How to Trade the Tax Bill

Why tech is a trade worth staying in

Senior Vice President of Research
Dec 18, 2017 at 8:43 AM
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"The SPX behavior I have observed relates only to the current tightening cycle, which began in December 2015. Simply put, in the four times that the Fed has raised rates -- even if expected to do so -- the next month has been challenging for stock market buyers. On the other hand, after the 12 instances where the Fed held rates steady, it has been a rather lucrative time for stock buyers in the following month... if the Fed indeed raises rates, both the expected return and the probability of the market moving higher over the following one-month period declines relative to the expectations if the Fed were to surprise market participants by holding rates steady."
    -- Monday Morning Outlook, December 11, 2017

Last Wednesday, as expected, the Federal Open Market Committee (FOMC) raised the fed funds rate for the fifth time in the current rate hike cycle, which began in December 2015. The chart below, which appeared in last week’s commentary, summarizes the S&P 500 Index’s (SPX - 2,675.81) one-month behavior when the Fed has raised rates versus holding them steady, looking at data since December 2015.  Clearly, the equity market’s short-term prospects are brighter when the Fed stands pat.

spx reactions to fed meetings

In the day following the Fed’s announcement, equities sold off, as rumors swirled that the Senate may not have enough votes to pass the tax reform bill. The rumors turned the other way on Friday, and stocks rallied back impressively, but the SPDR S&P 500 ETF Trust (SPY - 266.51) closed below the $266.75 and $266.78 levels -- its closing prices from the day of and the day before the FOMC decision, respectively.

Macro-level rumors, such as those related to the tax bill, tend to generate noise, as we saw both Thursday and Friday. Speculation regarding the likelihood of passage or failure are likely to circulate as the bill moves to a vote in both chambers of Congress over the next few days. It will be interesting to see if the area around the SPY's Fed-day closing level continues to mark resistance on the heels of last week’s rate hike, as the "wild card" factor of pending tax reform legislation didn't impact the stock market action around prior rate hikes in the current tightening cycle. Traders should keep this region on their radar in the days ahead.

Moreover, the SPY $268.23 level is a round 20% above the 2016 year-end close, and thus could also represent a hesitation area. In mid-July, the SPY hit the level 10% above the 2016 close, and traded sideways for weeks before finally leaving this level behind for good beginning in mid-September. 

If you prefer monitoring the SPX, the FOMC-based closing levels that I am monitoring are 2,662 and 2,664, which were taken out in Friday’s trading -- potentially a positive development for bulls. About one week after the June rate hike, there was a slight move above the Fed-day close too, but this was quickly followed by a mild retreat below that level that lasted almost a month.   

The Russell 2000 Index (RUT - 1,530.42), after being engaged in a retreat since its end-of-November peak at 1,544, found support just above the round 1,500 level last week -- the site of its October peak and its 40-day moving average, and just above the level that marks a round 10% year-to-date gain at 1,492. It isn’t a major surprise that 1,500 was revisited again, more than two months after RUT first touched it. However, it is encouraging that this level appears to be acting as support, unlike last month when a move below 1,500 did not end until the 1,450 level marked a trough.

Small-caps are viewed as one of the bigger beneficiaries of corporate tax cuts and, as such, led Friday’s rally. But note that this group has underperformed in 2017, and more retests of RUT 1,500 may be on the horizon -- especially if the passage of a tax bill becomes a “buy the rumor, sell the news” event, as the 1,550 half-century mark resides just above current levels.

"The ‘rotation out of tech’ was a storyline throughout most of last week.  However, as it was being discussed, it was a rotation back into tech, with the Nasdaq Composite (IXIC - 6,840.08) continuing the pattern like that of September and October, in which the 40-day moving average and a trendline connecting higher lows came into play as support around 6,735. Now, the challenge is for the IXIC to overcome a channel line drawn through most of the highs since June, which is currently situated just below 6,900, and represented Friday's high."
    -- Monday Morning Outlook, December 11, 2017

In Friday’s trading, the Nasdaq Composite (IXIC - 6,936.58) broke out above the channel line connecting multiple highs in May through November that I referred to last week. In the process, it closed the week above last month’s all-time closing high. The technical pattern that I identified two weeks ago, in which support comes in at IXIC's 40-day moving average and a trendline connecting higher lows, has indeed repeated itself. 

The trough began when media coverage started citing a rotation out of technology stocks. Last month, the IXIC similarly broke out above the channel line shown in the chart below. There was about a week of mild follow-through before the aforementioned “rotation out of tech” occurred. Technology has led the market, and it is a trade worth staying with until the pattern I’ve identified at recent troughs breaks down. 

IXIC with 40-day MA

It's interesting that even though big-cap technology stocks have led this year’s rally, short interest data (through mid-November) shows that short interest on components of the PowerShares QQQ Trust (QQQ - 157.65) grew by almost 5% in 2017. As you can see from the graph below, the short interest on these components is around the highest level looking back over about 18 months, and these stocks are prone to short covering as shorts' losses pile up.

Intel (INTC), for example, is a QQQ component that is up more than 20% year-to-date, yet short interest increased nearly 90% as of mid-November. Despite trading at multi-year highs, INTC is a $200 billion market-cap tech stock that could benefit from short covering.

QQQ short interest

The tax bill being considered in Congress will continue to dominate headlines in the days ahead, and a vote on this legislation comes on the heels of a rate hike last week. When and if signed into law, how the market responds relative to the key SPY and SPX levels discussed above may give you a hint as to the market environment over the next month. Bulls will hope that the pattern of weaker-than-normal equity performance in the immediate days and weeks following a rate hike is broken.

Continue to use call options as a stock-replacement strategy or in lieu of long stock plays, to play the trend while also managing risk associated with the uncertainty of the tax bill and the possibility of weaker-than-normal price action following the rate hike last week.

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