Welsh on the mkt

Today's letter:
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Much Ado about Nothing
As discussed in detail in the January Macro Tides the majority of professional investors do not have even
a basic understanding of how the Federal Reserve conducts monetary policy and how they communicate
policy intentions. This has become obvious in the past two months as many TV talking heads and the
Wall Street Journal have expressed the view that the Fed is reckless, clueless, and deaf for not listening
to the message of the financial markets The conclusion is that the financial markets have been telling
the Fed that the global and US economy are slowing rapidly. The verdict was virtually unanimous on
CNBC and in a Wall Street Journal editorial that the Fed made a serious policy mistake after the FOMC
voted to raise the federal funds rate by 0.25% at their December 19 meeting. This ‘mistake’ was further
compounded when their dot plot indicated there might be two more rate increases in 2019. Based on
the dot plot TV talking heads concluded that the FOMC would proceed robotically and raise rates in
2019 irrespective of incoming data since that’s what the dot plot said. As I noted in the January Macro
Tides, “After the December 19 meeting investors concluded that the dot plot indicated the FOMC would
increase the funds rate no matter what. This reveals a complete lack of understanding of how the FOMC
has proceeded in recent years.”
The most vocal critic of the Fed has been CNBC’s Jim Cramer who has said the Fed has been reckless and
won’t be happy until the unemployment rate is 5.5% and everyone is shopping at the Dollar Store.
Cramer’s new tease for his show Mad Money is that the Fed will be deciding whether to cut rates 2 or 3
times in 2019. Cramer has attracted and educated more retail investors during his tenure on CNBC and
often provides good insight for his viewers. I respect his passion but feel his professionalism has suffered
as he has ranted and raved about the Fed since early October. Cramer is entitled to his opinion and the
more outlandish his demeanor and statements are probably props to boost his ratings. Its’ one thing to
criticize the Fed based on policy, quite another to accuse the Fed of being reckless, saying Powell will be
happy if unemployment rises and wage growth for workers slows, and that the Fed is conducting
monetary policy to benefit the top 1% and not the middle class. After the FOMC meeting on December
19 Cramer criticized the Fed for being dogmatic and suggested that the Fed would mindlessly raise rates
in 2019. He’s dead wrong on this point and should know better than to suggest so.
As I noted in the January Macro Tides, “The changes in the FOMC’s GDP projections for 2018 and 2019
indicate that the FOMC has been responding to incoming data all along. This suggests that if economic2
data comes in weaker in 2019 than the FOMC expects the dot plot will not be adhered to. In 2016 the dot
plot projected three increases in the funds rate but the FOMC only increased it once. The dot plot is a
communication tool and not a policy tool.”
After the FOMC meeting on December 19 Chairman Powel provided the following statement.” We
always emphasize that our policy decisions are not on a preset course and will change if the incoming
data materially change the outlook. And, given recent developments, the post meeting statement notes
that we “will continue to monitor global economic and financial developments and assess their
implications for the economic outlook. This illustrates the nature of data dependence that we always
emphasize. In 2018, the economy was somewhat more robust than expected, and this led to a slightly
faster pace of policy normalization than had been projected. When the economy has, instead, turned out
weaker than expected, the Committee has slowed or paused the pace of rate increases as we did in 2016.
And when the economy has performed about as expected, the Committee has generally moved in line
with the median projection as we did in 2017.”
Clearly, the Wall Street Journal (WSJ), Cramer, and professional investors didn’t read or listen to
Powell’s statement which couldn’t have been more straightforward. Instead, investors revealed their
lack of understanding of how the FOMC operates and communicates its policy path. As discussed in the
January Macro Tides “There was absolutely no way the FOMC would shift from communicating 3 hikes in
2019 to none. Instead the FOMC lowered its projection for GDP growth from 2.5% to 2.3% and reduced
the expected number of increases from 3 to 2. This is the FOMC’s way of telling investors that it
recognizes and acknowledges that growth is slowing and will be responsive to incoming data. By
communicating in this manner the FOMC retained its optionality. Just as they don’t want to be boxed in
by the dot plot, they wouldn’t want to publically hit pause and then risk having to communicate the need
to resume hikes if incoming data proved stronger than expected.”
On January 4 the S&P 500 rallied by more than 3%. The WSJ January 5 headline proclaimed ‘Jobs Data,
Fed Shift Boost Market’ in explaining why the stock market rallied so much. Did the Powell and the Fed
really shift policy? You be the judge.
During a January 4 panel discussion with former Fed Chairs Janet Yellen and Ben Bernanke, Powell said,
“As always, there is no preset path for policy,” The Fed is "always prepared to shift the stance of policy
and to shift it significantly" in order to achieve its dual mandate of full employment and stable prices. He
cited 2016 as a recent example. In that year, the FOMC had indicated four rate hikes were likely but
ended up only approving one as financial conditions tightened particularly amid geopolitical concerns.
“No one knows whether this year will be like 2016. But what I do know is that we will be prepared to
adjust policy quickly and flexibly.”
After Powell’s panel discussion on January 4, Richard Fisher, former president of the Federal Reserve of
Dallas was interviewed on CNBC. Fisher stated that he knows Powell well after serving with him on the
FOMC starting in June 2012 and that Powell has always advocated a flexible monetary policy so his
comments are nothing new. Fisher said he wouldn’t describe Powell as a Dove or Hawk but as a Wise
Owl. Fisher reviewed Powell’s back ground and noted he is not an economist and understands capital3
markets far more than the markets are giving him credit. Fisher said, “I didn’t see anything new in what
he said. I hope you understand that he knows how markets work. He is much more market sensitive than
either Ben Bernanke or Janet Yellen who came from an academic back ground. This is Much Ado about
Nothing as far as I’m concerned. The markets are so hooked on accommodative monetary policy it is
very difficult to withdraw. We’re going through this volatile withdrawal issue as anyone who is overly
induced by alcohol or opiods. Now the course is changing. It is just going to lead to further volatility and
some pain and I don’t see that changing.” The full interview can be watched with this link and Fisher’s
segment begins at 1:40. Fisher is always articulate, thoughtful, and the consummate gentleman.
www.cnbc.com/video/2019/01/04/jay-powell-understands-markets-better-than-hispredecessors-says-former-dallas-fed-president.html?&qsearchterm=richard%20fisher
The markets incorrectly concluded that the Fed would increase rates
aggressively in 2019 and have not only concluded that there will be
no increases in 2019 but are now betting the Fed will be forced to
lower rates in 2019. Maybe too many people are listening to
Cramer! I thought professional investors misjudged the Fed on
December 19 and are likely making the opposite mistake on January
4. The economy is not as weak as most investors assume and could
very well begin to strengthen by mid-year with core inflation
grinding higher. If this is the path, the markets will be discussing Fed
rate hikes rather than cuts sooner than they currently expect.
Stocks
The overall outlook has not changed despite the perception that the Fed has changed course or by the
strong employment report. As noted previously, the 21 day Net percent of Advancing stocks minus
Declining stocks closed at -29.1 on December 24 (orange horizontal line), one of the lowest readings
since the 1987 crash, 1998 Long Term Capital Management selloff, September 2001 after 9/11, July
2002, financial crisis in 2008, and downgrade of U.S. Treasury debt in 2011. In each case the S&P 500
experienced a rally and then a subsequent decline to a lower low that recorded a less oversold reading
on the 21 day Net percent of Advancing stocks minus Declining stocks.
As of the close on January 7, the 21 day Net percent of Advancing stocks minus Declining stocks has
approached the overbought level (red horizontal line) after being deeply oversold on December 24.
Based on this indicator the market has lost an important prop – the extreme oversold condition that
existed on December 24. This led me to forecast a nice rally in the S&P 500 in the December 24 WTR.
“Once wave 3 completes, wave 4 could lift the S&P 500 150 – 200 points as wave 2 allowed the S&P 500
to rally from 2603 to 2815.” From its low of 2347 on December 26, the S&P 500 has rallied 219 points to
an intra-day high of 2566 on January 7.
The pattern of the rally is instructive. From the initial low of 2347, the S&P 500 jumped in two days to
2508 on December 28, before chopping sideways for 4 days. The S&P 500 dipped to 2444 on January 3
and rose strongly on January 4 after the strong employment report and the perception that the Fed had4
softened it approach to monetary policy. It should be noted that the rally actually began overnight after
China’s central bank cut the Reserve Ratio for Chinese banks by a full 1.0%. One of the markets concerns
has been the slowing in the global economy and a weak ISM report from China on January 2 added to
the gloom. With the Peoples Bank of China becoming more accommodative the Chinese and global
economy should stabilize in coming months and firm up as discussed in the January Macro Tides.
The rally from 2347 to 2508 could be wave a in a counter trend rally with the low at 2444 representing
wave b. If wave c is equal to wave a, the S&P could reach 2605. Markets often rebound to what I call
“The scene of the crime”. A test of 2600 would be classic since that is where the S&P 500 broke down
from signaling that a deeper correction was developing. The expectation that the S&P 500 would break
its support at 2600 was described in the December 10 WTR. “The S&P 500 traded under 2600 on
December 10 which suggests the support at 2600 has been eroded with each successive test. The next
time 2600 is tested a clean break below is likely to follow with a subsequent test of the February low of
2532.” The S&P 500 closed below 2600 on Friday December 14 and tested 2532 on the next trading day.
Once wave 4 has completed the S&P 500 is expected to at least test and probably fall below 2347. Wave
1 carried the S&P 500 down from 2940 to 2630 for a decline of 337 points. If wave 4 in the S&P 500 tops
at 2580 and wave 5 is equal to wave 1, the S&P 500 would fall to 2243. This is an interesting number
since the 61.8% retracement of the rally from 1810 in February 2016 to 2940 is 2242.
In the January 2019 issue of Macro Tides, I discussed why a recession is unlikely in 2019. The December
2018 employment report was quite strong with more than 300,000 jobs and wage growth of 3.2%.
Although this will mark the highest job growth for many months, it is also not the kind of labor market
strength that appears just before the onset of a recession. As forecast in the January Macro Tides, the
ISM manufacturing number for December was weak dropping from 59.3 to 54.1. Lower numbers are
likely in coming months as manufacturing responds to the drop in oil prices and a decline in drilling
activity. Healthy wage growth and the mini-tax cut from the decline in gas prices should be enough to5
hold growth near or above 2.0% in Q1. The recent 20% intra-day drop in the S&P 500 is similar to those
experienced in 1987, 1998, and 2011. In those prior declines the S&P 500 fell by 20.0% or more but the
economy did not enter a recession. These prior declines reinforce that it is possible for the S&P 500 to
suffer a meaningful decline without a recession. Importantly, the initial wave 3 decline was followed by
at least a retest of the initial low before a sustained rally took hold.
Nov ember December 1987 February March April May June July August September October Nov ember December 1988 February March April May June July August September October Nov ember December 1989

S&P 500 INDEX (2,498.94, 2,509.24, 2,482.82, 2,492.34, +6.60010)6
I can only guess what the news back ground may be that generates another selling wave. In all likelihood
it will be a combination of things. Based on the three prior instances, the odds certainly favor another
decline in the S&P 500 below 2347 before a more significant and protracted rally begins.
Last week I provided the following instructions. “At the open on January 2 establish a 33% short
position by purchasing the 1 to 1 inverse S&P 500 ETF SH as long as the S&P 500 is above 2470 and
increase it to 66% if the S&P 500 trades above 2520. Cover half of the position if the S&P 500 drops
below 2347.”
Overnight on December 31 the Caixin PMI for China was released and showed that manufacturing had
contracted in China in December with the PMI dropping to 49.7.
Chinese manufacturing had an even worse December than expected, more data show
 The Caixin/Markit Manufacturing Purchasing Managers' index (PMI), a private survey, fell to 49.7 in
December from 50.2 in November.
The Caixin / Markit data closely follows the ‘Official’ Chinese
manufacturing data. In the wee hours of January 2, China’s
“Official’ Manufacturing PMI was announced and it too fell
below 50.0 at 49.4. It was thus a surprise on the morning of
January 2 that the S&P 500 futures were down by more than
35 points on news that China’s manufacturing data showed a
contraction. The S&P 500 subsequently opened just above
2470 after closing at 2506 on December 31. After the gap
down the S&P 500 spent the rest of day in rally mode and
reached an intra-day high of 2519.49. The S&P 500 pushed
above 2520 on Friday January 4. The S&P 500 1 to 1 inverse
ETF traded at $31.80 on January 2 and was $31.16 when the S&P 500 exceeded 2520 on January 4.
Increase the position in SH to 100% of the S&P 500 trades above 2575.7
Dollar
As noted in the December 24 WTR, the Dollar confirmed that a top has formed after closing below 96.40
and the rising uptrend line. The expectation is that the Dollar Index can fall to 94.00 in coming months.
On January 7 the Dollar closed below 96.00 for the first time since October 23 providing additional
confirmation that a top is in place.
Treasury Yields
In the December 24 WTR I wrote “If the S&P 500 plunges below 2400, the 10-year yield could drop below
2.74% before reversing higher.” The S&P 500 fell below 2400 on December 24 and the 10-year yield
closed at 2.749%. However, I did not expect the 10-year yield to fall below March low of 2.719%. After a
weak close in the S&P 500 on January 3 (down more than 2%), the 10-year yield plunged to 2.554%. I
think the next big move in Treasury yields is up. But if the S&P 500 does test its low of 2347, it seems
prudent to wait before shorting Treasury bonds since yields may fall to test their January 3 low.
Unfortunately, the positioning data in Treasury futures is not available due to the government
shutdown. The Commitment of Traders (COT) report is released by the CFTC which is a government
agency. So the positioning data for Treasury Bonds, Dollar, Gold, S&P 500, VIX, and Oil has not been
available. There was a huge short position in Treasury futures and the recent rally in bond prices has definitely run over those short and contributed to the decline in Treasury yields.

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C L