Thursday, October 28, 2010

Yields Are Rising, Equities to Face Headwinds

Several weeks ago, I outlined my road map for the next couple of weeks, and this centered around rising Treasury yields.  So far this "call" is looking good as yields on the long bond are starting to show some life after 4 months of being crushed.  Rising yields at the long end of the curve just may be a response to QE2 and the perceived inflationary effects or it just may be the result of a smaller than expected asset purchase program.  In any case, we have rising yields and strong trends in crude oil and gold, and it is this combination of factors that is likely to act as a head wind for equities.

Figure 2 is a weekly chart of the S&P500, and the indicator below is a composite indicator that assesses the strength of the trends in gold, crude oil and yields on the 10 year Treasury.  In all likelihood, this indicator is going to end the week at or above the high inflation line, and this should be a headwind for equities.

Figure 2. S&P500/ weekly

I have developed a trading model utilizing the 40 week moving average and this indicator as a "fundamental" filter that easily beats buy and hold and a simple moving average model.  I have discussed this model at great length in the following articles:

In all likelihood, this trading model will give a sell signal at the end of this week.


Denali92 said...

I am COMPLETELY with you on this trade - Shorting the NOTE contract has now become a major focus.

I have been following your thoughts on the Treasuries for some time and decided October 8th was the date and it has worked very well.

A Headwind is spot on - Real Estate and Utilities are now both underperforming with the rise in yields.

THANKS for a GREAT blog!


Jim said...

Thanks for the heads up, Guy.

In Part 2 of earlier articles explaining the development of the model, you didn't mention the details of how the trends are quantified.

Although gold has been in a persistent uptrend for months, crude oil and T-note yields have only turned up in the past few weeks.

Judging by the rising value of the three-component combined indicator, I infer that the lookback periods are fairly short term ... in the range of 1 to 3 months. And that the high reading is dominated by gold, although this week's yield rise is probably the factor about to push the indicator over the 'sell' line.

The recent pop in T-note yields is contrary to the Fed's alleged intention of driving yields lower. Considering how poorly their previous Treasury purchases announced in March 2009 turned out (yields dropped a half percentage point on the announcement day, but were actually higher 6 weeks later), I'm surprised anyone expected this time to be different.

Your model confirms the traditional trading wisdom: buy the rumor, sell the news. Although you didn't cite the detailed performance stats, it appears that your model achieves an admirably high Sharpe ratio. May this next trade be an outlier!