although the reversal after such a run-up will be similar to GameStop, it won’t be as dramatic but it will be swift and sharp.
Dollar
The Net Short positioning against the Dollar by Asset Managers and Leveraged Funds remains historically high, which should be supportive of a rally in the Dollar in coming months. Once the Dollar begins to rally in earnest the pressure on those short to cover shorts and limit their losses will mount. That short covering buying will give the Dollar rally a boost.
Two other factors will likely play a role and act as a spark. As discussed previously the ECB is likely to become more vocal about the Euro’s strength which will over time lead to a decline in the Euro. In other words, some of the coming strength in the Dollar will be due to weakness in the Euro rather than Dollar strength. The other factor is the expected surge in inflation in April 7 and May as discussed in the February Macro Tides:
“The question is how will financial markets react, if the headline CPI climbs comfortably above 3.0% for a few months? Few will suggest the Fed will increase the federal funds rate in 2021 but strategists will begin to discuss the potential that the Fed could move sooner than the end of 2022 to raise the funds rate. If headline CPI inflation pops as seems likely, it might impact a number of markets, especially if strategists begin to express the view that the Fed might remain patient in 2021 but not so much in 2022. Potentially, Treasury yields would rise, the Dollar would rally, but Gold would also rally.”
The Dollar is expected to rally above 92.00 in the short run and sometime this summer test 95.00. This constructive outlook for the short term is dependent on the Dollar holding above 90.00. Should the Dollar manage to close above 95.00, a subsequent move up to 98.00 – 100.00 will be possible.
Silver
As discussed last week, the Reddit short squeeze was likely to fail since more traders were long Silver futures than short:
“The huge rally in GameStop, AMC and the other stocks targeted for buying to squeeze large short positions were successful because there was a large short position in each of these stocks to force those short to buy, which sent those stocks to the moon. Large Speculators, Managed Money traders, and small traders are actually long Silver futures, so engineering a short in the Silver futures market doesn’t have the short positioning to feed a squeeze.”
The spike higher in Silver on February 1 created a negative divergence between Silver and Gold, which as noted in last week‘s WTR is normally not a good sign:
“On February 1 Silver traded up to $29.79 slightly exceeding the high of $29.75 back in August, but Gold is more than $200 below its August peak. This type of inter market divergence is normally not a healthy sign and 8 suggests that Silver is likely to drop and could fall below $24.00, which would bring SLV down to $23.50.”
After peaking at $29.79 on February 1 Silver peeled off $3.77 before hitting a low on February 4. It rallied to $27.53 on February 8 and an equal decline would bring Silver down to $23.76. The recent strength suggests a drop below $22.00 is unlikely. Once this correction is over Silver is expected to rally well above $30.00.
Gold
Gold is still expected to fall below $1766 and could fall to the down trending line that connects the low in August, September 24, and November 30 which is near $1700. Gold could fall to $1660 during a spike low. Gold is expected to rally above $2070 this summer.
Gold
Stocks If GDX follows the potential pattern in Gold, which would allow Gold to fall to $1656, GDX could drop below $28.00. Traders can establish a 33% position if GDX drops below $32.00.
Treasury yields
The 10-year Treasury yield climbed to 1.193% on February 8 before closing at 1.160%. The 10- year Treasury yield is expected drop to 1.00% and possibly as low as 0.95% before climbing to 1.266%. A decline to 1.00 would match the low on January 27 while a dip to 0.95% would test the breakout level as noted by the lower black horizontal trend line. At some point in 2021, more likely in the second half of the year, the 10-year Treasury yield could spike up to 1.75% to 1.95%.
On February 5 and February 8 the 30-year Treasury yield climbed above the March high of 1.94%. After rising to 1.993% on February 8, the 30-year yield closed at 1.943%. This reversal may be the start of the expected rally which may bring the 30-year yield down to the low of 1.76% on January 28. Longer term the 30-year has the potential to rise to 2.15% to 2.35%.
TLT has been expected rally to $154.00 to $155.00, and possibly as high as $158.00. Three weeks ago traders were advised to take a 50% position if TLT dropped below $149.92, using $148.00 as a stop. TLT fell below $149.92 on February 3 and closed at $148.03 on February 5 after trading at $148.02. TLT’s RSI did not confirm the new closing low in TLT on February 5, which is a short term positive and supportive of a near term rally.
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. The S&P 500 has been expected to fall to 3550, but the willingness to buy the dip has precluded any meaningful correction. The S&P 500 still has the potential to revisit 3694 in coming weeks and possible drop to near 3600. Once this correction is complete (should it materialize), the S&P 500 is expected to rally to 4000 and potentially higher in the first half of 2021.
The primary 10 sectors for the S&P 500 with the Russell 2000 and Midcap included.
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