Inflationary Pressures Are Persistent

On November 8, 2010, our composite indicator that looks at the trends in gold, crude oil and yields on the 10 year Treasury registered  an extreme value.  At that time, I wrote: "A strategy that combines this "fundamental" filter with the 40 week moving average has given a sell signal."  With rising Treasury yields and persistence in the trends in gold and crude oil, the composite indicator remains in the extreme zone.  This is not the time to buy equities.  For those keeping a scorecard at home and for those who are buying the bullish nonsense, the SP500 has gained about 1% over the last 5 weeks.

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The Will Robinson Signal

With investors extremely bullish and company insiders extremely bearish and with the indicator constructed from the trends in gold, crude oil and yields on the 10 year Treasury flashing extremes, I am once again reminded of the robot from the hit 1960's TV show, "Lost In Space".  When the boyish Will Robinson was in peril, the robot would fling his arms up and down and announce in robot voice: "Danger,Will Robinson, danger!"  Historically, these set of market conditions should not be ignored.  If the market hasn't topped out already, it should do so within a couple of percent of the recent highs.  Rallies should be sold and stops tightened up.  The market is prone to sudden sell offs.  There will be better risk adjusted opportunities to buy in the future.

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Inflationary Pressures Heating Up

Although the Federal Reserve would like us to believe that inflation remains low, the markets say otherwise.  As of Friday, our composite indicator that looks at the trends in gold, crude oil and yields on the 10 year Treasury is at an extreme value.  See figure 1 a weekly chart of the S&P500.  

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Ooops! A Mis- Fire (Correction!)

Our indicator that is constructed from the trends in crude oil, gold, and yields on the 10 year Treasury did NOT make it into the extreme zone last week.  This was due to some end of the week weakness in crude oil and Treasury yields.  Therefore, the strategy that combines the 40 week moving average with this filter did NOT yield a sell signal.  The indicator is shown below.

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Update On Two Trading Models

This is an update on two trading models that I follow.  Both have provided "buy signals" for the S&P500 within the last couple of weeks.

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An Obvious and Important Divergence

As you know, equities have been on a tear in September, and in this market environment, we also know most assets are highly correlated and tend to move together.  At times, it seems like there are only two trades.  There is the "risk on" trade as represented by equities and commodities, and there is the "risk off" trade when bonds outperform.  This is nothing new and something that has been present for a long while.

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Is It Time To Short The S&P500?

A real headwind for the markets -now and in the past - has been when the trends of gold, crude oil, and yields on the 10 year Treasury are strong and rising.

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Trends In Gold, 10 Year Treasury Yields, And Crude Oil Remain Extreme

Our composite indicator that assesses the strength in the trends of gold, 10 year Treasury yields, and crude oil will remain in the extreme zone by the end of the week. This represents a headwind for equities.

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Like Minds...I Hope!

There are several commentators on the web that I read consistently, and John Hussman of Hussman Funds is one of them. I always take great comfort when my analysis rhymes with his because like myself I know he does his homework too.

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"Danger, Danger Will Robinson"

I feel like the robot in the television show, "Lost In Space". Investor sentiment remains bullish and trends in gold, crude oil, and yields on the 10 year Treasury bond are collectively becoming extreme as well. This combination has me thinking: "Danger, Danger Will Robinson".

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Trends In Gold, 10 Year Treasury Yields, And Crude Oil

Over the past year, I have most often discussed the composite indicator constructed from the trends in gold, crude oil, and yields on the 10 year Treasury in the context of high readings. Collectively, when these trends are strong and rising, stocks tend to under perform. This has been the case over the past 25 years and over the past 10 months during this epic bull run. But what happens to equities when this indicator registers a low reading - as in the trends in gold, crude oil, and yields on the 10 year Treasury are weak and falling?

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Inflation Pressures Moderating

The composite indicator that measures the trends in gold, crude oil, and yields on the 10 year Treasury has moderated and will end the week below the extreme zone. End of the week weakness in crude oil, gold and Treasury yields has caused the indicator to back off.

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Inflation Pressures Heating Up, Again!

The composite indicator that measures the trends in gold, crude oil, and yields on the 10 year Treasury will end the week in the extreme zone, and this should be a headwind for equities. Inflation pressures, whether real or perceived, are heating up. See figure 1 a weekly chart of the S&P500 with the indicator in the lower panel.

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The Next Big Thing

Let's talk shop.

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Headwinds Abate Slightly

Last week the price of crude oil lost almost 10% pushing our composite indicator that is constructed from the trends in gold, crude oil and yields on the 10 year Treasury back below the extreme line. See figure 1 a weekly chart of the S&P500 with the indicator in the lower panel.

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Oil ETF: Oversold

What seemed like a timely "call" back on October 8, 2009 "that crude oil could move significantly higher over the next couple of months" has kind of turned into a dud. Two weeks after this initial post, the United States Oil Fund (symbol: USO), the ETF that tracks crude oil futures, moved 14% higher. Since that time, USO and crude oil, have slowly given back all of those gains. From penthouse to the dog house.

So what gives?

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Inflation Pressures Moderating

The composite indicator that measures the trends in gold, crude oil, and yields on the 10 year Treasury has moderated significantly. See figure 1 a weekly chart of the S&P500 with the indicator in the lower panel.

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A Third Reason To Own Crude Oil

We had two reasons to own crude oil, and now we can add a third.

Figure 1 is a weekly chart of a West Texas Crude Oil (cash data). The indicator in the middle panel measures crude oil's 52 week performance relative to a basket of 8 currencies.Those currencies are: 1) Australian Dollar; 2) Canadian Dollar; 3) Swiss Franc; 4) Eurodollar; 5) British Pound; 6) Singaporean Dollar; 7) Japanese Yen; 8) US Dollar. Priced in these currencies, crude oil is out performing, and it is far from extreme.

Figure 1. Gold v. Currencies v. Sentiment

The data in the lower panel comes from the Market Vane Corporation, which publishes the Bullish Consensus. The current value is 44 meaning that only 44% of advisers are bullish on crude oil; peaks occur when the value is above 80%. When I last showed this data, the value was 39% when crude oil was 10% lower.

Modified Faber Model: Some Insight

As the prior post shows, we can improve a simple moving average strategy by going to cash when the trends in gold, crude oil, and yields on the 10 year Treasury are strong.

But for fun and education, let's pretend that the only time you are in the market is when the S&P500 is above its simple 10 month moving average and when our composite indicator that measures the trends in gold, crude oil, and yields on the 10 year Treasury is above the upper extreme line. This would represent the current market situation. See figure 1.

Figure 1. S&P500/ monthly

Going back to 1987, there have been 17 such occurrences. 11 were profitable. Your time in the market was about 15%. Such a strategy did not make money, and yielded the following equity curve. See figure 2. Clearly, this is not a favorable investing environment.

Figure 2. Equity Curve

Now let's look at the maximum favorable excursion graph or MFE. MFE measures how far a trade moves in your favor after you put it on and before it is closed out. See figure 3 for the strategy's MFE graph.

Figure 3. Strategy MFE

Look at the caret within the blue box. This represents one trade. This trade had an MFE or gain of 5% (x axis) before being closed out for a 0.5% winner (y axis). We know it was a winning trade because it is green caret. Of the 17 trades, 5 had MFE's greater than 4%; this is to the right of the blue vertical line. Only 4 of the trades had final gains of greater than 3%; this is above the red horizontal line. 3 of the trades (in the upper left corner of the graph, oval) had losses greater than 6%.

My interpretation of all this data is that this is not a particularly dynamic time to be investing. There appears to be a greater chance of losing money than winning. If a trade had an MFE greater than 3% it was likely to be profitable.

Overall, I still stand by the original assertion that stocks tended to under perform during times when the trends in gold, commodities, and yields on the 10 year Treasury bond are strong.

How Do You Get There From Here?

One our readers in the comment section of the blog suggested that I had a nice "call" on oil. Compliments are always great, but in the markets, sometimes, I think it is better to be lucky than good. No matter how much we back test or think we have an edge, the next hand could be a losing one. To make that good "call", a lot of effort has gone into understanding what works and what doesn't, and this is what I try to convey in my writing. However, I still cannot help myself and think that some degree of luck was involved. I guess it is the nature of this trader's mind to remain grounded.

But let's get real for a second and suggest that I have only made half a "call". I have said nothing about when to sell. We all know that tomorrow morning we could wake up and find crude oil down 10%. And then my good "call" becomes a bad "call".

One thing I learned early on in the stock market analysis game was that a "call" should have 4 components to it: 1) the entry; 2) the exit; 3) how much draw down one should tolerate to achieve their goal; and 4) how long it may take to achieve that goal. After doing this in a very public way for over 5 years, I am still amazed at how few analysts and pundits include these factors in their market "calls". I am even guilty of this at times.

People who write about the markets can do better. Period. Oddly, our readers don't demand they do so.

What piques my interest are markets or assets that have the potential for a significant, sustainable rally. These are the kinds of rallies that last months and generally have the secular winds at their backs. (As a side note and for another discussion at some other time, it seems that these kind of price moves are compressed into shorter and shorter time frames.) I have found that strategies -such as day trading or swing trading - that require me to thread the needle (i.e., buy exactly at the open or on the close) are difficult to execute.

I am always asking myself "how do I get there from here?". If I can find an asset or market that has those secular winds and isn't too loved by the investing masses, then all the better. These are the things that go into making a good "call". This is the way to make money.

Let's take the current equity rally. It has come an awful long way in a short time period, and there are a lot of folks invested at this point. This is not my cup of tea, and I am involved in a limited way. On the other hand, crude oil has been consolidating its gains for 4 months; it appears to have those technical, secular tailwinds that I favor; and it isn't loved by investors as sentiment towards crude oil is moderately bearish.

So I ask: How will I get there from here? What is the best way for me to make money at this point? Which hand do I want to play? Crude oil over US equities of course. It may not turn out to be right this time, but over time, it should. If I stay true to my style, things should work out.

This is a bit of a long way for me to get to two contrasting charts. Figure 1 is a daily chart of the S&P Depository Receipts (symbol: SPY). Figure 2 is a daily chart of the United States Oil Fund (symbol: USO). Volume is in the middle panel and the on balance volume indicator (with a 40 day moving average) is in the lower panel.

Figure 1. SPY/ daily

Figure 2. USO/ daily

Now this is just good old fashioned technical analysis. Looking at the SPY chart, the first thing to notice is all the red volume bars (in the middle panel) over the past month. Clearly, the volume on down days is much more significant then the volume on up days. The on balance volume indicator is below its 40 day moving average while price is probing new highs. This is distribution.

In contrast, the USO shows increasing or above average volume on up days. The on balance volume indicator is making new highs along with price. This is solid accumulation.

So once again I ask: how do we get there from here? Looking at these charts, I think USO has a greater probability of doing that for me than SPY.

Lastly, figure 3 is a weekly chart of the USO. The move from the low in February, 2009 to the high in June measures approximately 17 USO points. Adding this to the low of the current base at 31 gives a measured move of 48. Therefore, from a good old fashion TA perspective, USO has a chance of trading to $48.

Figure 3. USO/ weekly

Ok, I will take $50. This is a good round number that I like. This would make a very good "call" indeed.