Resistance, Dow Theory, Gold and the Fed

The first thing I want to mention today is that the S&P has finally cleared its overhead resistance at 2815. As you can see below, that price level turned the index back on five separate occasions. The fact that prices are holding above this mark is a good sign, as it suggests the selling pressure at this level has subsided.

S&P 500

There are two additional areas of resistance above us before the index can breathe untouched air. The first is at 2875 – the level at which the index peaked in February 2018, and the second is at 2930 – the market’s ultimate high-water mark, set last September. Neither of these levels are very far above us, so it’s possible we could see them come into play shortly.

A look at the broader market also shows signs of encouragement. In the chart below we can see the NYSE Advance-Decline line breaking out to new highs (again).

NYSE Advance-Decline Line

The common-stock only NYSE A-D line (not pictured) also recently touched new highs, suggesting overall equity participation is strong and that the new highs seen in the chart above are not purely the result of bond related issues moving higher.

Last week I mentioned that Dow Theory remains bearish, but the stage is being set for a possible bull signal in the weeks and months ahead. In the charts below (Industrials on top, Transports on bottom) we can see the long reaction rally that began on December 26th.

Dow Theory: Industrials and Transports

That rally petered out at the levels marked in the chart, at which point the averages turned lower as they attempted to set new lows. That downside move was quickly reversed however, and now both averages appear to be making their way higher again.

A rise by both averages above the levels denoted in the chart would turn Dow Theory bullish again. Right now it looks as though the Industrials will have no problem with that, while the Transports are lagging behind.

Recall that if the Industrials reach a new high but the Transports do not, it will be considered a non-confirmation, which in the broader context would be bearish. That is, at least until the Transports finally do confirm (assuming they eventually do).

Moving on, a look at relative strength and momentum by sector, using the RRG chart below, shows that cyclical sectors of the market continue to remain the strongest. Here we can see that Technology, Industrials, Communication Services and Consumer Discretionary are leading the way higher.

Sector Relative Rotation Graph (RRG)

On the lagging end of the spectrum, we have Consumer Staples, Health Care, Materials and Utilities. Most of these are defensive sectors that we would expect investors to flock to in anticipation of the end of the cycle. This is another sign that investors don’t believe the end of this expansion is upon us.

Another reflection of that outlook comes from the University of Michigan Consumer Sentiment Index. Pictured below, this index rebounded sharply in March, rising from 93.8 to 97.8, the second monthly increase.

University of Michigan Consumer Sentiment

The back-to-back gains are important for two reasons. First, consumer sentiment reflects consumers’ willingness to spend, an important consideration for economic stability. Second, sentiment measures such as this have a history of declining ahead of approaching recessions. The recent stabilization echoes other data which suggests that while conditions aren’t necessarily great, the next recession is likely a little ways off.

I know many of you remain fascinated by and invested in gold, which I haven’t touched on in a little while, so let’s do so now. In the chart below we can see that gold remains trapped beneath overhead resistance near 1380 – the same resistance that has held gold hostage for roughly five years now.


But beneath that resistance, gold has been tracing out a series of higher lows. This is a bullish sign, and together with the overhead resistance marks the formation of an ascending triangle. These patterns are typically continuation patterns, suggesting gold will eventually break above 1380, but of course that remains to be seen.

I don’t mean to come across abrasive in any way, but to give you some additional perspective, here is what the stock market has done over the same period. An investment in gold during the last seven years has treaded water while paying no dividends. Meanwhile, an investment in stocks has more than doubled, not including dividends.

S&P 500 7 Year Chart

Now to be fair, there are plenty of times during history when gold has outperformed stocks, so this could be viewed as an unfair comparison. But I show it to highlight two important facts. One, investments in gold can stagnate for years and therefore bullish price action (rising highs and lows) should be a prerequisite for maintaining large positions. Two, over longer periods of time, stocks almost always move higher as a result innovation, growth in the population/economy, and the fact that companies encapsulate inflation.

On that latter point, what I mean is that if we have inflation in our economy, it’s because companies are raising prices. As a result, stocks can always be counted on as an inflation hedge, while gold only acts as a hedge whenever its price happens to be rising. We’d like to think that commodities are the quintessential inflation hedge, but more often than not they move on supply/demand dynamics rather than currency deflation.

Switching gears, I’d like to now talk briefly about the Federal Reserve’s upcoming policy decision, due out tomorrow. No rate hike is expected, but there is one particular item that will draw investor attention: the balance sheet.

The market already knows that the Fed will stop reducing its balance sheet at some point this year, and we should receive an update on that tomorrow. But more importantly, the Fed is trying to figure out what the composition of the remaining assets on their balance sheet should be.

Ultimately, the Fed wants to own only Treasury securities, as opposed to the hybrid mix of Treasuries and mortgage backed securities (MBS) that they currently own. That said, the runoff of MBS will occur very gradually, as the Fed doesn’t want to upset the already tenuous housing market.

The real question, and the one of concern to investors, is whether the resulting balance sheet will be comprised primarily of short-term Treasuries, long-term Treasuries, or a combination of both. Recall that whichever type is owned by the Fed results in reduced supply for that particular segment of the Treasury market, which drives prices higher and yields lower. So in effect, the Fed must decide whether to use their holdings to ease rates at the short, middle or long end of the curve.

This is important for the obvious reason that it will impact the shape of the yield curve, as well as the amount of economic stimulus provided. We don’t know what the Fed will ultimately decide, but right now one of the strongest arguments favors holding short-term Treasuries.

The logic behind this has to do with the fact that lower long-term rates are considered more supportive to the economy than lower short-rates. If the Fed’s balance sheet ultimately contains short-term Treasuries, then conceivably they could ease policy simply by extending the duration of their balance sheet, without increasing its overall size.

In other words, the composition of the Fed’s balance sheet, as opposed to simply the size, is now going to play a bigger role in overall monetary policy. By moving from shorter to longer-dated bonds, or vice versa, the Fed can control the amount of stimulus in the market without modifying the overall balance sheet’s size. Think of it as a modified form of quantitative easing/tightening.

Part of the reason I believe staying up to speed on changes like this is important is because as you know, the market’s cues are always changing. Whereas market watchers used to look to the size of Alan Greenspan’s briefcase as a sign of impending policy decisions, we’ll soon need to look to changes in the composition of the balance sheet as an indication of which way the Fed is leaning.

Understanding their thought process and how these changes will influence both the yield curve and the economy will become more important in the years ahead. It’s time to add another tool to your market analysis toolkit.

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