How Fibonacci and the Fed Could Drive Stocks from Here

Stocks could potentially repeat the Fibonacci retracement that took place after the March rate hike

Senior Vice President of Research
Jun 19, 2017 at 8:36 AM
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"... the FOMC policy decision may be the most relevant headline impacting stocks, as Fed Chair Janet Yellen and company juggle the unpleasant task of normalizing rates in an environment filled with uncertainties (including tax reform, trade, infrastructure spending, and the implications of plunging oil prices, even as OPEC and Russia work together to cut back on production)."
    -- Monday Morning Outlook, May 8, 2017

"Along with 2,450, another yet-to-be determined SPX level could also become important in the days and weeks ahead, following the Wednesday FOMC meeting. As I pointed out early last month and repeated last week, the SPX closing levels on Fed rate hike days during the current tightening cycle have marked resistance in the immediate days and weeks following the meeting… investors are not exactly welcoming rate hikes, as growth concerns remain…"
    -- Monday Morning Outlook, June 12, 2017

"U.S. retail sales in May recorded their biggest drop in 16 months and consumer prices unexpectedly fell, suggesting a softening in domestic demand that could limit the Federal Reserve's ability to continue raising interest rates this year."
    -- Reuters, June 14, 2017

Several weeks ago, I observed that amid a barrage of perceived market-moving developments -- ranging from European elections to the political drama in Washington, D.C. -- the most relevant headlines to investors have been the outcomes of Federal Open Market Committee (FOMC) meetings, which occur every six weeks. The other headlines that dominate financial news channels and sites admittedly grab viewers' eyes, but only create day-to-day noise in the bigger picture.

This simple takeaway, as described in the second excerpt above from my early May commentary (and described in detail once again last week) is based simply on price action in the SPDR S&P 500 ETF Trust (SPY - 242.64) and S&P 500 Index (SPX - 2,433.15) in the days and weeks following Fed meetings.

Last Wednesday, on the heels of weak inflation and retail sales data, the Fed hiked rates for the fourth time in the current tightening cycle, and the third time since December. With Fed Chair Janet Yellen's perceived "hawkish" outlook accompanying the rate increase, equities declined, with the Tuesday close marking both the all-time high and the high for the week.

If the pattern in this rate-tightening cycle continues, I would expect the SPX's 2,438-2,440 area to act as resistance, or a "hesitation" area, until the next policy decision on July 26. While 2,438 marked the Fed day close, the 2,440 level was the site of the Tuesday high close just ahead of last Wednesday's policy decision. Note that these levels are situated not far below another potential resistance point -- the 2,450 half-century mark. For SPY followers, based on closing data on the same dates, the levels to watch are 244.24 to 244.55.

Also worth mentioning, but not seen in the chart below, is that in the aftermath of the first rate hike in the current tightening cycle -- December 2015 -- the SPY sold off mildly immediately after the meeting, then rallied back to its close the day prior to the hike about one week later, before embarking on a three-week, 10% correction that began in the last few trading days of 2015.

spy daily with fed meetings 0616

"What was less anticipated was the signal from U.S. policy makers that they still plan on an additional interest-rate increase this year despite relatively weak economic data of late... The U.S. yield curve is flattening as debt traders decrease their growth expectations... Bond traders are clearly worried that U.S. central bankers are on a path to harm the nation's prospects for growth without meaningfully adding to its arsenal of tools to deal with any downturn. The debt markets have an uncanny ability to be more right than wrong. It's worth paying attention to their message."
    -- Bloomberg, "Bond Traders Detect Fed Error," June 14, 2017

Since December 2015, investors have had a difficult time digesting rate hikes in the immediate days and weeks following a rate increase. Therefore, based on what we have witnessed so far, a short-term 10% correction could be a worst-case scenario, especially if the thinking from the Bloomberg article excerpted above -- a worthwhile read -- takes hold with current U.S. equity market investors.

Throw in the fact that large speculators on CBOE Volatility Index (VIX - 10.38) futures, per the weekly Commitments of Traders (CoT) report, remain in an extreme net short position -- so the risk of a volatility pop/stock "shock" lingers, given this group's poor track record in timing volatility moves.

A sideways grind, with a milder drawdown and resistance in the SPY $244-$245 area into the next Fed meeting in late July, would be considered a best-case scenario. But the upside in this scenario is that the FOMC is not expected to raise rates at its July meeting, so if this hypothetical comes to fruition, stocks may again rally if the Fed stays pat.

Also, for what it's worth, the SPY bottom in late March/early April was at a 61.8% Fibonacci retracement of the close in early February, when the FOMC met and did not raise rates, and the mid-March rate hike. If equities repeat the Fibonacci pattern that followed the March rate hike, support would be in the SPY $240-$241 zone, which is equivalent to the round SPX 2,400 century mark and 2,410.

There is good news, despite what could be short-term shortcomings for equities. While stocks have struggled in the immediate aftermath of rate hikes, another reality is that, from a longer-term perspective, equities have digested the Fed's actions quite well in the past 18 months. For example, since mid-December 2015 through last week's close, the SPX has rallied 18%. In other words, the technical backdrop is not a major cause for concern. Per the tweet embedded above, the SPX rally in the face of rising short interest among component names is particularly impressive, as this type of short interest build is typically a headwind.

Moreover, the sentiment backdrop favors equities from an intermediate-term to longer-term perspective. Survey results released last week by Bank of America-Merrill Lynch indicated that a net 84% of fund managers identified the U.S. as the most overvalued region for equities -- an all-time high. Plus, the average amount of cash held by respondents rose from 4.9% to 5%, above its 10-year average of 4.5%. This is indicative of ample cash to fuel the stock market higher, even if it experiences a short-term hiccup or two.

spx component short interest 0616

"... the energy sector is a group to avoid, as it is overcrowded and underperforming... as we move through earnings season, option prices will become less expensive, which means you can once again use calls as a stock-replacement strategy. This method allows you to commit fewer dollars to the stock market, but still participate in leveraged upside if the intermediate- and longer-term uptrends in the market continue to trump the underlying risks."
    -- Monday Morning Outlook, April 24, 2017

My advice hasn't changed. Recognize the short-term risks by using call options in lieu of stocks to play equities that have nice upside potential, in your view. Options allow you to place fewer dollars at risk, while still playing an impressive uptrend. Continue to avoid the energy group, and/or consider buying puts on energy names to trade around long positions.

The energy sector's vulnerability is related mostly to what is happening in the oil futures market, as crude prices continue to decline -- yet large speculators, per the weekly CoT report, are S-L-O-W-L-Y unwinding long positions. Per the chart below, there is still significant potential for further unwinding of these long positions, which could negatively impact stocks in the energy group.

cot large spec oil futures 0616

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