Friday, February 18, 2011

This Isn't Trivial

One of the strategies that I have frequently written about for the SP500 involves the 40 week moving average and the composite indicator constructed from the trends in crude oil, gold, and yields on the 10 year Treasury.  When these trends are strong and rising, the SP500 faces stiff headwinds.  This is data going back to 1984 and includes the 1990's as well.  In essence, using this indicator as a filter for a SP500 simple moving average strategy can increase returns by about 25% while reducing maximum draw down by 50% over buy and hold.  In other words, just stay out of the market or hedge yourself when the collective trends of gold, crude oil, and yields on the 10 year Treasury are strong and rising.

To review the strategy and its development, please click on these links:

The original indicator or filter uses the trends in crude oil, gold, and the yield on the 10 year Treasury.  However, crude oil -specifically West Texas Intermediate crude oil - has been lagging not only Brent oil but the entire commodity complex.  Figure 1 shows a weekly chart of the CRB index (upper panel) with WTI in the lower panel.  Since July, 2010, the CRB has gone parabolic while WTI has traded in a very tight range.

Figure 1. CRB v. WTI

So here is the question: what happens if we substitute the CRB index for crude oil in our derivation of the composite indicator?  After all, this seems to make sense as the index not only captures WTI already but the entire commodity complex.  Furthermore, we can take the back testing process all the way back to 1973.  As it turns out, the indicator performs exactly in line as the original.  In other words, the historical results from 1973 to 1984 are similar to those results seen from 1984 to the present.  Using the CRB index to replace for crude oil yields the same results.

This is the part that isn't trivial: with the CRB index rising and yield pressures still persistent and with gold catching a bid this week, the new indicator will likely end the week back in the extreme zone.  This represents a sell signal for my trend following SP500 methodology.  I will note that the previous sell signal was on November 5, 2010, and the SP500 rose about 4% over that time period until the next buy signal, which was on January 28, 2011.  This current buy signal will likely gain close to 5% for the SP500.

In summary, the CRB index will replace crude oil in the construction of our composite indicator.  Unless otherwise noted, our indicator that is now constructed from the trends in the CRB index, gold, and yields on the 10 year Treasury is likely to end the week in the extreme zone.  And dare I say -even in the great bull run of 2010/ 2011- this is a headwind for higher equity prices.


s said...

Thanks for the update on this indicator and how the signal works.

Do you have a single page that shows a weekly update of this indicator and it's current signal?

Toptick said...

Great stuff. Thanks!