Don’t Stop Believing!

Don’t stop believing!  Stocks closed virtually unchanged as the market had priced in only all good things. Equities bounced around the break even line throughout yesterday’s session ultimately closing unchanged to slightly higher as the trade war talks progressed in Washington DC.

WHAT YOU NEED TO KNOW:

1) US – China trade negotiations, well… they continue to progress… as we continue to be reminded by almost everyone involved.  What that actually means is, unfortunately, still a big mystery but one thing is clear: we only have until next Thursday before tariffs on $200 billion dollars in Chinese imports increases to 25%.  No stress though.  President Trump implied that his March 1st line in the sand is not necessarily a “magic date” implying that officials may be willing to accept a slip if talks continue to progress.

2) Retail sales continue to confuse traders.  Last week, we got a shocker of a Retail Sales Number that showed a -1.2% drop in December (the worst in 9 years) causing markets a bit of indigestion, though they ultimately recovered.  Despite the recovery, many analysts remain concerned that the weak number, which reflects a typically strong month, may be a harbinger of worse things to come.  But, alas, as with most events with the market, there are some things that just don’t add up.  Yesterday, Walmart announced its 4th quarter earnings beating both top and bottom line estimates and stated that they experienced same store sales growth +4.2%.  Not convinced?  Amazon announced that it had a +12.5% growth in sales for December.

3) Is a European trade war next?  The commerce department released a report yesterday suggesting that European auto imports may be a security risk prompting many to speculate that the President may set his sites on the EU auto industry.  As reported yesterday the European Commission President Jean-Claude Juncker tried to preempt any moves by providing some rhetoric of his own by threatening retaliation.  Today, the President will meet with the Austrian Chancellor to discuss… auto imports from Europe, with hopefully less rhetoric.

4)  The Federal Reserve will release its FOMC minutes today and they will provide an interesting read on just how passionate the committee was in its change of policy.  The policy change is perhaps the single largest driver of Equity market recovery since the December lows.

Stock traders had a hard time making up their minds yesterday as they started out in the red climbing slowly into the black through the session only to give up much of the gains in the last hour of trading. Walmart’s pre-bell earnings beat, the housing market index coming in higher than expected, and positive trade discussion vibes are credited with buoying equities.  The S&P500 rose by +0.2%, the Dow Jones Industrial Average traded up marginally by +0.03%, the Russell 2000 increased by +0.33, and NASDAQ 100 Index picked up by +0.16%.  Bonds also rose in yesterdays session as the ten year treasury yield fell to 2.63% and the 2/10 yield curve held steady at 14 basis points.  Stocks have enjoyed an almost +20% gain since hitting lows on December 24th driven primarily by the Federal Reserve’s policy shift and a potential end to the trade war with China.  With the Fed having solidified the policy shift in their Jan 29/30 meeting and a torrent of jawboning from virtually all of the policy makers, the market has by now fully factored in the Fed position.  Additionally, all known information from the Sino-US talks indicate some form of success which means that the market is expecting positive results on that front as well. What could be a possible driver for future market gains now that many expect first quarter earnings to be flat remains the big question in traders minds.  Additionally, the market went from being oversold to a degree that has not been seen since late 2015 to being overbought, a condition that may indicate asymmetric risk.  That means there is potentially more downside risk than upside potential given current market conditions.  So what does it mean to say that a market is oversold or overbought?  Because it is geek-out Wednesday and the S&P500 is overbought, perhaps we should delve a bit deeper into the topic.

 

GEEK-OUT WEDNESDAY:

The Relative Strength Index, or RSI, was developed by famed market technician J. Welles Wilder and introduced in his still relevant book “New Concepts of Technical Trading Systems”, which was technically new in 1978, when the book was released.  The RSI tells us where a stock is trading today relative to where is has been trading historically, indicating the momentum of a trading instrument.  It is devised as an oscillator which means that it moves between 0 and 100.  Though there are many interpretations of the indicator, the classic application states that if the oscillator goes below 30 the underlying security is oversold and if it exceeds 70, it is considered overbought.  In other words if something sells off too quickly it is oversold and conversely if something goes up too far too fast, it is considered overbought. Seems pretty convenient and what is more convenient is that the indicator is available on most free charting applications.  So let’s go into how the index is actually calculated.  The calculation takes two steps as follows:

Step 1: Calculate the RS

RS = AG / AL

Where:

AG = ( ( PAG * 13 ) + CG ) / 14

AL =  ( ( PAL * 13 ) + CL ) / 14

Where:

AG = Average Gain

PAG = Sum ( Gains from past 14 sessions ) / 14

CG = Current gain

AL = Average Loss

PAL = Sum ( Losses from past 14 sessions) / 14

CL = Current loss

The RS gives us a smoothed average gain and loss for the past 14 sessions.  Once calculated, we use the RS for Step 2, which creates the oscillator.

RSI = 100 – ( 100 / ( 1 + RS ) )

Let’s calculate the current 14 day RSI for the S&P500 (see attached spreadsheet for details on the calculations)

AG =  ( ( 0.4622% * 13 ) + 0.1499% ) / 14 =  0.4399%

AL = ( ( 0.11211% * 13 ) + 0.0% ) /14 = 0.1041%

RS = .04399% / 0.1041% = 4.2272

RSI = 100 – ( 100 / ( 1 + 4.2272 ) )

RSI = 80

Because the smoothed average gains in the past 14 days exceeded the smoothed average losses of the same period, the S&P is displaying relatively positive momentum.  If we force the numbers to fit within a scale of 0 to 100, we see that it is relatively 80% more positive than negative, which is why we end up with a number of 80.  If we go back to Wilder’s original boundaries of 30 and 70, we know that the S&P 500 would be considered overbought.  If, in fact, we look back at the the RSI over history, we can see that, more times than not, when the RSI goes above 70, it experiences resistance and pulls back.  Vice versa, when it goes below 30, it typically gets support and trades up.  There are many other ways to look at the RSI, one of the most common is by divergence.  Divergence is when the RSI goes in one direction and the underlying security goes in the opposite direction. If this divergence occurs, the price of the underlying security may be going up while the RSI is going down (or vice versa) and because they are diverging, the Relative Strength is not confirming the price and some traders use this signal to indicate a potential reversal of trend.  The single most common use for the indicator is to determine overbought or oversold conditions.  Caveat: while it may seem obvious to use the RSI as a trading indicator, like all things in finance it has enough flaws to get a trader in trouble.  Many quant traders will use it alongside a host of other indicators in order to get more accurate entry and exit points. For our purpose, we can use the index to tell us a bit about where the market is today and with it being overbought, perhaps we might want to be a bit more careful until we see what happens next.

WHAT TO EXPECT TODAY:

This afternoon, we will get the minutes from the FOMC’s January meeting and it will be the star attraction today.  While we know that Fed policy has shifted, many will look to see how whole-heartedly the policy was agreed upon.  More importantly, there are many who believe that the Fed’s intention was to reflect a pause in hiking and not necessarily cause the market to start factoring in interest rate cuts. Perhaps the rhetoric was more effective than they expected.  That is the main outstanding question that traders have and they will parse the minutes for answers.  This morning’s pre-bell earnings releases included CVS Health Corp. and Analog Devices, both of which beat Wall Street estimates.  After the bell we will hear from Albemarle, Equifax, Energy Transfer Partners, and Avis Budget group, amongst others.

daily chartbook 2019-02-20

SP500 RSI calculation