It seems the Feds Dudley was right a week ago when he said the market sell-off was small potatoes. As the market adjusts to central banks removing accommodations there are going to be setbacks and it will take more than one freak wave to influence the Fed. But, the market's underpinnings have changed and the Fed is no longer offering its continued support. So what is going on here?
Rotation was a primary theme for equities in 2017 as sector correlations were at their lowest since the summer of 2007. This made for low volatility and a smoothing effect as money flowed from one sector to another throughout the year. But, suddenly in January, this all changed. The average correlation of the 11 major equity sectors jumped to over 80 percent as retail money poured into stocks in all sectors.
The S&P 500 had 18 straight trading days with RSI above 75. To put this in perspective, this is how RSI works. The traditional RSI indicator uses a 14 day period. The Relative Strength Index gains when the average gains over that period are larger than the average losses. If RSI is at 100 that means all 14 days were gains and zero losses. 18 days above 75, I believe is a record. Exuberance was very much alive.
So, the equity market went from euphoria to fear in a blink as VIX exploded (the Feb 6th move in VIX was its largest move ever). With volatility diminishing this week and a reduction in trading volumes we had a first sign that the selling pressure was abating. The next options expiration will be next Friday and it will be interesting to see if the VIX can break back below the 17.50 area which looks pivotal technically.
We need to watch correlations carefully from here. When asset class and sector correlations rise sharply there is simply no place to go. You either sell, or wait it out. According to ivolatility.com the average correlation for the 11 SP500 sectors was 83.7 percent in January. During Q4 2017 they were well under 50 percent. Remember, correlations are critical to risk parity portfolios which may need to adjust market exposure.
This is the E-Mini S&P Futures (ESH) intraday chart from last Friday. At 1:30 EST, ESH was retesting its 200-dma for the second time that week and there was chatter of early margin calls. Had the market not lifted significantly that afternoon another wave of forced-selling would have hit. As it turns out the margin calls were held back and we now have a V-shape recovery underway. Timing is everything...
This week the focus was on the CPI report. We had been hearing over and over how important this weeks CPI (inflation) number was to the overall market. It was all that mattered and a hot number would undoubtedly lift long-term rates and punish equities. After all, the equity sell-off was induced by higher long-term rates, right? Well, it seems the only ones listening as the CPI data was released were the machines (algos). Humans waited and then bought the dip, and kept on buying as E-Mini S&P futures rallied +2.85 percent by the end of the day. So much for inflation fears being the cause of the equity meltdown.
The 200-day moving average is a widely used technical tool and can be extremely pivotal during sharp price moves. The 200dma in the E-Mini S&P held nicely last week as support. Twice. The first decline, now known as the Volatility Crisis, hit and held on Monday night, February 6. But, the market needed to see it hold during the day session when everyone could participate. Last Friday the 200dma was tested during the day session and it held again in ES and hit for the first time in SPX. That was big! The settle back above the 50dma (blue line) should add some short-term support in the index as we look towards a slew of earnings next week. Failure at the .618* retracement and a Friday settle back below the 50-day moving average would be ominous.
Like shooting fish in a barrel: it practically didnt matter what sector you were buying. The 200-day moving average is an important long-term technical key and you buy the break to the 200-day first and ask questions later. And since mostly every sector was falling at once you had your pick of the litter. The Health Care SPDR (ETF) (NYSE:XLV), Market Vectors Semiconductor ETF (NYSE:SMH), iShares Dow Jones Transport Avg ETF (NYSE:IYT), and SPDR S&P Homebuilders ETF (NYSE:XHB) all held their 200 days.
Just to show how oversold equity markets had become, TSX 60 (Toronto Exchange) had its lowest reading ever recorded on the equity plunge.
Another thing to be aware of is the passive investing chart, which is long both fixed income and equities via The iShares Barclays 20+ Yr Treas. Bond ETF (NYSE:TLT) and SPDR S&P 500 ETF Trust (NYSE:SPY). The passive investment strategy has worked extremely well since the financial crisis lows. Being long bonds and the stock index has been in a clearly defined trend, especially for the last year. That trend line has now been broken. 2018 is likely to see higher volatility, and the potential for failure here at the trend line is strong. but a move back above the trend line would go a long way to calming some fears for now. Failure at this trend line would likely signal renewed weakness in equities.
Long-term rates will continue to be a concern for equities, especially if they move higher faster. With the 30-year bond yield approaching 3.25 percent and its 100-month moving average, technical resistance may hold for now. 30-year yield has not had a monthly settle above its 100-month since April 1985. Once this gives way, all bets are off.
The potential for some type of currency war or rhetoric at least persists as the US dollar continues to weaken. This may be a ticking time bomb... The Chinese Yuan is at its highest level since China devalued its currency in 2015. It is likely that China does not want to see its currency appreciate much further. The US$ Index is at a three year low this week. If you are looking to trade or track the US dollar, you can do so with UUP, the bullish dollar ETF. It is currently sitting on its long-term .618 Fibonacci retracement support. This should prove to be a pivotal level at a pivotal time. A rally in the dollar from current levels would see gold weaken and that sector may become the next shoe to drop.
In conclusion, we feel that the market is at an inflection point both technically and structurally. We have our key technical points to keep us on track. High correlations and higher volatility are probably here to stay for the near term. Even with the complacency that investors have become accustomed to, you cant just shrug off that the markets have changed.
David Wienke is the editor of Keystone Charts. More than 30 years of experience providing technical analysis and execution services to institutional clients is now provided in a daily newsletter, The Daily Game Plan. Coverage includes equities, rates, currencies, and commodities. Dave is also an introducing broker with Capital Trading Group, LLLP (CTG); a Chicago based investment firm focusing on alternative investment opportunities for CTAs and individual investors. Charts are created using CQG, the best charting service there is. For a free trial of the Daily Game Plan newsletter go to www.keystonecharts.net , email me at email@example.com or go to Capital Trading Group to subscribe
Charting by CQG
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