Author Archive for McClellan Financial

Bund Spread’s Message for the Stock Market

Tom McClellan – McClellan Market Report

The folks who watch international bond yields have been giving a lot of attention lately to the fact that the spread between the 10-year U.S Treasury Note and the equivalent government bond from Germany is now up to its widest point since 2005.  CNBC’s Rick Santelli showed a chart of it in a segment on April 2, 2014, and what caught my eye was how much that yield spread looked like the behavior of the stock market.

So I downloaded the data on German yields from the St. Louis Fed, calculated the spread versus the 10-year T-Note, and put it on a chart with the DJIA as shown above.  And sure enough there is a nice correlation there.

The German bonds are known in the bond industry as “bunds”, derived from the German prefix “Bundes” which means “federal”, as in the Bundesrepublik Deutschland, or the Federal Republic of Germany in English.

Yield spread 10-year T-Note to German bunds

As noted above, the T-Note to Bund spread was just slightly higher in 2005, and also back in 1999, and both instances were associated with toppy conditions for the U.S. stock market.  If I were to try and craft a “rule” about this relationship, then I would say it gives a pretty good top signal for the stock market when it rises up above about 100 basis points (1 percentage point), and then turns down.

That turning down part is important, because the spread can keep on rising as stock prices keep on rising.  Only after the spread starts turning down does it seem to matter for stock prices, and with some degree of lag.

Why would this work?  I confess I have been struggling with that ever since seeing Santelli’s chart of just the spread on the air.  What I have come up with is that the spread is actually a measure of investors’ risk-seeking behavior.  When investors are fearful about the stock market, then the “flight to quality” mentality sends them into Treasury bonds and notes.  In such instances, people forget about fair values and just want the perceived greater safety of having the assurance that the U.S. government will guarantee their investment. That pushes down T-Note yields.

At the other end of the sentiment extreme, when investors are confident about the stock market, they get out of Treasuries so that they can invest in stocks, and that exit from Treasuries helps push bond prices down, and yields up.

Because of the Germans’ reputation for an almost religious devotion to low inflation, their bond yields can be thought of as more of a baseline value for gauging worldwide inflation expectations.  And so to the degree that U.S. T-Note yields are varying from that baseline, there is information in this yield spread about investors’ appetites for risk, or the lack thereof.

But it is really interesting to note that the relationship has only been working this way for about the last 25 years.  Here is a longer term look at the T-Note to bund spread:

T-Note to Bund yield spread 1956-2014

The data on bund yields goes back to 1956, a period when post-war West Germany was still working to rebuild everything, including its financial markets.  During the 1950s and 1960s, the divided Germany was still more like an emerging market than the established industrial power it is today.  So bond traders back then understandably demanded a higher yield for investing in West Germany’s debt.

That relationship flipped wildly to the other side in the mid-1970s, when ultra-high inflation in the U.S. pushed Treasury yields up to a high level, taking this spread up to as high as 536 basis points in 1984.  German reunification in 1989-90, and the eventual creation of the euro currency in 1999, helped to bring this spread to a more stable relationship that we see today.

Right now, the still-rising spread means that risk-seeking (or safety-avoiding) behavior is still on the rise.  And why not, with the Fed still giving away free money at the short term end of the maturity spectrum.  But at some point in the future, the amount of this spread implies that we are going to have to see a 2001-03 or 2008-09 style bear market, just to restore equilibrium in both the international bond markets and the U.S. stock market.

 


 

On an unrelated topic, the St. Louis Fed’s web site is a great source for accessing a huge variety of historical economic data.  They even have the DJIA back to 1896, and other stock market index data series.  But an announcement on their site says that Standard & Poors is about to yank away their authority to publish S&P index data after April 25, 2014.  So if you want to have a chance to access and download that data before it goes away, now is the time to act.


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Chart In Focus Archive

A Divergence Among Nasdaq 100 Stocks

Tom McClellan – McClellan Market Report

The Nasdaq 100 Index (NDX) has been leading the way higher, making higher highs and higher lows all throughout 2013 and into 2014.  But it has been doing so with diminishing participation.

This week’s chart shows an indicator whose value is featured every day in our Daily Edition.  It measures the number of component stocks in the Nasdaq 100 Index which are above their 100-day simple moving averages.  As the market advances, more stocks rise in sympathy and this indicator goes to higher values.  Similarly when the market falls, the component stocks fall, and this indicator goes down.  No surprise there.

NDX stocks above 100-day MA

The real information comes when there is a difference in behavior.  Seeing the NDX make higher highs while fewer stocks are above their 100MAs is a sign of waning participation in the advance.  But divergences can unfold over a long period of time before they finally matter and turn into a meaningful market decline.

That is the issue that we face right now.  This indicator peaked all the way back in September 2013, and has been making a series of lower highs ever since even as the NDX has trended higher.  History says that eventually this type of divergence is going to matter.  But the market is inconsistent in terms of the period over which a divergence can last before the point when it “matters”.

The chart below takes a longer look at this indicator:

NDX stocks above 100-day MA  2002-09

Sometimes it can make a quick spike up to above 80 on a blowoff up move.  Other times, the market continues going higher after a quick spike, and a long divergence is needed in order to build a top.  The 2007 market top came at the end of a divergence that lasted 12 months.  Patience can be difficult in such situations.

The current divergent condition is only 6 months old.  But it carries the same attributes of other important divergences of the past, telling us that the uptrend is continuing on diminishing participation.  Eventually it is going to matter.


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Housing Stocks Due for a Dip

By Tom McClellan – McClellan Market Report

The rally in housing stocks that I wrote about last November has been proceeding pretty much according to plan.  That’s the good news.  The bad news for investors is that lumber prices now say the housing related sector is due for a temporary dip.

Housing related stocks should see a recovery, for the most part, from that mid-year dip.  But by the time that the bottom arrives, history suggests that no one will be believing in any recovery.

The key insight behind this forecast is a relationship I uncovered back in 2008.  An interest in the movements of lumber prices led me to look at both the lumber market and the housing stocks sector.  Upon initial examination, it was clear to me that there was somewhat of a coincident relationship, which would only make sense since the two are closely related.  But the chart correlation was not quite right.  I unlocked the secret by shifting forward the plot of lumber futures prices by a year, to reveal how the HGX Index tends to follow the same dance steps with about a one year lag.

Lumber prices lead housing stocks by 1 year

It is really nice to get the answers ahead of time, even if they are imperfect answers.  And that imperfection is important to understand when using this relationship for insights.  The chart below zooms in closer on this same relationship, and allows us to see that at an up-close level, the correlation is not as good as it was when we looked from further away.

Lumber prices lead housing stocks by 1 year

Within this chart, we can see that back in 2011, the HGX did not feel compelled to follow the blowoff path of lumber prices a year earlier, when the April 2010 earthquake in Chile sent a tremor also through the lumber futures market.  Since that price spike was the result of an exogenous event, and not a case of a push-pull of market forces, it did not see an echo in the prices of housing related stocks.  And that reveals the key:

Lumber price movements do not “cause” the similar movements a year later in housing related stocks.  Instead, lumber just serves as an indicator of an underlying “liquidity wave” flowing through the wood market, and that same wave generally shows up again a year later in the housing stocks market.

The chart also reveals that the HGX Index does not perfectly follow every bump and wiggle in lumber prices.  And yet the overall correlation is evident. I take this to mean that it is a message worth listening to, but not one that is proper to expect perfection from.  Life just does not work that way.

Coming up, the relationship says that a top lies just ahead of us, and then a strong-looking dip to a low due in June 2014.  We saw similarly strong looking dips back in 2011 and 2012 that did not bring the same sort of magnitude response in the HGX Index, so that is worth understanding.  Still, the timing of the movements was well matched even if the magnitude was not.

After that presumptive June 2014 bottom is another rally up toward the end of 2014.  The corresponding rally in lumber prices did not make it to a higher high, but that does not necessarily mean that housing stocks cannot do so.  Remember, this model is good for timing, not for magnitude.


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Chart In Focus Archive

Yield Curve’s Message For GDP

Tom McClellan – McClellan Market Report

One of the really fun leading indication relationships involves the yield curve, the spread between interest rates on similar securities across different maturities.  The real yield curve has too many data points each day for visual modeling, and so a simplistic model of the yield curve can suffice to make for easier modeling.  In this week’s chart, the role of the entire yield curve is portrayed by the spread between the 10-year T-Note yield and the 3-month T-Bill yield.

10-year and 3-month yield spread versus relative strength

The fun thing that we get from this representation of the yield curve is a leading indication of what small cap stocks will do versus large caps.  Playing the role of each market segment are the Russell 2000 and Russell 1000 Indices.  Dividing one by the other gives us a relative strength ratio, which moves up or down as small caps outperform or underperform. 

Historically, the movements of the yield curve (as represented here by the 10-year to 3-month spread) get echoed about 15 months later in the movements of this relative strength ratio.  And that same 15-month lag period also shows up in other data.  Here is a comparison of that same yield spread versus GDP growth:

Yield spread versus GDP growth

Once again, the plot of the 10-year to 3-month spread has been shifted forward in the chart by 15 months.  This helps to reveal how periods of higher spread between long and short Treasuries gets echoed about 15 months later by stronger GDP growth.  And when the yield curve “inverts” and takes this spread down close to or even through zero, we see a corresponding dip in GDP growth about 15 months later.

We have a lot of years of history to show that this relationship works pretty well.  But the difficult question is whether it still works now that the Fed is pursuing a centrally managed interest rate market.  Economist Alexander Tabarrok had a great quote about this several years ago.  In a Forbes magazine interview, he said, “A price increase is a message about scarcity.  Price controls are like shooting the messenger.”

By manipulating the short end with its zero interest rate policy (ZIRP), and by manipulating the long end with more than $4 trillion of US Treasury bond mortgage back securities purchases, the Fed just may be killing the messenger, and ruining a great leading indication.  Ever since the Fed became more active, following the 2008-09 depression, the correlation has not been working as well.  The recent swoop upward in this yield spread should mean small cap outperformance and rising GDP growth into early 2015, but that is only if one is prepared to believe a manipulated interest rate model.


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Can Earnings Get Better Than This?

Tom McClellan – McClellan Market Report

The conventional stock market analysis world revolves around earnings.  “Earnings drive the stock market,” they say.  This myopic view is akin to the belief that carbon dioxide is the driving force behind the greenhouse effect (water vapor actually accounts for 90-95% of it, but you don’t hear that).  People believe that earnings are everything because they have been told that it is so, and everyone thinks so,  therefore it must be so.  Circularity of logic and contradictory evidence do not seem to be significant impediments to the acceptance of this belief system.

This week’s chart looks at the BEA’s data on corporate profits.  To access it yourself, go to the BEA web site at this link, and then click on Section 1 – Domestic Product and Income, and then Table 1.10, and scroll down to Line  15.  Then all you have to do is divide by GDP, which can be accessed here.

Corporate profits as percentage of GDP

Why doesn’t everyone look at earnings this way?  My answer is that Wall Street has a fascination with its own forecasts of earnings, and with the reported earnings of listed companies stocks.  But those are a pair biases which excluded private company earnings, and which also accept earnings estimates which are notoriously subject to revision.  I prefer to deal in hard data.  The next BEA report on earnings is not due out until Feb. 28, so using these data means accepting the inherent reporting lag. 

What we see now is an indication that the reading for overall corporate profits as a percentage of GDP is at one of the highest levels of recent years.  And when it cannot get higher, it can only get lower.  It is true that this measure has been higher in the distant past, but that was back in the 1960s and earlier, when GDP was a bit different than it is now, and when accounting standards for measuring profits were also different.  The current high reading has only been exceeded once in the past 46 years, and that was at the real estate bubble top for earnings back in 2006.  And we all know how that ended.

Why should this matter?  When profits get up too high, certain agents decide that “excessive” corporate profits are a worthy target to go after.  So new taxes or other restrictive rules come into effect, and stimulative measures such as Federal Reserve policy which may help spur earnings to a higher level are pared back.  Those twin agents have a negative effect on stock prices, or at least they have historically.  Maybe this time will be different.

The other troubling point about this chart is that the amplitudes of the swings from highs to lows in corporate profits seem to be getting bigger over the past 20 years.  This measure formerly had much smaller magnitude movements, but the big swings we have seen during the last 3 boom-bust cycles resemble a spinning top that is starting to wobble just before it falls over and stops.  Yikes!  And at the point when profits as a percentage of GDP starts to fall, you can see in the chart what usually is happening then to stock prices.  But remember that there is a reporting lag; we don’t even have Q4 numbers yet.  So it is not as if you can wait for confirmation from the earnings data, and then decide how to invest.


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Chart In Focus Archive

Coppock Curve Turns Down

By Tom McClellan – McClellan Market Report

A classic technical indicator gave a rare bearish signal for the DJIA with the down move seen in January.  The Coppock Curve has turned down.  More importantly, it has done so after a second big top, which seems to be the important set of dance steps to mark a major market top.

Named for the late Edwin Sedgewick Coppock, his eponymous indicator was originally developed as a way to find the upturns from major stock market bottoms.  But with the right interpretation, it can also have other uses.

Coppock was a market analyst and money manager a few decades ago, and was awarded the MTA’s Lifetime Achievement Award in 1989.  The indicator that bears his name now was something he himself called his Very Long Term (VLT) Momentum indicator.  It was based on an idea which originated from a conversation Coppock had with bishops of the Episcopal church.  Coppock asked how long it takes a person to grieve, and to get over the loss of a loved one.  The answer was 11-14 months.

So Coppock incorporated that answer into his indicator, which combines 11-month and 14-month rates of change for the monthly closes of the DJIA, and then smoothes that with a 10-month weighted moving average.  Technicians who later took up the use of Coppock’s VLT Momentum indicator gradually changed the reference to “Coppock Curve”, to honor its creator.

When the Coppock Curve gets down to a very low level and then turns up, it signals an important long term entry point.  Coppock was a money manager who wanted to find the really great long term buy signals, and was not so much interested smaller swings.  The most recent such signal came in May 2009, just after the March 2009 bear market bottom, and it was indeed a great long term entry point.

After it gives such a signal, the subsequent uses of the Coppock Curve are not as clear cut, and it was not originally meant to offer other interpretations of the market action.  Tops are especially tricky, because sometimes a downturn from a high reading is a big bearish signal, and other times it does not mean that much.  This week’s chart highlights an interesting recent behavior of the market and this indicator, which is to give a two-step long term topping condition.  Or at least that has been the case in the limited number of market cycles since the late 1990s.

Now we have a downturn from a second top, as of the end of January 2014.  That completes this iteration, and arguably sets the market onto the course of a long term corrective move.  Given the math of the Coppock Curve, it will be a long time before we can get another upturn.

 

DJIA Coppock Curve

 

To help visualize this principle, the next chart compares the DJIA to the price level needed to achieve a reversal in the Coppock Curve, what I call the “Coppock Unchanged” value.

DJIA vs Coppock Unchanged level

When the DJIA crosses down through the Coppock Unchanged line, that turns down the Coppock Curve.  If such a move happens at a major top, it is a pretty unequivocal signal.  But crossings at other points can give whipsaw signals as with any other type of trend following indicator.  To get back up on top of the Coppock Unchanged line and turn up the Coppock Curve, the DJIA would need to close above 16238.07 at the end of February 2014, and that number keeps on rising.

So is this January 2014 downturn a legitimate signal, or just another whipsaw?  That’s the important question.  But consider that the DJIA has now completed the familiar 1-2 topping pattern seen at the major tops in 2000 and 2007.  And this arises at a time when the stock market still appears to be following the 1929 top’s price pattern, albeit with a much smaller overall magnitude of price movement, and the Fed is pulling away the QE punchbowl.  That adds up to a compelling case for a meaningful top and downturn.

You can calculate your own Coppock Curve series with this spreadsheet.  See also Calculating The Coppock Curve.


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Gold Breaks Downtrend, Sort Of

By Tom McClellan – McClellan Market Report

Which of these statements is true:

1.  Gold is still in a downtrend.

2.  Gold has broken its downtrend.

It turns out that they are both true, but only if viewed from the proper perspective.  The price plot of gold as priced in dollars is still below the declining tops line which dates back to late August 2013.  But the same line drawn on the plot of gold priced in euros has already been broken.

Gold priced in euros

So who’s right?  The short answer is that the euro price of gold has nearly always proven to be “right” when there is a disagreement between the two plots.  Such disagreement can appear in a few different forms, but the two I pay most attention to are (1) divergences, and (2) different trendline behavior.  It is the second category which is of interest now.

Gold prices have just started the process of building a pattern of higher highs and higher lows to define an uptrend.  But we already have a broken downtrend line on the plot of gold priced in euros.  A couple of other examples of trendlines on each plot are shown in this week’s chart, and you can see that in each  case, the euro price plot broke its downtrend line ahead of the equivalent line being broken on the dollar price.  Indeed, the leftmost example did not even see the dollar price break its trendline, although there was nevertheless a pop upward after the euro price broke its downtrend.

Whether this sign of a downtrend break is going to turn into a real live uptrend, or just a brief pop and fizzle like the last two, is not something that this difference in behavior tells us.  All it says is that there is a disagreement between the dollar price of gold and the euro price.  History says that the euro price is nearly always right during such disagreements, so I expect that to be the case again this time.


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Chart In Focus Archive

Is The Presidential Cycle Inverting?

Tom McClellan – McClellan Market Report

When Dorothy went over the rainbow, she found that everything was backwards.  The world had been colorized, munchkins were grateful that it was raining houses, scarecrows could talk, a lion was a fraidy-cat.  And there was a wizard who was in charge of the whole place.

A new wizard is about to be in charge of the Fed, and that factor seems to be making the stock market turn backwards and upside down.

Our Presidential Cycle Pattern is a representation of the market’s average performance over each four-year period from presidential election to election.  It is not just a message about what the president does, but also about the whole political calendar as influenced by Congress, the federal fiscal year, and other factors.  I like to measure it from the November election rather than from January 1, since the market typically starts responding to the election results as soon as they are known.  Usually that means right away; the 2000 election was a rare exception.

SP500 versus Presidential Cycle Pattern

The Presidential Cycle Pattern often gives a good model of which direction prices should go, and when turns are likely.  But as an average pattern, some years are better and some are worse.  And sometimes, the market pays attention to other factors besides what the politicians are doing.  We appear to be in one of those exceptional situations now. 

On average, the SP500 peaks in July of the first year of a presidential term, and then spends the next 16 months chopping sideways to downward until the mid-term election.  But the current market is ignoring instructions and just continuing higher, presumably in response to the Fed continuing its money-pumping into the banking system.  What is the problem?

More than just zigging upward when it is supposed to be zagging down, the market seems to be doing precisely the opposite of what the Presidential Cycle Pattern (PCP) says it should.  Here is a closer in look:

SP500 versus Presidential Cycle Pattern

Zooming in closer allows us to see that even the minor pattern of the SP500 is doing a pretty good approximation of exactly the opposite of what the PCP says should happen.  The stock market was supposed to be bottoming at the end of December, but instead it made a top.  Now in January 2014, the market is supposed to be moving upward, but appears to be chopping downward.

What are we to infer from this?  The PCP is all about the 2/4-year political calendar in Washington, DC, which has often had a big effect on pushing the market around.  But Congress and the White House are not the big forces influencing Wall Street at the moment.  Instead, the Fed seems firmly in charge.  A different agent might perhaps mean a wholly different schedule, wholly uncorrelated to the “normal” pattern.  But instead, forces are conspiring to bring about a seemingly precise inversion of the pattern.

How long the inversion can persist is not known at this point.  And the installation of Dr. Yellen as the new Fed Chairman adds an additional unknown factor into the mix.  I have seen the market make tops and bottoms early or late by a few days compared to the PCP, but I cannot recall seeing a complete inversion like what appears to be happening.  In other words, we have a wholly irregular market right now that is not following the normal rules.  It is instead following some other set of rules, and so extra caution is in order.

The 1929 scenario discussed in a Dec. 12, 2013 Chart In Focus article still appears to be “working”, and that chart was updated in a recent issue of our twice monthly McClellan Market Report newsletter, which is available to subscribers.  I do not think that we are in for an event of the same magnitude as 1929′s crash and subsequent decline, but the imposition of “crash physics” on the market could be a possible explanation for the inversion we are seeing.  Just as compasses have been reported to swing wildly upon entry into the Bermuda Triangle, perhaps the entry into a 1929-style crash scenario is flipping the market’s polarity for a while.  Caution is clearly in order at a time when the market just is not acting normally.


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Chart In Focus Archive

The VIX ETN is Not Right For Investors

Tom McClellan – McClellan Market Report

In the Dec. 16, 2013 issue of Forbes magazine, the editors offer their list of “365 Ways To Get Rich” with their 2014 Investment Guide.  #100 on the list is this suggestion: “Profit from stock market volatility: Buy into a VIX futures fund and use wild, seemingly irrational swings as buying opportunities.”

The most commonly known VIX futures fund is VXX, the iPath SP500 VIX Short-Term Futures ETN.  And while it might be a useful trading vehicle for someone looking to trade extremely short term moves, it is a horrible idea for “investors“.

The share price history of VXX has a terribly negative bias, and it has ever since it debuted back in 2009.  VXX ended 2013 at a price of 42.55 (unlike SPY or GLD, VXX’s numerical price is not directly related to the numerical value of the VIX).  That is down huge from its March 2, 2009 high of 7449, when we adjust for 3 separate 1 for 4 reverse splits.

VXX - VIX Futures ETF


This persistent negative bias has to do with the nature of the VIX futures contracts that VXX invests in.  Most of the time, those futures contracts have a contango to their pricing, meaning that the price is higher the farther out into the future you go for a contract’s expiration.

The table at right quote table for VIX futuresshows the closing prices for VIX futures as of Dec. 31, 2013, extending out through the September 2014 contract (the furthest one currently open).  You can see that all of the contracts are priced higher than the spot VIX Index, and the further out you go, the greater that premium is.

As of this writing, VXX currently has its holdings divided between the January (F4) and February (G4) 2014 VIX futures contracts.  As the January contract nears expiration, the folks at iPath will have to replace it with the March contract (H4), and presumably at a higher price.  That price premium will then decay back down toward where the spot VIX is as the contract nears expiration.  So VXX shareholders are continuously being victimized by the “roll” to later expiration month contracts, with that ETN buying higher and then selling lower, and repeating.  That explains why the VXX’s long term “performance” has been so awful.

That does not mean VXX cannot be used for very short trading periods, when a rising VIX pushes up the prices of its futures contracts, and when the effect of the roll to the later contracts is not an important factor.  But for investors with a longer time horizon, owning VXX can be a hedge against a portfolio ever making any money.

Interestingly, just as the roll to later contract months can hurt investors in VXX, that same factor can help others.  XIV is an ETN sponsored by VelocityShares which is designed to move inversely to the VIX.  So if the stock market were to be making a short term price bottom, with the spot VIX up at a high level, then a trader could own shares of XIV to play the possibility of the VIX coming back down.  In other words, with a long position in XIV, a trader can be short the VIX.

And unlike VXX, which gets hurt by the roll to later contract months, XIV gets the benefit of that roll by shorting VIX futures at a higher price, and then harvesting the benefit of the decay as each contract’s price moves back closer to the level of the spot VIX Index.  It is for that reason that XIV has a positive bias relative to what the actual VIX does.

XIV - Inverse VIX ETN

You can see that XIV does move inversely to the VIX in the short run, and the magnitude of those movements can be quite violent.  But the longer term trend is decidedly upward, owing to the profit factor from harvesting the contango by shorting VIX futures contracts at higher prices further into the future.

Because the VIX has a reliably inverse relationship to the SP500, and because the XIV moves inversely to the VIX, many traders have figured out that they can use XIV as a leveraged proxy for the SP500.  Since January 2011, the daily percentage changes in the SP500 and XIV have a correlation coefficient of +0.82, and a “beta” (leverage factor) of 3.19.  In other words, if the SP500 were to move up or down by 1%, then the expectation would be that XIV would move by 3.19% in that same direction.  It does not always work out perfectly that way every day, but on average that is their relationship.

And in addition, XIV gets a performance enhancement by harvesting the contango as mentioned above.  Here is a chart comparing the SP500 to XIV for the past 3 years:

XIV versus SP500 2011-13

Since January 2011, the SP500 has grown 45%, but XIV has grown 178%, adding up to 33 percentage points of alpha over that 3-year period.  It has not been a very smooth advance though, as some significant drawdowns have occurred over that period.  Most notably, the big drop in 2011 took XIV down 74% from its high that year to its low.  There were not enough months of harvesting contango to make up for the negative effects on XIV from that big rise in the VIX.  So investors and traders really can get hurt.

But in a period of a rising stock market, traders who can enter and exit efficiently and who can stomach the higher beta may find the XIV a useful trading vehicle, turning the problem of the roll to higher price futures contracts to their advantage.  Please note: I am not advocating that anyone adopt such a trading scheme, and I never recommend the use of any individual securities or trading plans.  My purpose here is to help educate readers about how these products work.


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Chart In Focus Archive

A Review of Analogs

By Tom McClellan – McClellan Market Report

Have you ever lived through an earthquake?  I grew up in southern California, and lived through the 1971 San Fernando earthquake that fractured the Van Norman dam, knocked down several buildings, and generally caused turmoil.  I got to skip school for 3 days after the quake.

I now live in western Washington, and lived through the 2001 Nisqually earthquake, which knocked down some buildings in Seattle and generally caused great annoyance.

None of these compare to the magnitude of the big Tohoku earthquake in Japan, which spawned a tsunami that destroyed the Fukushima nuclear powerplant, and caused great damage to other areas of Japan.

And according to the Pacific Northwest Seismic Network, I have also lived through 201 earthquakes in just the past 14 days, although I did not even notice any of them.  An earthquake does not have to destroy a city to still be an earthquake.

This is an important principle to understand when we contemplate the topic of price pattern analogs in the stock market.  I attracted a lot of attention, and a lot of derision, when I wrote about the resemblance of the current market’s price pattern to that which occurred back in 1929.  This week’s chart updates that relationship, and we can see that the relationship has not broken correlation yet.  For as long as the correlation continues, it is interesting and potentially useful.  But anyone who endeavors to employ such an analytical tool should understand that all such pattern analog relationships break correlation eventually, so they should always be viewed with skepticism alongside the fascination we have for the pattern correlation and its (potential) message about the future.

I made that very point two weeks ago in my Chart In Focus article about the 1929 stock market pattern analog.  But some people could not get past the point that I had brought up the 1929 event, and they concluded that I was forecasting a huge crash, another Great Depression, and more.  That was not what I said, but the actual words I used and the analysis I offered seem to be secondary for some people, whose agenda is to be dismissive of others.  Why let the actual evidence and statements get in the way of a wonderfully inflammatory and critical story?

1929 DJIA versus 2013
The criticisms of that 1929 analog tend to fall into 3 general categories:

  1. The scaling is different, and so the comparison is wrong.
  2. The fundamentals are different, and so the comparison is wrong.
  3. Someone can take any 2 periods and put them on a chart to make them look the same.

 

Addressing point number 1, that the 1929 analogy is supposedly wrong because the scaling on my chart is not equivalent, and therefore the conclusions are necessarily wrong:  This stems from a prejudiced view that it is the magnitude which matters, and not the “dance steps” of the pattern.  The earthquake analogy should be sufficient to illustrate that identical magnitudes are not always the important factor.

Fred Astaire could dance the Charleston.  And a sumo wrestler could dance the Charleston.  It would admittedly look different in some ways, and it would definitely feel different from the standpoint of the dance floor.  But it would still be recognizable to an observer as the Charleston.

But to those for whom such logic is insufficient, let me offer a case history to illustrate how price magnitude is not really the important factor in governing the way that prices behave, and whether or not an analog is valid.  Most modern traders have at least heard of the big crash of 1987, but few remember the little micro-crash of 1994.  The total price damage in 1994, top to bottom, was just 9.9%, and yet the pattern itself strongly resembles what happened in 1987.  The magnitude of the 1987 event was much greater, both in terms of the volatility before the top and the severity of the actual crash.  And yet the “dance steps” look an awful lot like what happened in 1994.

analog comparing 1994 and 1987

If it was the total magnitude of the price decline which mattered, then we could have never discovered the pattern analog between 1987 and 1994, since the magnitude of the price change in each period was so very different.  But it is obvious from looking at the chart that there is indeed a genuine similarity.  And so if someone had been insightful enough to match up the pre-crash patterns between what happened in 1987 and what happened 7 years later in 1994, then that analyst could have potentially foreseen ahead of time what unfolded.

The 2nd argument, that the fundamentals are different now and thus the whole comparison is all wet, is something that I acknowledged and addressed in my article two weeks ago.  While it is true that the so-called fundamentals are different now, that factor has not stopped the current pattern from looking the same as the 1929 pattern up until now.  So why does that factor have to mean that the resemblance must stop working?  A lot of analysts think that they know which factors are the ones which matter.  But if wholly different economic and fundamental factors can still produce stock price patterns which correlate so closely (up until now), then my question is this: are those really the factors that matter?

And if those factors are not the ones that can explain the current price behavior similarity, then why are they the ones that matter for future price pattern similarity, or lack thereof?

Why do price pattern analogs ever work at all?  My answer is that human populations tend to fall into similar and repeating patterns of human emotional response, and this gets reflected in repeating patterns of price action.  This is the entire basis for classical bar chart pattern analysis.  Even though 2 different triangles might look different in some ways, or 2 different head and shoulders structures, the driving psychology behind the formation of such structures is largely the same, and tends to result in similar outcomes.

The 3rd argument is a peculiar one, asserting that a chartist can take any 2 periods, throw them together on a chart, and make them look similar.  This argument could only ever be made by someone who had not actually tried to do this.  Anyone with the least bit of experience in playing around with price data would know that this is not the case.  But such critics convert their hypotheses into assumptions, and then into “facts”, without ever checking whether they are actually true.  Prejudiced assumptions are not the same as facts.

Here is a case in point.  The 1987 crash was a lot like the 1929 crash in some respects, and different in others.

analog comparing 1987 and 2013, a comparison which does not work as well as the 1929 analog

Throwing together the current market pattern with the 1987 crash pattern results in a wholly unsatisfying comparison.  Both are in uptrends to this point, that much is true.  But there are so many points of pattern dissimilarity that I would never put this forth as representative of what is happening.  One can shift the patterns fore and aft, and it does not really get any better.

Perhaps the biggest point about analogs which their critics (and mine) do not understand is that all analogs eventually break up.  They don’t work in perpetuity if one extends backward off of the left end of the chart, and similarly at some point within the chart or off of the right end, the pattern correlation eventually breaks up.  Price patterns suddenly fall into correlation with a prior pattern, and they dance together for a while, and then they break up.  Or at least that has been the case in every single pattern analog I have ever studied.  So when we notice a similarity between now and the 1929 stock market pattern, that does not mean we can count forward 12 more years and expect the Japanese navy to bomb Pearl Harbor again at that equivalent point.  Life does not work that way.

When I find an analog that works, or seems to, it is great for a while, and then suddenly the nice relationship ends.  In my experience, the point of a loss of correlation usually arrives right at the point when I am counting on it most to continue working.  The key to not getting hurt by that breakup lies in knowing that a breakup in correlation could arrive at any time, and then to watch for and recognize the signs that it is happening.

Here is a great example, one that I have shown in past Chart In Focus articles in August 2013 and also in May 2013, and also in our McClellan Market Report and Daily Edition.  Apple’s price pattern over the past 3 years has very closely resembled that of Microsoft around the time of the 2000 Internet bubble top.

AAPL vs. MSFT pattern, showing breakup of correlation as of Dec. 2013

There was one notable misstep in the pattern leading up to the top, which is highlighted.  In April 1999, MSFT got knocked down by adverse news from its antitrust case.  AAPL’s share price did not undergo an equivalent drop at that point, because it did not suffer a similar adverse and exogenous input.  Afterward, the two patterns got back into step, and they proceeded nicely in strong correlation, that is up until just recently.

In the summer of 2013, we saw the first sign of pattern correlation breakup when AAPL made a higher low at a time when the MSFT pattern said that a lower low was on the script.  They continued to dance somewhat together for a few more months, but now in December 2013 the correlation appears to be pretty thoroughly broken.  What was a bottom at this point for MSFT’s  price pattern is decidedly not a bottom for AAPL’s price pattern.

So in summary, analysts and market participants should not expect more from such pattern analogs than they can offer.  But neither should we dismiss them as wholly without use.  The story does not have to be repeated in exactly the same way, or with the same magnitude.  We just have to be able to recognize the same dance steps being traced out to a satisfactory degree, and when we do, then we can see a model of what the future may look like, while also knowing that the correlation might break up at any time.


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Gold COT Data Again Proclaiming a Price Bottom

By Tom McClellan – McClellan Market Report

Back in June 2013, when gold was making its lowest price low since early 2011, I pointed out that commercial gold futures traders were at a really low net short position according to the Commitment of Traders data, and that this was a meaningful sign of a price bottom.  Now we are seeing a similar condition in the commercial traders’ net position, which is conveying a similar message.

The Commitment of Traders (COT) Report is published each Friday by the CFTC, showing traders’ positions as of the preceding Tuesday, and broken down into 3 groups: Commercial traders (big/smart money), non-commercial traders (large hedge funds), and non-reportable traders (small-time traders who as a group typically do the opposite of what ends up being a good idea).  The commercial traders are generally the ones to bet with, but there is a big fat caveat: often the commercial traders will get to a big skewed condition early, and so while they may end up being right in the long run, betting with them too early can get expensive.

Commercial traders' net position in gold futures

The last time that commercial gold futures traders were actually net long at all was back in late 2001.  Since then, they have been continuously net short to varying degrees, and so the game consists of evaluating their comparative net short position.  The reason for that bias to the short side is that a lot of the commercial traders are the major gold producers who use the futures market to sell forward their future production.  Selling what you don’t have yet makes you a “short” trader.

When the commercial traders were at this same sort of low net short position back in June 2013, that marked a nice price bottom for gold prices.  Now we are seeing the same sort of sentiment condition, and with gold prices retesting that June low.  Gold stock prices (XAU and GDM) have already broken below their June 2013 lows, as stock traders seem to be uniformly pessimistic about the future for gold.

One of the big fears that is voiced about gold is that the presumptive end to QE will be bad for gold prices because the Fed will stop printing excess money.  But what those voices seem to forget is that QE has not been all that helpful to gold over the past couple of years.  Gold topped at $1900/oz in 2011 when the Fed’s balance sheet was smaller than it is today, and that increase in the balance sheet since then has not stopped gold from falling.  So if the end of QE is really a bad factor for gold, then why was the continuation of QE since 2011 not helpful for gold?

Zooming in closer, we can see the comparison between the current condition in the COT data and what we saw back in June 2013:

Gold COT data

The recent drop in gold prices has had the commercial gold traders paring their collective net short position, perhaps due to hedging less of their future production, or perhaps out of outright smart-money speculation on a bullish outcome.  We cannot know which motivation is the operative one, but we are able to say that the last time the commercials were at a similar level, it marked a pretty decent bottom for gold prices.

Sentiment readings like this represent potential energy; when they get skewed in a big way, they show us how much potential there is for a big move the other way, but they don’t tell us when the avalanche is going to cut loose.  For that we have to turn to other tools to tell us when a move is actually getting going.  But seeing the skewed sentiment conditions tells us which way to start leaning, and which directional signal to start looking for.

COT Report data are reviewed every Friday in our Daily Edition, since Fridays are the day each week when these data come out.  These data do not always have a big message to convey, but when they do, it is usually worth listening to.


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Perhaps The Only Chart That Matters (For Now)

Tom McClellan – McClellan Market Report

There are a lot of different indicators and studies that technical analysts use, and all of those tools came into usage due to some degree of merit.  But the one factor which seems to be trumping everything else lately is what the Fed is doing with its QEternity program, which shows no sign of stopping anytime soon, or maybe ever.

This week’s chart compares the SP500 to the total assets held by the Fed.  That plot is made up from the total of the Fed’s Treasury holdings and its mortgage backed securities (MBS), which are sometimes referred to as “agency” debt products.  The agencies which that title refers to are Fannie Mae, Freddie Mac, etc.

 

Total Assets Held By Fed

Putting the chart together this way helps us see just how important the Fed’s purchases have been to the task of sustaining the bull market for stocks.  Whenever the Fed has decided to change the slope of the green line, the slope of the SP500 has also changed in a dramatic way.  That makes it such an important question to contemplate a “tapering” off in the rate of growth of Fed assets, or even an outright end to quantitative easing (QE).

This chart also helps us see just how critical the Fed’s actions were in bringing about the awful bear market of 2007-09.  Back then, the Fed just held Treasuries, and it did not start buying agency debt until January 2009.  The Fed’s holdings of Treasury debt peaked in August 2007 at $790 billion, and over the next 17 months the Fed sold off more than $300 billion of those holdings.  That’s right, in the middle of the worst liquidity crisis in decades, with banks folding and with Congress handing out tax rebates, the Fed was pulling liquidity OUT of the banking system.

Total Fed Assets 2006-09

When the Fed finally stopped pulling liquidity out of the system and started adding it back in again in early 2009, the market turned upward, and the banking system and economy started working their way back toward health again.

Given the now obvious importance of the Fed’s actions on financial market liquidity, why did they decide in 2007 and 2008 to pull so much money out of the system by selling so much of their Treasury holdings during that bear market?  That will be a great question for the historians to uncover.  But what I can say is that the man who orchestrated and conducted those sales, the former president of the New York Fed, left that job in early 2009 to become the new Treasury Secretary.  So you can draw your own conclusions.

Will all of this QE someday bring us inflation?  Of course it will, because it already has.  In recent decades, many people including Fed officials have come to think of “inflation” as what happens to consumer prices.  But the original definition of inflation refers to the excessive expansion of the money supply.  QE is inflation.  So far, innovation and productivity gains are keeping prices from running away in step with the growth in the money supply.  But rather than allowing consumers to enjoy the benefits of those lower prices, the Fed is confiscating that benefit for its own purposes, insisting on 2% annual growth in consumer prices instead of the “price stability” mandate given to the Fed by Congress.

When will it all end?  That is a hard question, because it goes to the thinking and the decisions of the 12 voting members of the FOMC.  As a markets analyst, I am accustomed to analyzing the collective decisions of millions of people.  THAT can be modeled.  Forecasting the decisions of 12 people is a much harder task.

But it is worth noting that back in 2007, the A-D Line actually peaked 3 months before the Fed’s Treasury holdings peaked.  And the April 2010 stock market top preceded the end of QE1.  Likewise, the market peak in 2011 arrived before the end of QE2.  So it is not reasonable, given these historical events, to conclude that one can just wait to hear news about the end of QEternity in order to know when the top for stocks is going to arrive.


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