The stock market has been hold for several weeks following the initial "Trump" rally. That hope-filled rally is now facing the reality that all the changes that would help the stock market might struggle to become reality. Now it's waiting for some additional information that will support a continuation of the rally and many are expecting disappointment instead.
Today's Market Stats
Following the election of Trump we had a surprisingly strong rally that lasted about 6 weeks, into the December 13th highs for the blue chips, but it's been basically a choppy 5 weeks of consolidation since then. The tech indexes were able to continue higher into last week before hitting some potentially strong resistance and now they too have gone on hold while waiting to get through Inauguration Day (Friday). Assuming nothing bad happens to disrupt the inauguration and/or parties after it (from international terrorists or domestic terrorists, some of whom are disgruntled Hollywood types), there's a good chance the market will continue its rally.
Many are expecting the market to reverse the Trump-inspired rally, which is reflected in some of the options trading as well as sentiment, but we have to wonder if the market will surprise the majority just as it did after Trump was elected.
Before moving to tonight's charts I wanted to look at one chart that shows why it's a good time to worry about additional upside, even though I believe there is additional upside at least for the short term. We know the market depends on liquidity to continue to move prices higher. Without liquidity to add to the purchasing power we'd see natural selling begin to overwhelm the buyers (selling is often a requirement, to free up cash for expenses and purchases whereas buying is almost always an option). And a big liquidity provider over the years has been the Fed. Whether it's through money printing or abnormally low interest rates (cheaper loans) the Fed has been a huge primer for the financial markets. That's been quietly changing and could soon have a negative impact.
With all the talk in the past year about the Fed's desire to raise interest rates and take a less accommodative stance, it's interesting to note how much they've been draining liquidity since late 2014. For about two years we've seen a decline in the reserve balances held at Federal Reserve banks, as can be seen in the chart below (blue line). The red line shows the S&P 500 index by comparison
Reserve Balances with Federal Reserve Banks vs. S&P 500, 2008-Jan 2017, fred.stlouisfed.org
There are a couple takeaways from this chart, the first being the huge spike in the balances from a virtual flat line into the fall of 2008 (seasonally as well as the stock market). As a comparison between where we were and where we went to, the data series goes back to 1985 and the peak in 1988 was around $40B (a rounding error in today's numbers). The balances ranged between about $5B and $20B from 2000 through 2008 (you can barely see a couple of small spikes before September 2008). Following the scary banking crisis in 2008 the Fed came charging in for the rescue and between September 2008 and January 2009 the balances spiked to a little more than $800B and then $1200B ($1.2T) by the end of February 2010. With each QE program following that you can see a further spike in the balances until it reached a high near $2.8T by the fall of 2014. Six years of unrelenting money printing.
Coinciding with money growth were of course abnormally low interest rates. The combination of new money coming into the financial markets and nearly free borrowing by corporations to enable them to buy back their shares, we saw a very steady rise in the stock market into the end of 2014, coinciding with the end of the Fed's money growth. After a bit of a wobble/consolidation in the stock market through 2015 the corporate buybacks continued as companies were able to continue borrowing the funds at nearly no cost. Borrowed funds and earnings were used to buy back stock because they saw little reason to invest in their own business. That alone is a worrisome sign.
While corporate profits were in decline it was hidden by the fact that earnings per share were improving, or at least holding up, because the numbers of shares outstanding were declining. The problem for the market since the end of 2014 has been a battle between the continuation of corporate buybacks and the removal of some of the excess liquidity from the financial markets. But at least the buybacks were helped by the Fed keeping rates so low. That's now changing.
One of the reasons we're seeing bearish divergences on the weekly and monthly stock charts is because the buying momentum has been slowing as corporate buybacks have become the primary source of buying (something like 70-80%). The rest has been a battle between sellers and buyers in a trading battle, especially with all the HFTs hitting the market whichever way the wind is blowing at the time. Combatting the corporate buybacks has been the decline in Federal Reserves and of course that begs the question about what will happen in the stock market when companies are forced to curtail their buy-back programs.
With interest rates ticking higher, and the Fed promising to continue raising them, how much longer will corporate buybacks continue to support the market? And if buybacks start to drop off, as I strongly suspect they will this year, and the Fed continues to withdraw liquidity (they won't implement another QE program while simultaneously raising rates) and reduce its balance sheet, how much more upside potential will there be for the market? Could the Trump rally be the last hurrah, even if there's to be one more leg up following the inauguration? I think these are very important questions, which highlight the risk for the market right now. I strongly believe in Caveat Emptor right now.
As for the stock market, as mentioned at the beginning, so little has happened in the past two weeks (it's been quieter than the currency and commodity markets) that there's not much to add that's different from last week's commentary. Until we get through Friday's inauguration I suspect not much is going to happen, but what happens next week could be very different from what I know many market pundits are predicting (I see so many similar predictions in a lot of newsletters). So many are now looking for a market pullback following the inauguration, which is based on the idea that the majority of investors will realize the "Trump" trade was built more on hope than substance. I firmly believe that's true but as always, it's the timing of that realization that's important.
This week there has been heavy buying in VIX call options and stock put options, both of which are big bets the stock market is going to decline from here. With so many now expecting a reversal of the Trump trade I have to wonder if the market is once again going to disappoint the majority, just as it did following the Trump election. As usual, we'll just have to let the charts lead the way, even as confused as they currently appear to be.
S&P 500, SPX, Weekly chart
Since peaking near 2277 and closing near 2273 on December 13th it's been a choppy sideways consolidation since that time. Only a couple of days has it been able to close above 2273, which keeps the Gann Square of 9 zone at 2271-2273 in play (this is where the March 2009 low aligns in both time and price, just as the October 2007 high aligned with the October 2002 low). Today's close, at 2271.89, was again inside this potential topping zone. But because of the consolidation pattern I expect to see further upside and as depicted, I'm expecting to see a run up to the trend line along the highs from April-August 2016, which will be near 2315 by the end of the month. The first warning sign for the bulls would be a drop below the December 30th low near 2233 but until then the pattern remains bullish. The real question is whether upside potential is worth the downside risk.
S&P 500, SPX, Daily chart
Assuming the bulls don't drop the ball in the coming week and we get at least one more push higher, there are two upside target areas I'd watch for. The first is a price projections zone at roughly 2286-2293, which are based off wave relationships in the rally. As can be seen on the weekly chart above, there are two projections, at 2285.53 and 2290.44, which are based on equal moves in the rally legs since the January 2016 low. The daily chart below shows the same two projections and a short-term trend line along the highs from December 13 - January 6 (gray line), which crosses the lower projection on Friday. A broken uptrend line from November-December also crosses the lower projection on Friday.
Based on these coinciding price projections and trend lines I'll want to see the bulls get SPX above 2290 before thinking we'll see higher prices. But if SPX does make it above 2290, and holds above that level, there's another price projection at 2313.69 where the 5th wave of the rally from November would be 62% of the 1st wave. That projection crosses the trend line along the highs from April-July-August 2016 a week from today. Keep a close eye on price action around there if reached. SPX would be more bullish above 2315.
Key Levels for SPX:
- bullish above 2315
- bearish below 2233
S&P 500, SPX, 60-min chart
There's one more price projection that shows why the 2315 area could be trouble for the bulls (if reached). The price pattern for the rally from December 30th could produce two equal legs up (for a 3-wave move to complete a rising wedge pattern), which points to 2316 if the sideways consolidation completes as depicted (green wave-b near 2268 midday Friday). The first thing the bulls need to do is get SPX above 2277 whereas the bears would be looking stronger if they drive SPX below the January 12th low near 2254, although I'd be watchful for just a quick move down to complete a possible larger 3-wave pullback from January 6th before reversing back up. The bottom line is that we have a choppy mess here and predicting the move out of this mess is challenging, to say the least. Wait for the log jam to break before playing one direction or the other and keep in mind that a move out of this range might not have any staying power.
Dow Industrials, INDU, Daily chart
The Dow has developed a small megaphone pattern for its consolidation (or it could be considered just a flat channel) and as such it could be considered a topping pattern. But for the moment I'm giving the bulls the nod with an expectation we'll see one more leg up, potentially up to the trend line along the highs from August-December 2016, which will be near 20500 by the end of the month. As noted on the chart, that would be about a 700-point rally from here, and even more if we first see the Dow drop a little lower heading into Friday. The first thing the bulls need to do is break out of the megaphone pattern with a convincing rally above 20,040. The bears need to drop the Dow below the bottom of the pattern, near 19650, and then watch out for possible support at the rising 50-dma, currently near 19430.
Key Levels for DOW:
- bullish above 20,040
- bearish below 19,650
Nasdaq Composite index, COMPQ, Daily chart
The tech indexes were the place to be for the bulls following the pullback into December 30th. They powered to new highs and looked ready to drag the other indexes higher. But they haven't been able to drag the rest of the market with them and now they look dangerously close to a reversal. As can be seen on the Nasdaq's daily chart below, last week it ran into the top of a rising wedge pattern and then poked above it on Friday but closed on the line. This week it's back below the line and it looks like a little throw-over completion to the pattern, which means it's now on a sell signal by this pattern. Confirmation would be a drop below the January 12th low at 5496.82, as well as below its 20-dma and uptrend line from November-December, which will be near the same level next Monday. But if the bulls can hang on and push the techs higher, watch the top of the rising wedge, which will be near 5596 by Friday and then maybe up to the trend line along the highs from April-September 2016, near 5670 by the end of the month.
Key Levels for COMPQ:
- bullish above 5585
- bearish below 5496
Russell-2000, RUT, Daily chart
The RUT is in the same position as the blue chips with a larger choppy consolidation pattern following its December 9th high. In fact it fits well as a bull flag and the expectation therefore is for another rally leg out of this. Assuming it will break out to the upside, with a rally above the top of the parallel down-channel, currently near 1385, there might not be that much additional upside since it's likely to be stopped by the trend line along the highs from 2007-2015, near 1410. A drop below the bottom of the down-channel, currently near 1348, especially if a breakdown is followed by a back-test and then a further selloff, would leave a failed bullish pattern and that would likely mean strong selling to follow.
Key Levels for RUT:
- bullish above 1410
- bearish below 1346
10-year Yield, TNX, Weekly chart
Treasury yields have been retreating since their December 15th highs, which indicate bond prices have been getting a bounce while stocks traded sideways. Going back to the first chart I showed above, the one showing liquidity is in decline, a bond rally without a stock market selloff could exacerbate any liquidity problems that the market is currently struggling with. A lack of liquidity is what exposes the markets to the potential for a downside disconnect (flash crash). None of this can be predicted but I think we're at the point in the rally where it must be considered and positions carefully managed.
As for the 10-year yield, it dropped to support at its broken downtrend line from 2007-2013 (purple line) and the shorter-term pattern supports the idea for at least a bounce correction before heading lower. Not shown on the weekly chart is an uptrend line from September 30 - November 4, which today crosses the downtrend line from 2007-2013. So that's another reason for support here, which also makes it important for support to hold at yesterday's low at 2.313. Below that level would spell more trouble for the yield and support for bond prices.
KBW Bank index, BKX, Daily chart
Yesterday's strong selloff in the banking index looked bearish but in fact it could have been the completion of its consolidation pattern off its December 8th high. For a similar pattern take a look at the SPX daily chart and what happened following the sharp little selloff into the December 30th low. The potential is for a rally to a price projection at 100.44, which is where the 2nd leg of the rally from February (the leg up from June) would be twice the size of the 1st leg up. That price projection crosses the top of a parallel up-channel for the rally from February 2016 this coming February 15th. That's more upside potential than I'm seeing in the other indexes but it does show how much upside potential we could be looking at. As for the bearish side of this pattern, since it's very possible last Friday's high completed its rally, a decline below this morning's low at 89.17 and its 50-dma near 89 should be considered more bearish.
U.S. Dollar contract, DX, Daily chart
Yesterday the US$ made it down to support at its broken downtrend line from March-December 2015 (the top of a previous parallel down-channel for its consolidation off the March 2015 high. In addition to this downtrend line there is the bottom of a parallel up-channel for the rally off the August 2016 low and a broken trend line along the highs from July-October 2016, all of which were tested yesterday. A successful back-test followed by a bullish kiss goodbye would be bullish, especially since the pullback from January 3rd is just a 3-wave move (correction) so far. Today's strong bounce off support is the start of what turn into the next rally leg for the dollar (despite Trump's call for a weaker dollar). A rally above 103 would leave a confirmed 3-wave pullback, which would point higher. But a drop below yesterday's low at 100.23 would help confirm we're likely in the early part of a larger pullback, which could extend all the way back down to the 92 area before setting up another rally leg.
Gold continuous contract, GC, Daily chart
Gold has rallied as far as it should if it's just a bounce correction within a larger move back down. That's not to say it can't work its way higher in some kind of larger 3-wave bounce pattern, maybe even back up to its 200-dma, near 1268, or its downtrend line from 2011-2012, near 1300, but the current (bearish) wave count suggests the bounce off the December 15th low is just a correction to the decline from July and that it will be followed by another leg down.
The 2nd leg of the decline from July came within $3 of hitting the price projection at 1121, where the 2nd leg is 162% of the 1st leg. The typical bounce correction following that kind of move is back up to the 100% projection, which is at 1204, before continuing lower. Between that projection and price-level S/R near 1205 I figured gold would have a tough time rallying through it without at least a pullback first (shake lose the weak holders) and then power through resistance. Yesterday's strong rally did power through resistance but it was not able to hold it today and closed at 1203.70. If it's able to continue above yesterday's high at 1218.90 it would be a bullish statement but a drop back below 1192 and then price-level S/R near 1180 would indicate we'll see at least a larger pullback, if not down to a new low for the decline from last July.
Oil continuous contract, CL, Daily chart
On January 10th oil had found support at its October 2015 high at 50.92. The back-test followed by a bullish kiss goodbye the next day looked bullish for oil. But the 2-day rally stalled and today it lost support at the trend line along the highs from October 2015 - June 2016, near 52.35, and dropped back down to 50.92 support (with a low at 50.91. It's trying to bounce again but the failed bullish bounce off 50.92 last week is not a good sign for the bulls and it's looking more likely that support will break. Unless oil can get above Tuesday's high at 53.52 I think the odds favor the bears here.
Today's economic reports, including the Fed's Beige Book this afternoon, were largely ignored. Tomorrow's economic reports, which include housing starts and permits and the Philly Fed index, will be largely ignored. Next week's reports will be largely ignored. I'm not sure when the market will get back to any kind of fundamental concerns, unless you now consider the Fed as THE fundamental concern.
The market has once again entered a holding pattern while it awaits clearance to proceed to the next check point, which is presumably higher. But we have many mixed messages between the indexes and various sectors and it's a tough call on market direction when I see the tech indexes calling for a reversal back down from here while the blue chips, RUT and many other sectors point higher once we get through Friday's inauguration. At the moment, with most of the indexes suggesting higher prices, I lean long while acknowledging the need to keep the exit door propped open with my foot. The techs are telling me to be very afraid of the long side and while it's only a warning at the moment it's enough to keep me very cautious (and flat through the rest of this week).
Sentiment seems pretty heavily in favor of a reversal of the Trump trade and that also makes me think they'll be proven wrong by a market that loves proving as many wrong as possible. A strong short-covering rally could follow the inauguration and then, just as everyone becomes convinced the risk of a pullback/decline has passed, the market will surprise with a downside disconnect. Keep in mind the liquidity concerns that I discussed in the beginning of tonight's report. It's just one reason to be afraid of the long side, even though I think there's a good chance we'll see higher prices this month before reversing back down. Trade very carefully in the coming week.
Good luck and I'll be back with you next Wednesday.
Keene H. Little, CMT