INVESTMENT EDGE
The US stock markets continue to consolidate and digest its huge 2017 year run-up and subsequent double digit correction. The lone exception being small cap stocks as they have moved on to all-time highs. Will the rest of the market follow suit? The benefit of the doubt has to be given to the prior underlying trend but I don't think the answer will be resolved any time soon. Until then, check out this month's Charts on the Move video at the link below ...
Looking at the daily chart of 20-year US treasury bonds TLT below, you can see after forming a double top, they have fallen more than 8% and closed right on the 116 support zone. With the large head and shoulders topping pattern in the background and price below a falling 200 day moving average, long term bonds look like a horrible place to be invested right now. This is especially true if price cannot stay above the pattern’s (green horizontal) neckline as it portends to another 8% or more decline.
As we have learned, looking at a longer term time frame helps identify the direction of the trend and helps to keep us focused on the bigger picture. The 5-year weekly chart below looks familiar, doesn’t it? The huge head and shoulders topping pattern stands out like a sore thumb. It should be obvious but if not, notice how the daily chart above is just a close up of the right shoulder in the weekly chart below. Yup, another example of a pattern within a pattern (see Monday’s post “Nesting”).
It goes without saying that if bonds break their current levels being pushed down by rising rates, we can likely put a fork in the 35+ year bond bull market. If this should occur, it could have an ominous impact for all investment markets. I have been warning about this potential for years, its impact to investor’s portfolios (most investors don’t know what a bond bear market is or how to deal with it) and just as importantly the huge potential negative impact to pension funds here in the US and across the globe. It’s time to be concerned, very concerned if this scenario unfolds and reaches its downside pattern target. The bullish alternative scenario would be If support holds right here and the pattern fails. Only time will tell but because of the impact bond holdings have on overall portfolio returns, its easy to see why we are at a crossroad.
Almost every prior stock market crash was caused, or at least exacerbated, by market illiquidity.
As you can see in the chart below, the FED’s recent activity of unwinding their balance sheet by selling a small fraction of their QE accumulated holdings coincided with the most recent 12% stock market consolidation (not the sole reason for the correction mind you). It is important stock investors understand the correlation between the FED removing liquidity and lower stock prices. When you combine this balance sheet activity with a simultaneous push higher in interest rates we are entering into uncharted territory knowing just how the market will react.
Regardless, the current consolidation in the SP500 has a clearly defined upper and lower boundary, 2670 & 2530 respectively, making it a much easier task to manage whatever happens. Above I add exposure, below I decrease.
With the markets still in a sideways, consolidative, sloppy, directionless chop, it’s becomes more difficult to identify ideas that aren’t following suit. During times like these I like to share the thoughts and views from other technicians. Not only does it provide a different perspective but also helps to keep investment biases in check. Regular readers know one of the people I respect and follow closely is Tom McClellan. Not only does Tom have a very unique and interesting approach to viewing the markets but his accuracy is very compelling. Today’s post, Tom’s latest hits home on a topic that has me very concerned about stocks continuing their climb higher over the intermediate term.
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Make me Emperor for a day, and I would compel the FOMC to outsource interest rate policy to the bond market. Why should we pay 12 experts, most with expensive Ivy League PhD degrees, to do what the bond market can do far more efficiently (and cheaply)?
This week’s chart compares the 2-year T-Note yield to the stated Fed Funds target rate. The FOMC has actually said that the target rate is 1.5% to 1.75%, so I’m splitting the difference by calling it 1.625%. What this chart shows is that first, the two interest rates are very strongly correlated over time, which is as one would expect. But second and more importantly, the 2-year yield knows best what the Fed should do. And the Fed screws up when it does not listen.
If the FOMC would just set the Fed Funds target to within a quarter point of wherever the 2-year T-Note yield is, we would have fewer and quieter bubbles, and also much less severe economic downturns. For whatever reason, the FOMC members have not learned this lesson. None of them, as far as I know, is a subscriber, which is their loss.
The “Taylor Rule” for setting short term rates is an equation involving figures for GDP, inflation rate, and “potential output”, all of which are numbers which can be fudged by statisticians. The “McClellan Rule” is much simpler: listen to the 2-year T-Note Yield, which the statisticians cannot monkey around with. By this rule, the Fed is still being overly stimulative, by setting the Fed Funds target well below where it ought to be. In other words, the Fed is being “too loose” with interest rate policy, according to this measure.
But complicating that equation is what else the Fed is doing, in terms of liquidating its holdings of Treasury debt and Mortgage Backed Securities (MBS). During 3 separate rounds of “quantitative easing” or QE, the Fed got up to total holdings of $4.25 trillion. At the most rapid rate of acquisition, the Fed was buying up $85 billion per month in 2014.
In 2017, the Fed announced it would be starting to unwind those holdings, slowly at first, but accelerating to a rate of $30 billion per month of “quantitative tightening” (or QT) now in Q2 of 2018, and supposedly going to a rate of $40 billion per month in Q3. So while interest rate policy is still arguably stimulative, that effect is counteracted by what the Fed is doing in other ways, sucking liquidity out of the banking system with its QT.
The Fed was a little bit slow at first in keeping up with its stated rate of QT, but it is catching up now. One could argue that the Fed is not really selling off these assets, and instead it is just allowing them to expire and not be renewed. But it is still the case that several billion dollars of debt are having to be absorbed by the market place instead of by the Fed. It is also true that the size of QE between 2009 and 2015 was small compared to the total amount of federal debt, but it was still important enough to lift the stock market in a huge way.
Now the amounts of the QT unwinding are pretty small compared to the total debt, but they are having a similar effect of depressing the stock market, just as QE elevated it. And this is where the modeling gets difficult - interest rate policy is stimulative, by the Fed Funds target rate being below the 2-year yield. But at the same time the Fed is being repressive by sucking liquidity out of the banking system with QT. I don’t know how to construct a “balance of forces equation” to depict how those two factors interact with each other, as this is pretty new territory for market history.
But I can say that when the Fed worked hard to reduce the size of its balance sheet in 2008, during the worst liquidity crisis in decades, the effect was pretty direct and pretty obvious. The Fed blew up Bear Stearns and Lehman Brothers by sucking too much liquidity out of the banking system.
In a text note within this chart, I pose the rhetorical question of why the then-president of the NY Fed, Timothy Geithner, would orchestrate a huge reduction in the Fed’s holdings of Treasury debt during the worse liquidity crisis in years. Part of the answer can be found in the historical observation that this bear market helped to assure the election of President Obama in November 2008. And Mr. Obama very quickly appointed Timothy Geithner as his Treasury Secretary. You can insert your own conspiracy theory here, since I don’t have subpoena authority to investigate contacts between the Obama campaign and the New York Fed in 2008.
The point of that historical lesson which we should remember in the current moment is that having the Fed reduce the size of its balance sheet carries an enormously powerful effect on banking system liquidity. My expectation is that by sometime later this summer, the FOMC is going to realize that its reduction of holdings of Treasuries and MBS is creating a big liquidity problem, and they will abandon or curtail those plans. But it is going to require a lot of damage to the stock market to get them to realize what they need to do. I expect that realization to hit them sometime around August 2018, and it should lead to a huge stock market rebound into year-end. But it will be a rebound from a big selloff.
There are many recognizable patterns that prices develop in technical analysis but few are as important as island reversals (also known as an “abandoned baby” in Japanese candlestick lingo). An island reversal is a reversal pattern that forms with two gaps and price action in between the two gaps. These gaps tell us that the island reversal marks a sudden, and sharp, shift in direction. Even though they are relatively uncommon, island reversals are potent patterns that warrant our attention. The islands can be formed either at the top or bottom of a stock’s price movement, both indicate the prior trend is done and price has reversed.
The alignment of the gaps holds the key. First, note that a bullish island reversal forms with a gap down and then a gap up. A bearish island reversal forms with a gap up and then a gap down. These gaps overlap to create an island of price action, hence the term “island reversal”. The island is above the gaps on a bearish reversal, and above the gaps on the bearish reversal.
As you can see in the chart below of the Nasdaq 100 index, QQQ, it created a bearish island reversal on Monday when price gapped down below the gap created in the early March move higher. Why islands are important is because traders establishing long positions on the island (and maybe those who initiated on the rise into that island) are now trapped with losses. As such, if price were to move higher from here, closer towards the open gap, you would expect a large supply (sellers willing to sell) to quickly slow, stop, or reverse the advance as those late buyers exit their losing positions. You have often times heard me reference this as “resistance”.
The stock market is in a trading range and looking for a catalyst and there is an important FOMC meeting today, 3-21. It is important because the Fed began increasing interest rates at the last meeting. Traders want an idea of how often and how much the Fed will raise rates this year. The meeting creates uncertainty, which is a hallmark of a trading range. And trading ranges need a catalyst to bust out. As such, the odds are that there will be a big move after the report. Unfortunately, the move can be up, down, or even in both directions. We will only know the answer after the fact. Either way, strap in as I expect some fireworks in the coming day(s) and to discover whether this island top reversal pattern will be an accurate predictor of the short to intermediate term future.
