Written by Jim Welsh
Macro Tides Weekly Technical Review 22 February 2021
Higher Rates Compress Growth Stocks
In last week’s WTR entitled “Interest Rate Spike Could Derail the Equity Buying Binge“, I discussed why higher interest rates could lead to a quick decline:
“The market’s valuation is stretched but has been justified based on historically low interest rates which have been deemed low enough to support a P/E ratio of 20 for 2022 earnings. That is changing as Treasury rates have pushed higher and are now approaching the highs recorded in March 2020.
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If Treasury rates breakout above those highs the market could be vulnerable to a quick valuation check. As noted in recent weeks,
“Longer term the 30-year has the potential to rise to 2.15% to 2.35%.”
The 50% retracement of the decline in the 30-year yield from its high of 3.455% in November 2018 to 0.837% in March 2020 would allow for the 30-year yield to rise to 2.146%. The 30-year Treasury bond has been weaker than the 10-year so it may retrace 61.8% which would target 2.455%. This is just above where the 30-year traded in the fourth quarter of 2019. The 30-year closed at 2.18% on February 22 so it may reach 2.30% – 2.45% soon.
On February 22 the 10-year Treasury yielded rose to 1.370% which is not far away from where the 10-year Treasury yield bottomed in 2012 (1.394%) and 2016 (1.336%). These price lows now represent resistance which may slow the speed of the increase from a technical perspective.
However, the Biden administration is likely to promote an infrastructure bill after the $1.9 trillion stimulus bill is passed by Congress in March. Candidate Biden proposed infrastructure spending of $2 trillion during his campaign but in a meeting on February 16 a number of unions suggested $4 trillion would be more appropriate. As discussed in the February Macro Tides, headline CPI inflation is expected to jump well over 3.0% in April and May so Treasury bonds are facing significant headwinds that are likely to pull rates higher.
As noted in the February Macro Tides:
“The Federal Reserve has communicated that it will be in no hurry to increase the federal funds rate. At the December 16 2020 meeting only one FOMC member supported an increase in early 2022, while 3 members expect the funds rate to be 0.375% at the end of 2022 (FOMC has 17 members).
If core PCE inflation holds below 2.0% as expected, members of the FOMC will remind investors that this is their key inflation metric and not the headline CPI, which is why patience is warranted.
The question is how will financial markets react, irrespective of FOMC member statements, 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.”
Markets are being less patient than I expected and have already begun to move the timing of interest rate hikes forward.
If the stock market suffers a correction, bond yields may temporarily fall before resuming their uptrend. The weekly RSI for the 10-year is above 70 which indicates it is overbought. In the past decade weekly RSI readings above 70 have developed near short term yield peaks. The 50% retracement of the decline in the 10-year yield from its high of 3.248% in November 2018 to 0.40% in March 2020 would allow for the 10-year yield to rise to 1.82% (red line Weekly chart).
Stocks
In the four years prior to the Pandemic annual GDP averaged 2.3% which is why investors were willing to pay up for companies that were growing at a multiple of GDP growth. That’s what the fascination with FAMANG stocks was all about.
The perception of muted growth is changing and forecasts for GDP growth in the second half of 2021 are jumping with some estimating growth of 5% to 6%. Whether this is achieved is secondary to the current perception that it is actually possible, so owning expensive growth stocks doesn’t look attractive. Investors would rather own cyclical companies that should experience a nice increase in revenue that could translate into much better earnings.
The other factor that has started to pressure growth stocks is the increase in Treasury yields which is forcing investors to reconsider what the proper multiple the FAMANG stocks deserve. After recording a new all time high on February 16 the Nasdaq 100 has displayed a noticeable decrease in its relative strength to the S&P 500 (red arrow). The Nasdaq 100 ETF (QQQ) closed below the rising trend line connecting the lows on November 2 and January 29. This should lead to a drop that brings QQQ down to 305 – 310 which is 3% to 5.2% below the close of 322.44 on February 22.
The FAMANG stocks still represent 22.2% of the S&P 500 and will drag the S&P 500 down as they correct. The QQQ’s were off -2.59% on February 22 but the S&P 500 lost just -0.77% since cyclical sectors were up, with Materials +4.8%, Industrials +0.32%, Financials +0.93% and Energy +3.46%. If these sectors pullback a bit, the S&P 500 can drop to the blue trend line near 3750 and may test the January 29 low of 3694.
After this pullback the S&P 500 is expected to rally above 4000 which could be fueled by the next round of stimulus checks. After the initial stimulus was sent out last spring the number of Robinhood accounts jumped from just over 5 million to 10 million last summer, and then rose to 13 million after another $600 was sent in late December and early January.
Robinhood traders have been leveraging their money by buying Call options which have forced dealers to buy the underlying stocks. Since the end of 2019 the 20 day average of Call volume has tripled from less than 10 million contracts a days to almost 30 million. Congress is likely to pass the next round of stimulus in the first half of March which will be followed by another surge in Call buying that will goose stocks.
Gold
Gold has been expected to fall below $1766 and potentially drop to the down trending line that connects the low in August, September 24, and November 30 which is near $1700. On February 19 Gold fell to $1761.70, failed to close below the middle trend line, and on February 22 Gold rallied to $1811.
By falling below $1766, Gold fulfilled the minimum expectation, but until Gold closes above the higher channel trend line, Gold could still close below the middle trend line and trade down to $1730 or lower. Given the uncertainty, I will suggest taking a 50% long position in the Gold ETF IAU at the opening on February 23, and will add if Gold does drop to $1730 or closes above $1860. Gold is expected to rally above $2070 this summer.
Silver
Silver has been expected to drop to $23.76 but today’s strength calls that outlook into question. A close above $29.00 (the top channel line) would eliminate a decline below $24.00
Gold Stocks
As long as GDX remains below the green downtrend line, GDX is expected to fall below the February 18 low of $32.54. Take a 33% long position if GDX closes above $35.60 or below $32.00. GDX could still drop below $30.00 if Gold sinks to $1730.
Dollar
The Dollar was expected to rally above 92.00 as long as it held above 90.00. The Dollar has dipped below 90.00, so the odds have increased that the Dollar will drop to a new low below the January 6 low of 89.21. Additional Dollar weakness could provide Gold a tailwind that enables it to avoid a drop below $1761 in coming weeks and instead helps it move above $1860. A new low in the Dollar would complete 5 waves down from the March 2020 high and set the stage for a strong rally that carries the Dollar up to 95.00 in the summer.
TLT
As noted in the February 15 WTR ‘TLT has the potential to drop to $142.00 or lower if the 30- year Treasury yield rises to 2.15% – 2.35%.’ TLT closed at $142.18 on February 22 and its RSI is down to 22.5, so it is oversold. A reflex rally is possible, especially if the stock market experiences more weakness. Lower prices are expected in TLT after any bounce.
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.
The following cyclical sectors should benefit if the prospect of an infrastructure bill materializes in coming months.
Industrials – Today the relative strength of XLI broke above the down trend that had been in place since mid November. XLI is on the verge of breaking out above the recent highs. This is a sector that can be bought on weakness should the market correct further.
Financials
The Financial ETF has closed above the high it made in 2007 and 2018 as illustrated on the monthly chart. This breakout suggests it should move higher in coming months.
Financials – Daily
The Financials ETF XLF broke out above its early 2020 high and January 2021 high as Treasury yields rose and the yield curve widened. Loan demand may increase if the economy strengthens as forecast in coming months. This is a sector that can be bought on weakness should the market correct further.
An increase in infrastructure spending will increase the demand for the raw materials and chemicals.
Here are two ETFs that have exposure to the sectors that will benefit.
Basic Materials XLB has the potential of testing the higher trend line near $80.00
Materials XME – Would wait for a pullback after such a big up day on February 22.
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