Airline Sector (Follow Up)

The Wall Street Journal had a recent article on the airline sector entitled, "Airlines Predict More Trouble, Broaden Cuts". The airline sector is one of the sectors that I had highlighted back in April as possibly being one of the next bull market leaders - of course, when and if we get that new bull market.

See figure 1 a monthly chart of the AMEX Airline Index (symbol: $XAL.X) with the "next big thing" indicator in the lower panel.

Figure 1. $XAL.X/ monthly

Some of the positive techical factors are:

1) the "next big thing" indicator is in the zone where there is a high likelihood of a secular trend change

2) the close below and then above the pivot at 16.08 is bullish

3) a close above the down sloping trend line is bullish

Negative technical considerations include:

1) a monthly close below 16.08 is bearish

2) prices have yet to close above the simple 10 month moving average

Upside resistance for the airline sector index is at 28.62, which are the lows from the prior bear market which ended in February, 2003.

While the technical picture remains positive (as long as prices remain above 16.08), the fundamental picture, as explained in the article, appears to be afflicted by those factors affecting the economy at large.

"Slumping demand for travel" is consumer retrenchment. "Higher fuel prices" are a tax on all of us and cut into profit margins. "Massive cuts over the past year to industry capacity" is emblematic of the lowered standard of living that Americans are now experiencing.

AMR's chairman and chief executive, Gerard Arpey, stated that today's airline industry wasn't "built for an environment of negative global economic growth and nonfunctioning capital markets." But then again what business or part of our economy was built to withstand this severe economic downturn? Overcapacity and over leveraged are found in all aspects of our economy. Too many malls, too many homes, too many cars, too many airline seats, and too much debt.

Gary Kelly, chairman and CEO of Southwest Airlines, summarizes the fundamental picture: "It's a very difficult time. Earnings are going to be severely stressed until the economy changes."

While we don't need to pit fundamentals versus technicals, the technical picture appears more bullish. Clearly this is one important sector worth watching.

How Will We Know The Secular Trend Change In 10 Year Treasury Yields Is For Real?

I am on record stating that yields on the 10 year Treasury bond will move higher over the next 12 months, and this will represent a secular trend change.

Figure 1 is a monthly chart of the yield on the 10 year Treasury bond (symbol: $TNX.X), and a monthly close above the prior pivot low at 3.432% yield provided the technical confirmation that yields are likely undergoing a secular trend change. In other words, the very long term trend has changed from down to up.

Figure 1. $TNX.X/ monthly

Of course, nothing grows to the sky especially if it is not in the government's best interest, so the pullback has occurred right on schedule.

So how do I know if this pullback will be "the pause that refreshes" or the start of a new down trend that will push yields back to the lows seen in December, 2008? The short answer is: I don't know, but let me put forth some clues or as I like to call them, technical sign posts that will guide our way.

First, a monthly close below our new support level of a yield of 3.432% would suggest that we will not be seeing higher yields over time, and this would basically kill my thesis that yields are undergoing a secular trend change.

Now let's look at a weekly chart of the yield on the 10 year Treasury bond. See figure 2. The pink markers over the price bars - if you squint at the graph long enough you will see them - represent negative divergence bars between a momentum oscillator that measures price and price itself. Negative divergences typically indicate slowing upside momentum with the highs and lows of the negative divergence bar acting as levels of resistance and support respectively. In other words, look for yields to remain within the range of the highs and lows of the negative divergence bar.

Figure 2. $TNX.X/ weekly (1985 to present)

The indicator in the lower panel of figure 2 actually counts the number of negative divergence bars occurring over a 13 week look back period. What we see from the indicator is that there have been 3 negative divergence bars over the past 13 weeks, and this is noted when the indicator moves above the pink horizontal line. As we can see from the chart which goes back to 1985, 3 negative divergence bars over a 13 week period for the most part marked a high in yields that led to new secular lows. This is the strength of a 25 year bull market in bonds.

Now look at figure 3, a weekly chart of the yield on the 10 year Treasury bond capturing the period from 1962 to 1987; the two occurrences of multiple negative divergence bars actually led to a period of consolidation in yields and led to much higher yields once yields broke above the negative divergence bars. This is the strength of a 20 year bear market in bonds.

Figure 3. $TNX.X/ weekly (1962 to 1987)

So what is our conclusion? If this is going to be a secular bear market for bonds (i.e., higher yields), then two things need to happen: 1) the current multiple negative divergences will lead to a period of consolidation; 2) yields must remain above support at 3.432% on a monthly closing basis.

Investor Sentiment: You Have To Believe

Investor sentiment continues on the same path as the two previous weeks as the "Dumb Money" indicator is moving to new bullish extremes. Typically, this is a bearish signal.

The "Dumb Money" indicator is shown in figure 1. The "Dumb Money" indicator looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money"/ weekly

Going back to early March, 2009, the "optimal" time to buy into the market was when the S&P500 closed at 756.55 on March 13, 2009. The "optimal" time to sell was at the close April 17, 2009 with the S&P500 at 869.60. This represents a gain of 15% gain over 5 weeks or 3% per week. This is annualized to a 156% gain, and this is what one would expect at the bottom of the price cycle when the trend changes from down to up. We get an acceleration of prices higher.

From our "optimal" sell signal to this past Friday's close, the S&P500 has gained 9% over 8 weeks or 1.13% per week. This is annualized to a 59% gain, which isn't too shabby but certainly less than the move from the "optimal" buy to the "optimal" sell signal. As an aside, "optimal" doesn't mean best. "Optimal" assumes all occurrences over the length of the observable data. Could the "sell" signal have been better timed? Yes, but over the past years the "optimal" time to get out of the market and protect profits was the "optimal" sell signal. We should note that the "Dumb Money" indicator had yet to move to a bullish extreme, and we were basing our signals on prior bear market experiences.

Then on May 8, 2009, the "Dumb Money" moved into the extreme bullish zone, and this is a bear signal. On May 8, 2009, the S&P500 closed at 929.23. Since that time the S&P500 has gained 1.8% over 5 weeks or 0.36% per week. This is annualized to a 18.72% gain. Once again, this isn't too shabby, but clearly much less than the move off the bottom or from our initial "optimal" sell signal.

Yet, with the "dumb money" now bullish to an extreme, this is the part of the price cycle that appears to be attracting the most attention and most acceptance from investors. Yet, this is the part of the price cycle where the markets haven't gone anywhere. It does seem kind of odd -doesn't it? The time to have been bullish was when investors were fearful.

To embrace higher prices with sentiment so extremely bullish, you must embrace the notion that we are in a new bull market. You must embrace the notion that higher oil and higher interest rates don't matter. You must embrace the notion that second derivative growth will lead to real, sustainable growth. You must embrace the notion that our housing and commercial real estate troubles are all behind us. You must embrace the notion that a PE of 150 on the S&P500 doesn't matter. You must embrace the notion that we can have an economic recovery without any meaningful change in unemployment. And we can go on and on and on....

I have picked my poison. It is a monthly close over the simple 10 month moving average on the S&P500. Once this occurs, I will add equity exposure (that is adjusted for the inherent risk of the asset (equities) and adjusted for the other assets in my portfolio). Personally, I don't like it, and this is at odds with my own analysis that leads me to state that this is not the proper launching pad for a new bull market in equities. But then again, the market cares little what I think or do. Nonetheless, this is how I am choosing to play it. The Faber strategy, which I discussed last week, is a strategy that helps me manage money and manage risk. It is not a "call" on the markets.

For the record, the "Smart Money" indicator is shown in figure 2. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders.

Figure 2. "Smart Money"/ weekly

One More Chart

Figure 1 is a weekly chart of the Ultra Short Lehman 20 plus Year Treasury Bond (symbol: TBT). This is the ETF proxy that moves in lock step (for the most part) with long term Treasury yields. TBT is running into resistance.

Figure 1. TBT/ weekly

Technical Sign Posts: 10 Year Treasury Yield

No matter which way the prevailing winds blow, no asset ever goes in the same direction all the time. So while 10 year Treasury yields may have the tailwinds to move higher over the next 12 months at least, it doesn't seem likely that we will see 5% yields all at once. In fact, looking at monthly and weekly charts of the 10 year Treasury yield (symbol: $TNX.X) suggests that we are coming into significant resistance levels around a yield of 4%.

Figure 1. $TNX.X/ monthly

Figure 2. $TNX.X/ weekly

Anatomy Of A Top

One of the major themes that I have been highlighting on this blog since its inception 6 months ago is the potential for a secular trend change in long term Treasury bonds. Starting back in December, 2008, there was a high likelihood of higher yields and lower bond prices. Last month provided technical confirmation that the top is in for Treasury bonds, and we should see yield pressures in the long end of the curve lasting at least 12 months.

There are a lot of fundamental reasons out there why we should see lower yields, and these include (but not limited to): 1) we are still in a recession; 2) lackluster growth despite second derivative improvement in "the indicators"; 3) unemployment has yet to peak; 4) inflation is low; 5) Fed intervention is highly probable; 6) sovereign wealth funds (i.e., China) are still buying our debt. Nonetheless, yields continue to rise. My theory is that we are starting at such an artificially low level that the coil has been set, and yields are moving higher to reflect a new equilibrium. I think this new equilibrium is the start of a new secular trend that will see higher yields.

Figure 1 is a monthly chart of the 10 year Treasury bond. The pink markers on the price bars are negative divergence bars between price and an oscillator that measures price momentum. Multiple negative divergence bars over time is the first sign of a market top. Then we couple this with a break below the negative divergence bar and the simple 10 month moving average, and we get confirmation of a market top.

Figure 1. 10 Year Treasury Bond/ monthly

See the mini - market top in bonds from July, 2003 to July, 2005 that is highlighted in the shaded rectangle. There are multiple negative divergences and several whipsaws above and below the simple 10 month moving average. Bonds did absolutely nothing during this time period and eventually sold off.

Returning to the current set up or time period, real disaster for the 10 year Treasury bond will be a break below the rising trend line which is now at 110. This is support. Resistance is the low of the negative divergence bar and soon to be rolling over simple 10 month moving average. This is at 118.

Make no mistake about it, this is a major top for Treasury bonds. How much downside there will be is yet to be determined.

The LEI, S&P500, And 10 Month Moving Average

Over the past month I have highlighted the strategy attributed to Mebane Faber. It is a simple but elegant strategy that probably gets more merit for its aversion to risk than its ability to time the exact bottom of a bear market. It is a strategy - a way of executing a plan of when to buy and sell. It is not a "call" or opinion on the market. That stuff I will leave to others.

I have adopted the strategy as a back stop just in case I have got it wrong. You see, I believe that the current rally from early March is a bear market rally and that this isn't the launching pad to a new bull market. So a monthly close over the simple 10 month moving average has become my arbitrary line in the sand to say, "Yes, I got it wrong".

Interestingly, the Economic Cycle Research Institute's Leading Economic Indicator (LEI), which is constructed from numerous fundamental variables, is now above its simple 10 month moving average. The LEI is about 60% correlated with the S&P500. So let's see if the LEI, which is a good barometer of economic activity, can add any value to the Faber model.

In all the models discussed in this article, I will be using monthly data on the S&P500 (or LEI) with a starting date of September, 1970. From this time period to the present day, the S&P500 has gained approximately 850 points. This is our buy and hold bogey. Slippage and commissions are not considered, and I am not considering any interest earned when the strategies are in cash.

The variables that I am assessing are in Table 1 and may require some explanation. The maximum MAE refers to "maximum adverse excursion". MAE is the amount in percentage terms you had to see a trade go against your entry price before the trade was closed out. MAE represents that period of self doubt when you ask yourself if you really have this one right. The bigger the MAE the more self doubt and loss you are likely to have. The other term is the RINA index. The RINA index is a measure of risk constructed from the strategy's points gained, draw down and time in the market. The higher the number the better, and ideally, we want a strategy to gain a lot of points with as little draw down as possible and within as little market exposure as possible. RINA is a measure of trade efficiency.

The Models

The Faber model is to buy the S&P500 on a monthly close over the simple 10 month moving average; the sell strategy is to sell on any monthly close below the simple 10 month moving average.

The second model is to buy the S&P500 when the LEI closes above its simple 10 month moving average; the sell strategy is to sell the S&P500 when the LEI close below its simple 10 month moving average.

The third model is to buy the S&P500 when both the LEI and S&P500 are above their simple 10 month moving average; the sell strategy is to sell the S&P500 when both the LEI and S&P500 are below their simple 10 month moving average.

The fourth model is to buy the S&P500 when both the LEI and S&P500 are above their simple 10 month moving average; the sell strategy is to sell the S&P500 when either the LE or S&P500 close below the simple 10 month moving average.

The fifth model is to buy the S&P500 when both the LEI and S&P500 are above their simple 10 month moving average; the sell strategy is to sell the S&P500 when only the S&P500 closes below its simple 10 month moving average.

Now let's look at Table 1. For the most part, adding the LEI model to the Faber model provides little value. The Faber model still has the most points gained and with the highest RINA index, it is the most efficient strategy. Adding the LEI does seem to improve the winning percentage and therefore, the LEI may prove to be an additional filter for the Faber model. The best exit strategy is the one based upon price - a monthly close by the S&P500 below its 10 month moving average.

Table 1. Strategies

The Faber model provides a simple methodology to participate in the market. Its greatest asset, I believe, is risk aversion and the sell strategy. Referring back to the table, note that draw downs in excess of 40% were seen in the strategies involving LEI as an exit signal. The Faber sell signal, a close by the S&P500 below its simple 10 month moving average, led to draw downs from the 17% to 24% range. Despite the "wonders" or "magic" of the simple 10 month moving average, there are risks to this strategy as noted by the high MAE and modest draw down.