The Bullish Case for Equities

Our indicator constructed from the trends in the CRB Index, gold, and yields on the 10 year Treasury  has not been in the extreme zone for 8 weeks now , and within the context of a trend following strategy that I have detailed here, here, and here, the SP500 should have a positive bias.   In essence, with prices on the SP500 above its 40 week moving average and our indicator not in the extreme zone, prices should move higher.  The trend remains up and inflation pressures are neutral.   This is the bullish case for equities.

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Inflationary Headwinds Increasing

Our indicator constructed from the trends in the CRB Index, gold, and yields on the 10 year Treasury is not extreme but it did rise last week suggesting that inflationary headwinds are increasing for equities.   Another push higher in gold or possibly in Treasury yields would send this indicator into extreme territory.

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Buying The Dip: Good Idea, Fraught With Consequences

Our indicator constructed from the trends in the CRB Index, gold, and yields on the 10 year Treasury has come off of the extreme readings seen several weeks ago, and within the context of a trend following strategy that I have detailed here, here, and here, this represents a buy signal for the SP500.  In essence, with prices on the SP500 above its 40 week moving average and our indicator not in the extreme zone, prices should move higher.  In other words, this is a good time to be "buying the dip"; however, this strategy is not without risks.

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Still A Headwind

Strong and rising trends in CRB Index, gold, and yields on the 10 year Treasury persist, and collectively, this represents a headwind for equities.

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We're Off!!!

As we start the new year, it is well worth repeating what I wrote on October 15, 2010: "In essence, higher yields are in the immediate future, and this should have negative ramifications for equities and commodities.  Trends in gold, crude oil, and yields on the 10 year Treasury are rising and this in aggregate will put pressure on equities."  Equities have continued to perform better than I would have thought considering the rising trends in Treasury yields, gold and crude oil.  As we start the year off, it is the same old same old.  If equities rise, then Treasury yields and crude oil will do so as well, and if I had a preference, this is where I would put my money.  Think of it as a tax on higher equity prices that eventually will result in an equity sell off.

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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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SPY v. UDN

Figure 1 is a daily chart of the S&P Depository Receipts ETF (symbol: SPY) in the upper panel versus the PowerShares DB US Dollar Bear ETF (symbol: UDN) in the lower panel. 

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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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"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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Treasury Bonds In The Balance

As I have been chronicling for better than a year now, longer term Treasury yields have a high likelihood of undergoing a secular trend change from down to up. See figure 1 a monthly chart of the yield on the 10 year Treasury (symbol: $TNX.X), which has served as our proxy for the long bond.

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

On Friday, yields on the 10 year Treasury spiked higher by little over 3%. Our composite indicator that assesses the strength in the trends of gold, 10 year Treasury yields, and crude oil is back into the extreme zone. This represents a headwind for equities.

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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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Treasury Yields: Observations

The only asset moving up over the last week has been longer term Treasury yields. This is odd especially in the face of equity market weakness and especially since demand for Treasury bonds has outstripped supply over the past year. So why are yields moving up now? Maybe yields are rising in anticipation of buyer fatigue as this week's record bond issuance comes to market.

This is difficult to know until it happens, but I can say for sure that yields are not rising because of inflation concerns nor are they rising because of strength in the economy. Yields generally rise after an economic expansion is well under way and they generally rise when the unemployment rate falls. The last time I checked, the unemployment rate was still rising; the economy had stopped its free fall, but visibility was less clear; and deflation seem to be a bigger threat than inflation.

Over the past several months, lower Treasury yields did not confirm the strength in the stock market, and this has been a glaring divergence that I have noted on more than one occasion. Now with weakness in the equity markets imminent (but not guaranteed), yields start to move higher. Hmm. I hope this isn't the new normal?

Technically, long term Treasury yields have the characteristics of an asset that could undergo a secular change in trend. This has been a theme that I have been on for over 10 months now, but in all honesty, yields have yet to show real sustainable strength. The best that I can say about my analysis is that I have said to avoid Treasury bonds for anything but a trade.

See figure 1, a weekly chart of the yield on the 10 year Treasury bond. The 10 year Treasury did trade to a yield of 4% back in June, but they fell back to 3.1% level before bouncing. Yields are above the prior weekly pivot high point at 3.437% and the down sloping black trend line, and it would be bullish for higher yields if there was a monthly close over the prior low pivot (on a monthly chart) at 3.432%. Yields appear likely to trade to the resistance zone between 3.856 to 4%.

Figure 1. $TNX.X/ weekly

Why yields should move higher has been a subject of much conjecture all year long. Nonetheless, increasing bond supply has been met by buyer demand, and the fundamental back drop (despite the stock market rally) really has not been conducive for higher yields. The technicals are at odds with the fundamentals.

Other observations are noteworthy. Figure 2 is a daily chart of the ProShares UltraShort Lehman 7-10 Year Treasury (symbol: PST), which seeks results that are twice the inverse of the daily performance of the Barclays Capital 7-10 Year U.S. Treasury index. The triple bottom is is quite noteworthy.

Figure 2. PST/ daily

Figure 3 is a daily chart of the ProShares UltraShort Lehman 20+ Year Treasury (symbol: TBT), which corresponds to twice the inverse of the daily performance of the Barclays Capital 20+ Year U.S. Treasury index. The double bottom is quite noteworthy, as indicated by the volume spike.

Figure 3. TBT/ daily

Another observation comes from the Treasury Inflation Protected Securities or TIPS market. As recently as last week, I was under the belief that yields were heading lower. Why? TIPS were headed higher. There is a very clear inverse relationship between TIPS and 10 year Treasury yields. This can be seen in figure 4. As TIPS go up; long term yields go down.

Figure 4. TIPS v. $TNX.X/ weekly

However, TIPS have not followed through (and I could be wrong!), but they haven't broken down completely yet. A monthly close below the pivot at 102.75 would be reason enough to abandon the notion of higher TIPS. See figure 5. A monthly close below this level would add credence to the notion of higher Treasury yields.

Figure 5. TIPS/ monthly

So let's summarize. There are lots of conflicting crosscurrents when it comes to yields on longer term Treasury bonds. Whether the current mini-lift in yields develops into a longer term sustainable trend is not certain as the fundamentals are at odds with the technicals. Nonetheless, betting on higher yields - because of the technical, secular tailwinds - may be the easier trade to make at this juncture.

The Inflation Indicator Meets The "Dumb Money" Indicator

I thought it would be interesting to combine my inflation indicator, which is derived from the trends in gold, crude oil and yields on the 10 year Treasury, with the "Dumb Money" indicator, which is derived from widely available investor sentiment data.

Both indicators are now in that extreme zone, and I recently reviewed each indicator over the past week. The inflation indicator is in that extreme zone that should be a headwind for equities, and the "Dumb Money" indicator has been in the excessive bullish zone (i.e. bear signal) for 3 months now . Alone, each should produce headwinds for equities but what happens when there is a confluence of these two extremes - one detecting strong trends in gold, crude oil, and yields on the 10 year Treasury and the other detecting excessive and bullish investor sentiment?

Figure 1 is a weekly chart of the S&P500. The red dots over the price bars indicate when both the inflation indicator and the "Dumb Money" indicator are in the extreme zone at the same time. I have labeled each occurrence with the date. The two instances in the current rally were associated with the only meaningful pullbacks since March, 2009. The other three instances on this chart were associated with the run up to the 2007 bull market top.

Figure 1. S&P500/ weekly

Figure 2 shows those occurrences from 2003 to 2006. There were multiple dots that occurred throughout the bull run of 2003. For the most part, the bulls won out as this was one of those circumstances where it took bulls to make a bull market. But if you look closely, the dots at 7/25/03 and 10/10/03 did result in a trading range. Only the 12/12/03 signal resulted in a bull market blow off that was retraced over the next 3 to 4 months.

Figure 2. S&P500/ weekly

Figure 3 is from 1999 to 2003. The 1999 signal led up to the market top in 2000, and the bear market signals in 2001 and 2002 marked the highs that led to significant down legs. (Hindsight is 20/20!!!)

Figure 3. S&P500/ weekly

For the rest of the 1990's, there was only one other signal (not shown) and this was on 2/23/96, and this led to a 5 month trading range - the first real consolidation since the January, 1995 lows.

In the last 2 weeks, I have included the following words in my weekly articles on sentiment: "There is probably greater risk of a market down draft now than in past weeks." This past week I even underlined those words for emphasis. So why did I do that? When looking at these signals, it is clear to me that prior occurrences were associated with some fairly nasty 1 week sell offs, and I am not really considering those intermediate bear market highs from 2001 to 2002.

In a market driven by Dollar devaluation and "liquidity" this is what I would expect: there will be sudden down drafts that should be scooped up rather quickly as long as investor sentiment remains as bullish as it has been.