Written by Jim Welsh
Macro Tides Weekly Technical Review 03 May 2021
Four tailwinds developed after the Pandemic effectively shut down the U.S. economy. These tailwinds allowed the stock market to look forward rather than focusing solely on the widespread economic dislocation the Pandemic caused. The Federal Reserve slashed its policy rate to 0%, opened special facilities to provide liquidity to market sectors that were shutting down, and expanded its balance sheet from $4 trillion to $7 trillion. Congress quickly passed the $2 trillion Cares Act in March 2020 and the $484 billion Paycheck Protection Program and Health Care Enhancement Act in April.
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The monetary and fiscal safety net bought time for the development of a vaccine in record time. The optimism surrounding the prospect of a vaccine kept selling pressure at bay even as economic data was weak. That optimism was rewarded when Pfizer and Moderna announced they had developed vaccines that exceeded expectations by a wide margin. The vaccines made it possible for the fourth tailwind to take hold – the reopening of the U.S. economy. The Four Tailwinds – Monetary stimulus, Fiscal support, Vaccine development, Economic Reopening – enabled the stock market to rally to a new all time high. In the next six months each of these tailwinds are set to diminish.
The FOMC has said it will wait until it sees the unemployment rate fall materially and inflation move above its 2.0% target. In the next few months job growth may average 1 million jobs which will bring the unemployment rate down from 6.0% in March to near or less than 5.0%. In March the Core PCE rate of inflation ticked up to 1.8% and could easily exceed 2.0% in the next few months.
The FOMC is not likely to react to the improvement in the labor market or the rise in inflation, since the FOMC’s party line has been that any tick higher in inflation will be transitory.
As discussed in the May issue of Macro Tides the coming surge in inflation will be stronger and more persistent than the FOMC’s definition of transitory. Market participants are likely to be less patient than the FOMC and the narrative could change quickly. Rather than taking the FOMC at its word, investors may develop their own narrative that questions whether this bout of inflation will be transitory and wonder if the FOMC is behind the curve.
The wonder could shift to worry if inflation data provides more negative surprises, which increasingly seems likely. Investors will begin to expect the FOMC to reduce its $120 billion in monthly purchases and anticipate that the FOMC might be forced to increase the federal funds rate sooner and more frequently in 2022 than currently projected by the FOMC. Even within the FOMC the topic of when the FOMC should discuss tapering its monthly purchases has begun.
Last week, Robert Kaplan the president of the Federal Reserve of Dallas made the following comments:
“We’re now observing excesses and imbalances in markets. I do think at the earliest opportunity it will be appropriate for us to start talking about adjusting those purchases.”
If job growth jumps and the unemployment is near 5.0%, and Core PCE inflation is at or above 2.0%, the FOMC will discuss tapering their asset purchase at the July meeting and certainly at the September meeting.
Although the FOMC will probably wait until January 2022 to actually begin tapering, the coming loss of liquidity will dampen bullish sentiment that has been bolstered by the FOMC’s extraordinary accommodation.
Congress has passed more than $6 trillion to initially support the economy and subsequently to address infrastructure and Green New Deal promises. The $1.9 American Rescue Plan was passed in March and the $2.3 trillion American Jobs Act and the $1.8 trillion American Families Plan was proposed in April.
In coming months there is a good chance the amount of money approved for the American Jobs Act and the American Families Plan will be less than proposed. It is possible the Democrats may be able to jam these bills through Congress but the odds are less than 50% – they don’t appear to have enough Democratic votes to do so. At the end of the day, something will get approved and it will still be a lot of spending. The economy will get a lift from whatever is approved but the boost from infrastructure may occur over many years and not concentrated in 2022 or 2023, as discussed in this month’s Macro Tides. Proposed fiscal stimulus has peaked and will be whittled down in coming months.
A vaccine was developed and more than 35% of Americans have been vaccinated. This is a remarkable achievement within 15 months. In the next few months there will more stories about the resistance to getting vaccinated than success stories, which will delay the attainment of herd immunity. The news on vaccination is going to get less positive and more contentious as the country struggles with making getting vaccinated required by companies or mandated by government.
Economic growth is accelerating as more sectors are able to reopen. In the first quarter GDP grew 6.4% and could grow by more than 10.0% in the second quarter. The news on the economy is going to get better before it reaches a peak in the second quarter. Even though GDP growth will be stronger relative to the 2.4% average of the last decade, it will be decelerating sharply in the second half of the year.
The table is set for each of these factors from being a strong tailwind to a weaker tailwind before the end of 2021, and ultimately in 2022 to modest headwinds. This shift for each factor will unfold gradually. But as we get past July 1 more attention is likely to be focused on this tailwind dynamic and lead investors to become less bullish. Obviously, tax increases for corporations and individuals will add to this more sober assessment of these tailwinds and temper enthusiasm about the prospects for 2022.
Dollar
As discussed in the April 26 WTR the change in the narrative surrounding the FOMC and the timing of their tapering discussion and first rate increase could provide the foundation for an important low in the Dollar:
“The Dollar recorded a trading low on January 4 of 89.21 and rallied to a high of 93.44 on March 31. Since that high the Dollar has been decisively trending lower, which suggests that Wave 4 ended on March 31. Ultimately, the Dollar is expected to test and probably drop below the January 4 low, which could mark an important low.”
In fact the Dollar is likely to drop below the February 2018 low of 88.25 before the bottom is in place.
In January 2017 the Dollar topped at 103.82 and declined in 5 waves for about 14 months before bottoming in mid February 2018 at 88.25. (Wave A) The Dollar subsequently rallied in a choppy overlapping fashion, which looks nothing like the strong move down from the January 2017 high. (Wave B)
Since topping in March 2020 the Dollar has experienced another strong move lower that mirrors the decline after the January 2017 high. If the Dollar falls below the January 2021 low of 89.21, it will complete 5 Waves down from the March 2020 high. (Wave C) If the Dollar does record a lower low in the next two months, it would almost match the length of time (about 14 months) after the January 2017 high. The January 2017 high was 103.82 and was 102.99 at the March 2020 top.
If the decline from the March 2020 high equals the January 2017 – February 2018 drop, the Dollar would bottom 0.83 below the February low of 88.25. This is why the Dollar is expected to not only drop below the January 2020 low of 89.21 but also under the February 2018 low of 88.25.
If all of this unfolds as described it suggests that the Dollar is nearing the end of the correction that began in January 2017 (Wave A 88.25 low, February 2018 – Wave B 102.99 high, – Wave C 87.00 – 87.50 low).
The coming low in the Dollar could set the stage for a large rally that could be expected to last at least 14 months and exceed the January 2017 high of 103.82. A rally of this magnitude would have a large impact on a number of markets. Emerging markets would be vulnerable as the drag from dollar denominated debt would be problematic. Stay tuned.
Treasury Yields
The 10-year Treasury yield expected to drop below 1.52% before resuming its uptrend. In the second half of this year the 10-year is expected surpass 2.0% and could reach 2.25%, before the FOMC intercedes with talk about Yield Curve Control (YCC).
The 30-year Treasury yield is expected to drop to below 2.207%. Before year end the 30-year Treasury yield is expected to climb to 2.85% and could jump to 3.15%.
The Treasury bond ETF (TLT) is expected to rally to $142.00 – $143.00. Longer term TLT has the potential to decline to $125.00 and potentially as low as $110.00.
Gold
At Saturday’s Berkshire annual videoconference Warren Buffett sounded the alarm about the surge in inflation his company’s are experiencing:
“We’re seeing very substantial inflation – it’s very interesting. I mean, we’re raising prices. People are raising prices to us. And it’s being accepted. But there’s more inflation going on than– quite a bit more inflation going on than people would have anticipated just six months ago or thereabouts.”
Mr. Buffett’s comments got investor’s attention and Gold jumped today.
Mr. Buffett’s comments echoed the wave of price increases I noted in the May Macro Tides:
“The wave of prices increases has already begun. Kimberly-Clark, the maker of Huggies diapers and Scott paper products, said it will start raising prices on much of its North America consumer products to help defray higher raw-material costs. Cheerios maker General Mills, Skippy peanutbutter maker Hormel Foods Corp. and pet-snacks maker J.M. Smucker Co. have indicated similar plans. Two big U.S. manufacturers of heating and cooling equipment have announced price increases. Lennox International Inc. said this week it would raise prices by about 6% to 9% on heating and cooling equipment starting June 1 for commercial and residential orders. Trane Technologies PLC recently increased prices by up to 7.5% on some products in its commercial HVAC business. In early March, Trane boosted prices on some residential equipment by up to 6%.”
Today’s move higher could be the beginning of the expected move to $1820 – $1840. Ultimately a rally above $1900 is expected, with a test of $1950 possible. The Dollar could influence how much Gold is able to rally in the next few months. This positive outlook will be maintained as long as Gold holds above $1750.
Silver
The expected rally to $27.40 probably began today. Silver could test $30.00 in the summer as inflation concerns intensify. A close above $30.00 could lead to a rally to $33.00 – $36.00.
After buying the initial 50% in the Gold ETF IAU at $17.23 on February 23 and the second 50% position at $16.09, the cost basis is $16.66. Use a stop of $16.72. Traders took a 50% position in the Silver ETF (SLV) when SLV dropped to $23.25 on March 23. Use a stop of $23.85.
Gold Stocks
Traders were recommended to take a 33% long position if GDX closed below $32.00, and on February 26 GDX closed at $31.13. Two weeks ago traders were advised to add 33% to the GDX position on a pullback to $32.75. GDX fell below $32.75 on March 23, so the cost basis was $31.94. The stop of $34.70 as end of month selling caused GDX to weaken more than expected. A rally to $37.50 is still expected.
Stocks
If the big picture analysis for Treasury bonds and the Dollar is correct, the stock market could record an important high in the next few months. In the short term better economic data, lower Treasury yields and weaker Dollar should continue to support the stock market. It is noteworthy that a number of Mega Cap stocks reported terrific earnings last week but the 10 stocks faded after rallying on the news. That is not a good sign. The Nasdaq 100 (QQQ) did manage to make a new high as expected but it was marginal.
In addition the Semi-Conductor Index has recorded a double top and is showing weakness relative to the S&P 500, even though there is a chip shortage. Today the Semi- Conductor ETF (SMH) closed below a trend line it had broken above in December.
The NYSE Advance – Decline line has been quite helpful in the past in warning of intermediate and major tops. The A-D Line usually peaks before the S&P 500 tops. Last week the NYSE A-D Line recorded another new high, which suggests the market is not yet vulnerable to a large correction. The S&P 500 also continues to make higher highs and higher lows which is the definition of an uptrend. Until the S&P 500 closes below the prior low of 4123, even the trend of the shortest time frame is up.
As long as the Russell 2000 holds above 2250 it has the potential to test the all time high of 2360. It would be negative if the Russell 2000 closed below 2210 after having reversed higher one day after closing below that level.
The shallowness of the recent pullback suggests that the S&P 500 will complete 5 waves up from the March 4 low by rallying above 4219 before a more significant top forms.
Sector Analysis and recommendations
In the February 22, 2021 WTR, I recommended buying Industrials (XLI), Basic Materials (XLB), and the Financials (XLF). In each case I suggested to buy the sector on weakness and the market accommodated. On February 22, the S&P 500 closed at 3876 but traded down to 3806 on February 23 and 3790 on February 26. In the April 12 WTR I recommended price levels to sell half of each position. The remaining 50% should be sold when the S&P 500 trades above 4220.
Industrials
On February 22 Industrials XLI closed at $91.27 and on February 23 traded down to $90.19. Sell half of the position at $101.10. XLI traded up to $101.10 on April 14.
Basic Materials
On February 22 the Basic Materials XLB closed at $75.34 and on February 26 traded down to $73.07. Sell half of the position at $81.10. On April 15 XLB traded up to $81.10.
Financials
On February 22 the Financials XLF closed at $32.71 and on February 26 traded down to $32.19. Sell half of the position at $35.40. XLF traded up to $35.40 on April 14.
Materials
On February 22 the Materials XME closed at $38.35 and on February 26 traded down to $35.83. Use a stop at $38.60. Sell 50% of XME on the opening of May 4, and the remainder when the S&P 500 trades above 4220.
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, 2020 as the S&P 500 closed at 2800. A new bull market was confirmed on June 4, 2020 when the WTI rose above the green horizontal line.
The S&P 500 is expected to push to a new high above 4220 which could mark a high. We will have to wait for the NYSE Advance – Decline to show more weakness and for the S&P 500 to fall below a prior low. Until then the trend is higher until Treasury yields reverse higher and the Dollar bottoms
The primary 10 sectors for the S&P 500 with the Russell 2000 and Midcap included.
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