Is the Dow Rally a New Impulse Wave or a Bull Trap?

The Dow Industrials average has been on a tear since November 7th, rising over 990 points in two-weeks.  The question we have to ask, though, is if we're seeing the start of a new bullish impulse wave or if this represents an end-of-year bull trap.  Let's look at the daily chart:

Dow Industrials Daily Chart

A short but very productive impulse wave started on February 11, 2016, and that wave pushed the market to a high on April 20th.  If we consider that Wave 1, then Wave 2 ran pretty much through the remainder of 2016.  It was a fairly flat consolidation that culminated with a very tight two-month congestion leading up to the US presidential elections.

The current impulse wave - which may very well be Wave 3 - started November 7, the day before the election.  From there, the market surged skyward, gaining 990 points in a week.  This flagpole formed the foundation for a classic pennant pattern that we appear to have broken yesterday.

Now, the rosy interpretation of this chart places a price target at 19,920 for that flagpole pattern, and it should be obtained relatively quickly - no more than a week or two.  Similarly, the target for Elliott Wave 3 is 20,500, and that lines up rather well if the flagpole target ends at a sub-wave consolidation before continuing to the peak. 

All of this is plausible, especially as we head into a period traditionally marked by a Santa Claus Rally.  That's when this could get a bit ugly, though.  The alternation rule states that Wave 2 and Wave 4 must differ in form and time.  Wave 2 was long and relatively flat.  Therefore, Wave 4 must be short and deep.  Expect a very sharp correction that takes out anywhere from 50% to 61.8% of the Wave 3 gains, and expect it to happen very quickly.  That's as much as a 1650 point drop before Wave 5 commences.


Are there other warning signs on the horizon?  Certainly.  The Dow just achieved an all-time high, but it did so on relatively low volume and with two consecutive narrow range bars.  This implies there really wasn't a lot of enthusiasm pushing the rally, and we may shortly see some climactic action as the large investment houses wind down for the holidays.  This rally would have been much more convincing if accompanied by high volume.

There are also a couple of major events on the horizon that could easily turn this rally into a bull trap.  First, it's a near certainty that FOMC will raise interest rates when they meet on December 14.  In fact, the futures market has priced in a 98.2% chance of a rate increase.  Fed Chair Janet Yellen has also signaled an intent to raise rates twice more in 2017 (data permitting, of course.)  So that would likely mean a June and December hike, and that's precisely what you see if you look at the futures market.

In the midst of this slight tightening of US monetary policy, the UK will be moving towards an Article 50 invocation.  Prime Minister May has targeted the end of March for that major milestone, although the UK courts have added a measure of doubt to the timetable.  Whenever it's done, however, it will certainly have a sobering impact on the EU and British markets.  The combination of Brexit and US interest rate hikes will certainly send shock waves through the world markets. 

So, what does all this mean for us as traders?  Well, that we are in a bullish impulse at the moment cannot be doubted.  We're going to continue playing the long side as long as that impulse remains in effect.  Now, Friday's an early close and will be ultra-low volume, so I'll be sitting that one out.  But once the market opens on Monday, my bias will be to the long side.  The closer we get to 19,500 and then 19,900, however, the tighter my stops will be, and the more I'll be watching for sub-wave 4.  That sub-wave and then the actual Wave 4 will be two that we will want to catch to the short side.  Both will be deep, but both will be short, so remain vigilant.  There won't be much of an opportunity to hop into those waves once they are in full swing.

For now, have a Happy Thanksgiving here in the States, enjoy a nice 4-day stretch away from trading, and let's see where the market decides to take us next week.

BoE Cuts Rates, Adds to QE

The UK's Monetary Policy Committee today announced their first interest rate cut in seven years, lowering the benchmark rate to a record low of 0.25%.  The rate cut came as no surprise to markets worldwide, and the MPC vote was 9-0 in favor of the cuts.  What did surprise some, however, was a £170 Billion stimulus that will be introduced via the purchase of Gilts (UK government backed bonds similar to US Treasury Bonds), the purchase of corporate bonds, and a new bank lending program.  That portion of the stimulus package was not expected to coincide with the interest rate cuts.

The FTSE responded positively to the news, finishing the day up 1.56% although the Pound dropped 1.5% versus the US Dollar and 1.3% versus the Euro.  US markets responded with a yawn, finishing the day flat.  The US 10-Year Treasury Yield, however, dropped 2.58% to 1.51.

BoE Governor Mark Carney sounded a pessimistic note in his presentation, stating, “We took these steps because the economic outlook has changed markedly.  Indicators have all fallen sharply, in most cases to levels last seen in the financial crisis, and in some cases to all-time lows."  That's a bit troubling, given the lengthy duration anticipated for the actual Brexit events to unfold.  With the benchmark rate now down to an extreme low, there is very little additional room for the BoE to maneuver should the British economy slow further.

Surprisingly, the MPC signaled the potential for a further rate cut, although Carney assured reporters that the central bank had no intention of bringing rates into negative territory.  That they would consider - and even signal - that rates could drop to near zero, however, indicates the level of concern the committee has over the economic prospects during the Brexit transition.

The fallout from the Brexit vote has manifested more slowly than critics had forecast, but - at least in the UK - it is starting to be felt.  Consumer Confidence is dropping dramatically, and the industrial outlook is starting to decline as well.  The forecast for the UK GDP is now down to 0.8% for 2017, and the Central Bank foresees a strong decline in corporate investment and in the housing markets.  The Pound's weakness is certainly hurting UK imports, and that is having a marked effect on growth potential over the next 18 months.  That import price pressure is expected to have an impact on inflation in 2017, with the central bank forecasting inflation to hit their 2% target in the fourth quarter of 2017 and exceed it throughout 2018.

What all this signals is a period of weakness, uncertainty, and potential market instability in the UK that will likely last through 2018.  With the ECB taking a bit of a "wait and see" attitude mingled with a healthy dose of skepticism a couple of weeks ago, the likelihood of continental fallout is extremely high.  US 10-Year Treasury yields have declined steadily since December, 2015, and are now sitting at the lows last seen in August, 2012.  That represents a significant flight to safety, and with US equities sitting near all-time highs, it's reasonable to conclude that the heavy demand on US treasury bonds is coming from overseas.

There is a limit to how long the US can remain immune to economic weakness in the UK and the EU.  The strong US dollar is having a severe impact on US exports, and that, in turn has a serious impact on US companies that are heavily exposed to Europe.  This is evident in the behavior of the S&P 500 where demand has fallen off over the past few weeks, and the market has gone essentially flat since it reached a record high in mid-July.  With GDP growth down dramatically in Europe, the UK, and the US, prospects for a global recession are mounting as we transition from a tumultuous US presidential election to the uncertainty of a prolonged Brexit negotiation and execution.

Earnings season in the US is almost over, and there is not another FOMC announcement before September 21.  So now we turn our attention to tomorrow's jobs report.  The pattern in the market right now is not encouraging, so the key economic reports over the next few business days may well set the tone for the remainder of August. 

Happy Trading

Bank of England Holds Rates Steady; Signals August Stimulus

Despite market estimates of an 80% chance for a rate cut today, the Bank of England held rates steady at 0.5%.  With new Prime Minister Theresa May signaling a slow and cautious path towards Brexit and also signaling an invocation of Article 50 no earlier than 2017, the central bank's delay in lowering interest rates makes sense. 

Only 2 1/2 weeks have passed since the Brexit vote, and that is an insufficient amount of time to gather enough data to make an informed projection on the economic climate for the next six to twelve months.  The MPC (Monetary Policy Committee) next meets on August 4th, giving them additional time to gauge the reaction and potential impact.

Additionally, despite the immediate reaction worldwide on June 24 and 27, markets in the UK and around the world have since stabilized and, in fact, rebounded significantly.  In the Forex market, the British Pound did indeed take a significant hit against both the Euro and the US Dollar, however the currencies have since stabilized albeit at the lower levels experienced immediately following the vote.

Given the slight trade imbalance the UK currently experiences, that overall drop in the Pound is actually very good for their exports.  It provides an immediate boost to UK-based corporations and, in that context, is a nice stimulus without the Central Bank taking any actions at all.  Coupled with that, initial fears that companies would seek to relocate out of the UK have since abated.  To that point, JP Morgan Chase CEO Jamie Dimon specified in today's earnings call that he had no intention of leaving the UK despite rumors to that effect on June 24th.  Following the initial shock of the vote, we now see other companies taking a step away from the ledge, realizing that the new dynamic offers tremendous opportunity, not peril.

What the Bank of England has done by standing pat is afforded themselves some options later in the year should the British economy weaken to the point where a stimulus in the form of a rate cut becomes necessary.  Lowering that key rate today would have left the Central Bank with no room left to move as the UK approaches what will certainly be a period of uncertainty after they invoke Article 50.  Remember, the BoE already provided a significant stimulus on July 5th when they eased capital requirements for commercial banks, effectively providing a £150 Billion short-term stimulus.

The change in capital requirements on 5 July was seen as a direct attempt to prevent a repeat of the 2008 crisis in which banks ceased lending.  Whether or not that move is sufficient only time will tell, however as of today the signal is that the MPC is thus far satisfied with the short-term results.

Today's decision underscores a strengthening in the overall financial stability of the UK and stands in stark contrast to some dire warnings issued by Governor of the Bank of England Mark Carney just a week ago: “The number of vulnerable households could increase due to a tougher economic outlook and a potential tightening of credit conditions. In particular there is growing evidence that uncertainty about the referendum has delayed major economic decisions, such as business investment, construction and housing market activity.  The UK has entered a period of uncertainty and significant economic adjustment."  The wording is particularly harsh coming from such a prominent member.

There's no word as to what measures the Committee are considering in August, however according to officials there was significant discussion of it in today's meeting: “Most members of the committee expect monetary policy to be loosened in August.  The committee discussed various easing options and combinations thereof. The exact extent of any additional stimulus measures will be based on the committee’s updated forecast, and their composition will take account of any interactions with the financial system.”

The August 4th meeting comes only a week after the US Federal Opens Markets Committee (FOMC) meets.  Fed Chair Janet Yellen typically addresses the economic environment in Europe and the UK in her post-meeting announcement, so it will be worth listening to that release for clues as to any action the Bank of England may feel necessary.  Given the interrelationships between the various central banks and the global impact each of their decisions have, it would be a mistake to focus only on the MPC for guidance as to what the future economic environment may entail.

Also of interest is the next European Central Bank (ECB) meeting, scheduled for 21 July.  Again, listening to Mario Draghi's perspective will add further insight.  It's likely that, between the ECB and FOMC, we should have a fair idea of the direction the Bank of England may take on August 4th.

Happy Trading.

Theresa May Poised to Take the Helm in the UK

The topics of Brexit and UK's next Prime Minister are back in the news front-and-center with the overnight announcement that Andrea Leadsom, the most conservative of the remaining candidates, had withdrawn from consideration.  That leaves Theresa May as the presumptive new head of the Conservative Party, settling the issue two months ahead of the original September 9th deadline.  The exact date of the transition has not yet been set - at least, not as of this writing - but could be within the next few days.

The UK and US markets have greeted the news positively, with US futures pointing to a continuation of Friday's rally.  Settling the Prime Minister question early removes a measure of uncertainty, which is always positive for the market.  Some caution is warranted now, however, since it does bring the Brexit discussion back to the forefront several months earlier than anticipated.  We can expect a bit of volatility as that plays out.

Despite being described as a Euroskeptic, May stated after the vote that "Brexit means Brexit."  She has said that there will not be a second resolution, and there will also be a clean break, not some Schrödinger's Cat variant of maybe in, maybe out, maybe both.  This implies that a move to invoke Article 50 may come sometime before the end of this year, setting a 2-year negotiations deadline in motion with a potential exit sometime in late 2018 or 2019.

While the monetary cost of executing the exit logistics is an unknown - but likely very high - it will bear careful scrutiny since it will have an impact on companies with UK exposure.  The financial impact will likely be lower in the EU, but again, it bears watching.

Of immediate interest will be the policies that May sets forth as the new Prime Minister, and some of those policies could have direct financial impact on companies operating in the UK.  Despite being the new leader of the Conservatives, some of her views are as left or even further left than what has been proposed by Labour, at least when it comes to management and oversight of corporations.

May has said,  “I want to see changes in the way that big business is governed. The people who run big businesses are supposed to be accountable to outsiders, to non-executive directors, who are supposed to ask the difficult questions, think about the long term and defend the interests of shareholders. In practice, they are drawn from the same narrow social and professional circles as the executive team and – as we have seen time and time again – the scrutiny they provide is just not good enough. So if I’m prime minister, we’re going to change that system – and we’re going to have not just consumers represented on company boards, but workers as well.”

 She has also pledged to reign in executive pay - which, keep in mind, is already significantly lower in the UK than it is here in the US - and intends to change the shareholder proxy structure to make shareholder votes on pay binding as opposed to recommendations.  Neither of the changes she is proposing will entice companies with global reach to remain in the UK following a Brexit that will certainly complicate their cross-border trading both in Europe and through other parts of the world.

Many of her other policy statements are synonymous with the Democratic platform in the US:

• “Right now, if you’re born poor, you will die on average nine years earlier than others. If you’re black, you’re treated more harshly by the criminal justice system than if you’re white. If you’re a white, working-class boy, you’re less likely than anybody else to go to university,”
• “If you’re at a state school, you’re less likely to reach the top professions than if you’re educated privately. If you’re a woman, you still earn less than a man. If you suffer from mental health problems, there’s too often not enough help to hand. If you’re young, you’ll find it harder than ever before to own your own home.”
• She has pledged to refocus the Conservative Party to be “at the service of working people" who, she believes, voted for Brexit because they did not feel in control of their lives either in the workplace or in government.

If any of this sounds familiar, it's only because we're hearing the exact same platform in the Presidential elections here in the US.

What it means to us as traders is that we will need to adapt to a less conservative leadership in the UK, a climate that is less business friendly, unknown impacts on foreign exchange for companies operating in both the UK and the EU, and unforeseen strains on cross-border trade.  Those of us that only trade US and Canadian stocks still need to be aware of the impact on S&P 500 companies with heavy exposure to Europe.  What is certain for now is that these considerations will add to what Janet Yellen consistently calls "headwinds" and it's likely those headwinds will be in our face for the next couple of years.