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A Big Bag of Bad News

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In the most recent video update, I cited the prospect of yield curve inversion as one of the culprits behind stock market volatility; hence the focus this week will be solely on the Fed decision. 

Is a fourth rate hike in the cards for 2018? This much-anticipated Fed meeting is more important than any other in recent memory because the most followed Treasury yield curve is on the verge of inverting (going negative). This yield curve is simply the difference between the yields of the two most-followed Treasury notes, namely, the 10-year and the 2-year. 

Referring to the chart below, the yield curve is currently hovering around 0.16. Flat, but not inverted yet. What would it take to bring about inversion? You got it: a rate hike. (Click here to open the actual chart in your browser). You see, a rate hike would push the yield of the shorter-maturity 2-year note higher than that of the 10-year; hence it could be just the drop needed to spill the glass.  

(Click the chart images below to enlarge. Press ESC to close)

Now, to get an idea of how the series of rate hikes, starting in December 2015, have impacted Treasury yields, look no further than the chart below and notice how competitive the 2-year has suddenly become relative to the 10-year. The convergence rate began to increase dramatically in late 2017, which explains the stock market jitters during December 2017, and then later in February/March 2018. Chart wise, the yield curve will invert when the green line finally crosses over the blue line. Unsurprisingly, the 2018 rally to new highs turned out to be a sucker rally.

    

Who's really flocking to the safety of the bond market? Is it just investors? Is the bond market crowded? How much 'rate hiking' is already priced in? Valuable insights can be gleaned from this October 2018 Marketwatch article.

What are the odds of a December rate hike? Quite high. according to El-Arian who believes the Fed will have to go through with another rate hike or risk appearing politically influenced.

THE MARKET TOP

In recent weeks, I have been on the lookout for the completion of the right shoulder of a massive Head and Shoulders top in the S&P 500. My initial view advocated a right shoulder that would rise to the same level as the left shoulder, namely, the January 2018 high of  ~2872 (CASH) and ~2878 (FUTURES). But the recent price developments, which I'll articulate further down, have led me to conclude that the right shoulder is probably already in place. In fact, I'm now of the opinion that the chart sports two right and two left shoulders, making this particular Head-and-Shoulders top a 'complex' one. (Refer to Bulkowski's Complex Head and Shoulders guidelines).

Pattern Symmetry

While outlining the shape of an early-stage Head and Shoulders formation, chartists often sketch a prospective right shoulder that's equal in height to the left one and is nearly the same distance from the head (equidistant). That's all fun and games in theory. In practice, however, a Head and Shoulders comes in more than just one variety. In addition to being 'complex', this particular Head and Shoulders also sports a pair of right shoulders that are much closer to the head compared to the left shoulders. In short, the pattern looks ugly, leading a chartist to believe the right shoulder is nowhere near complete. 

But what does Tom Bulkowski have to say about the 'ugly' ones? "The more unsymmetrical a head-and-shoulders top appears, the better it performs. I like to think of this as ugly patterns work best, but it varies from pattern to pattern". (http://thepatternsite.com/HSTExplained.html)

 

Odds of Right-Shoulder Completion

 Here's why it's highly likely that the right-shoulder section of the pattern is already in place. Referring to the chart below, the 5-wave decline outlined in yellow developed on the heels of the Elliott Flat (a-b-c) indicated in the above chart. In the context of what's happening here, this 5-wave decline is likely the beginning of the next bear market phase because 5-wave patterns, according to the Elliott Wave rules and guidelines, aren't one-offs; they are the beginning of a trend reversal or the continuation of an already-established trend.  

 

Downside Objective

The measured rule (or measure move guideline) for the Head and Shoulders pattern is depicted by the red arrow in the chart below. It's indicating a rough estimate of 2,265 (FUTURES). But the measured rule, as I recall Bulkowski once telling me, "...is really an artificial guideline".

Elliott Wave

Generally, I would look for a meaningful support level to be reached before even considering testing the waters.  Luckily, there's more evidence in support of the downside objective indicated by the Head and Shoulders in the above chart. Referring to the Elliott Wave sequence in the chart below, wave 2 achieved a 42% retracement relative to wave 1, thus requiring no more than a 38.2% retracement by wave 4 relative to wave 3, That's somewhere in the vicinity of the 2227-2238 zone. (The sum of the two retracements is typically 80 to 120 per the Harmonic Elliott Wave guidelines.)    

Volume Profile

More supporting evidence is on hand in the form of the yearly volume profile chart below, in which the Head and Shoulders' measured move is in line with last year's VAL (value Area Low).

CONCLUSION

There appears to be a 'reset' in the works, a winding back of the clock to the price levels of January 2017 when a newly elected U.S. President took office. This begs the question: what chain of events are poised to cause the market to roll back two years' worth of gains? We know the market has been fixated on the yield curve and its imminent inversion, and we also know that for the last several decades, yield curve inversion has consistently been a foreboding sign of a forthcoming recession. Given the stellar economic data currently on hand, what is bound to bring about a recession?

After all, what's a bear market but a big bag of bad news?

 

Trade vigilantly,

Peter Ghostine (@peterghostine)


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