Major Moves 

Many people think the economic data you read about in the financial press is gathered, compiled, and reported without any modification. This is definitely not the case: most economic data is heavily adjusted to account for issues that the entities reporting the data believe would make it too volatile to understand the important trends.  

For example, jobs data is adjusted for seasonality. Hiring in the summer and prior to the Christmas holiday is very high, so it is adjusted lower, while the annual firing cycles in the fall and in January result in an upward revision in hiring. However, because adjustments are themselves estimates, they are often very wrong, which leads to revisions and surprising swings from one month to the next.

An adjusted, and very disappointing, Empire Manufacturing Report from the New York Fed was released this morning. The Empire report is a sentiment survey that looks at manufacturing activity in the Northeast United States. This month, it experienced its largest single-month drop into negative territory since the index was created.

As bad as the data looks, it must be tempered with a huge positive surprise last month. As I have mentioned several times in the Chart Advisor, the process of adding statistical adjustments often leads to over-corrections after a surprisingly positive or negative report. This doesn't make for very exciting headlines, so the financial press generally ignores that context in favor of broadcasting the alarming isolated numbers.

This is one of those tricky areas where investors must fight our inherent bias toward seeing everything in black and white terms and consider some of the nuance behind the data. Just because swings like we saw today are normal after a huge positive surprise last month doesn't mean that the data is totally wrong (therefore bullish) or completely correct on its face.

The truth in the data is somewhere in the middle, which is basically an essential tenet of technical analysis. Technicians try to determine when the market is overbought or oversold in order to reduce risk and take advantage of value, and the same principle applies here as well.

A strategy that I use to evaluate data like this is to apply a moving average of at least two months so I can see the trend without being distracted by the "adjustments" that can create volatility. As you can see in the following chart, the red dots (representing a two-period moving average) show a decline in sentiment since last year, but I think it portrays a more accurate view of what is happening.

Although I have argued that the news is probably not as "bad" as it looks on the surface, I think it still indicates increasing weakness in the manufacturing sector. From a relative performance perspective, that shifts my bias a bit negatively against manufacturers in the short term.

Empire Manufacturing Sentiment

S&P 500

As I said last week, without some kind of external shock, the S&P 500 will probably remain relatively flat while investors wait for the Fed's FOMC announcement on Wednesday. It's common for the market to run up until a week or so before the FOMC report and then flatten out while traders prepare for the data to be released.

From a technical perspective, I still see some strong potential for support in the 2,820 range around the neckline of the previous head and shoulders pattern if the index declines after the Fed. I don't see much short-term upside that would take prices beyond the prior highs after the Fed announcement, as so much has already been priced in. At this point, I expect the major index to oscillate between support and resistance until second quarter earnings season takes off in mid-July.

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Performance of the S&P 500 Index

Risk Indicators – A Negative Trend in the 'Dot Plot'

Speaking of the Fed, this will be a very interesting report for investors, like me, who have been watching monetary policy since before the financial crisis. This is one of the FOMC meetings when the Fed will be releasing its economic projections and the "dot plot" that breaks down each participant's estimates.

This is a new innovation that was introduced by Chairman Bernanke after the financial crisis, so the only dot plots traders have ever seen indicated rising interest rates and economic growth. This will be the first report that will show future rate cuts and potentially negative economic growth expectations.

We don't know how the market will react to a statement in black and white that the Fed expects the economy to contract – or will need monetary stimulus to head off recession. Will traders see this as a lack of confidence by the Fed, or do investors already know what to expect and will shrug off any negative trendlines?

One of the sectors that has a very strong relationship with the Fed's expectations is housing, which is already at a key inflection point. As you can see in the following chart of the SPDR Homebuilder ETF (XHB), the sector is at its long-term highs, where any missteps in the Fed's communications could send the group lower.

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Performance of the SPDR S&P Homebuilders ETF (XHB)

Bottom Line - Expect Volatility After Wednesday

The market is still in wait-and-see mode where traders are willing to ignore concerns about trade, falling energy prices, and geopolitical tensions with Iran while they wait for the Fed. Often, this kind of pause leads to wider swings once the release has been made. In my view, that means risk is likely to be elevated toward the end of the week.

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