My SP500 system passed its summer test. +. EURUSD and Spain worries.

Over the past couple of years I have been monitoring the performance of a 'Trend-Following' system which I created and which I have back-tested going back to 1970. The system faced a major test of its performance this summer, when equity markets went through a torrid correction and phase of up and down swings: Various moving-average indicators (such as the 50/200 Death Cross), and other signals such as the 'Hindenburg Omen' produced Bearish signals.Though my system came close to giving a bear market signal, it ultimately failed to trigger it and retained its Bull Market signal, which was generated in August last year. The system can either be 'Bullish', 'Bearish' or 'Neutral'. I first mentioned my system in a post on the 29th July (Can be seen by clicking here). The system, being a trend following system, is not used to give advance signals, however it does seem to be doing a great job of capturing the underlying trend of the market. Without giving too much away the system is a combination of moving average and trend strength, moderated by volatility and a stop-loss rule. The chart below is the SP500 Index on a Log-Scale from 1970 to 2010, below that is my Bull Marker/Bear Market signal produced by the indicator.

The following is a basic comparison of this system versus the 50/200 cross, Buy and Hold, and 3 year compounded Treasury Yield,I have kept it as simple comparisons. Thus as well as producing a far better return than all these measurements, the system had a much better ratio of winning signals to losing signals on the 50/200 day crossover method; my system had 75% of all directional signals producing positive results, versus 55% for the 50/200 crossover. 

 
As I said the system is trend following not leading, however it does provide a reliable guide to longer-term  market conditions.

Getting away from my system and focusing on the short-term outlook, I believe the SP500 may be vulnerable to some profit-taking. Last week's big news is now out of the way, the April 2010 highs having been hit, a great run-up for stocks since early Sep is now at a mature stage, and elevated concerns of the European Sov Debt crisis are re-surfacing, with all this I can not help thinking some longs may wish to take some chips off the table.  

EURUSD and the EUROPEAN SOV DEBT CRISIS.

Concern continues over the re-emergence of the European Sov Debt Crisis, this continues to undermine the EURUSD. Friday's post highlighted the weak daily structure of the EURUSD on the daily charts, the weekly chart also looks unfavourable for the EURUSD and suggests a possibility of deeper losses to come. I have shown a weekly chart of the EURUSD below, last weeks price action produced a 'Shooting Star' candle. I have highlighted previous 'Shooting Star' candles on this chart.

For the last couple of weeks the Sov Debt crisis has been bubbling under again, I focused on Ireland and Greece in a post a couple of weeks ago whilst Portugal has also been getting much attention. However now the Spanish yield spread v Germany is starting to re-widen and Spanish CDS prices are also pushing up towards their highs of the summer. The charts below show both of these over the past 6 months, technically they both appear to have broken out of a large triangle pattern, which suggests higher levels ahead.

The market, whilst paying lip service, has largely ignored the Greece, Ireland and Portugal woes in recent weeks, however if Spain starts to have problems, then it will have trouble ignoring this, the table below highlights the glaring reason why this would be so.

One final point on the EURUSD, the whole pattern since the June low may be starting to take on the appearance of a '3 Peaks and a Domed House' Pattern (see chart below). As I have mentioned in the past these are very rare patterns but can be extremely dynamic if they follow through. This is one to keep an eye on.

SP500 - Consolidation continues after the failed breakout.

I am not sure how significant yesterday's failed breakout was, it was so brief and fleeting that I am not sure whether to give it serious consideration or not. Turning to the bigger picture, I think overall things still remain finely balanced, the medium-term trends favour the bulls at the mom, the shorter-term indications are sending some ugly warning signs, whilst the overall longer-term picture and outlook still remain ugly in my opinion. Thus we remain at some sort of Crossroads, I have summarised the various components that I see which contribute to the current outlook below. In the meantime I think that a meaningful and sustained break over 1150 (SP500 Future) will favour continued further upside progress. However the longer this fails to materialise, the increasing chance we see some sort of correction, with breaks of 1132 and a sustained break of 1118 as likely catalysts for a deeper move. 

Just to re-iterate the above points: Medium Term I see some favourable factors which I have pointed to over the weeks and months. Amongst these include:

• Large bullish 'Falling Wedge' on the weekly charts.
• Inverted 'Head+Shoulder' continuation pattern.
• 40 Week moving average (Approx equivalent to 200 Day ma) failed to turn lower (or maintain a turn lower), and price has broken back over this level.
• The SP500 has made a new 20 Week High (though as I write it has failed to maintain it).
• Note, the above is largely true for a number of other key broad indices, including the Dow Industrials, the Dow Transports, the NYSE comp, the Nasdaq comp, the Russell 2000.

The chart below shows some of the above.

In addition to the above points there are one or two other signals which fall outside the realm of less-conventional Techinical Analysis, that I watch:

• The first of these is my own long-term trend following system on the SP500, unlike the 50/200 day moving crossover, this did not give a sell-signal in the summer, and is thus still in buy signal mode. (Click here for more detail of my system). I will add however, that this is a lagging indicator, and has little short-term forecasting ability as an indicator.
• Secondly is a comparison between the charts in the mid-70s and the current chart (Can be seen here). I have been following this from a distance as this is a not a tool to be used in daily decision making.
• In addition, the recent USD weakness, continued ultra-low rates, and strong possibility of a new round of QE, all continue to be favourable short-term developments for US equities. 
• Also, strength in certain currencies, notably the EUR and the AUD suggest that risk aversion is low, although JPY strength does somewhat seem to mitigate this a touch.

The Short-term charts continue to cause me concern however, particularly if a sustained break above 1150 on the SP500 futures does not materialise.

• Firstly I have some short-term patterns which bear watching. I have highlighted these on the chart below. In particular the Broadening/Expanding formation. However, as I have previously pointed out these patterns are erratic and can be misleading, as I have also highlighted on the chart. Nonetheless, this current formation is bearing a close similarity to the pattern which formed in late April, though it also looks like the March pattern which led to one final rally higher.
• I also have a strong rising Pivotal line, which currently resides near 1150, this line is drawn in Purple on the chart below. Previously failed attempts to break above, or indeed to follow though on a break above have led to deep corrections on a number of occasions. Note however, that when this line was successfully broken, it then switched to very strong support.
• Additionally 1150 is also the centre line of an Andrews Pitchfork, and is the high of the market before it topped in January.
• 1150 is also a 2/3rds retracement. Although this is not a Fib level, the 2/3rd retrace can be significant when it stalls the market and is tied with other signals. Also worth noting is that the Nasdaq Composite and the NYSE Comp have both stalled at the 2/3rd retracement, whilst the Dow Industrials has hit the 76.4% retrace. The confluence of these key levels as resistance may yet prove to be significant.
• Finally I have highlighted on the chart that the RSI is showing signs of bearish divergence, though this may be just a correction of the overbought status.

In addition I do have some other concerns.
The Bank Index continues to lag heavily. This may of course be a red herring, as it is only one sector, however it is a key sector.
The VIX is churning and not moving lower, though as the period in Q3 showed last year, this need not hold the market back.
The European Sov Debt Crisis continues to rumble on in the background, though the market has largely ignored this of late, it still has the potential to be the 'Elephant in the Room'.

Finally the very long-term charts. The possiblity of a Large Expanding/Broadening formation in my opinion continues to overhang this market. The chart below shows this, together with the large pattern highlighted from 2007. As I have mentioned before these patterns are extremely difficult to navigate, and I do not feel that right now it is a major feature with regard to the short-term direction.

Finally something for the weekend. It is one of my favourite comedy sketches, it comes from 'the Two Ronnies' ,a British TV series from the 1970s. I hope you enjoy it.  Have a good weekend.

Rates Update + SP500 may be getting ready for break higher.

Global Rates

The past couple of weeks have seen some very sharp corrective activity on Rates markets. This corrective phase has occurred in the face of very sharp drops in Government Bond yields over the past few weeks and indeed months. There have been a number of events which have helped contribute to the large drop in yields over the summer, chief amongst these have been 'Flight to Safety' fears regarding the Euro Periphery (PIIGS), Double Dip fears as US economic data disappointed over recent months, poor economic data in other G7 countries, and the increasing belief that Central Banks were going to increase Quantitative Easing in response to fears of further economic pain.  - Is this the beginning of a real turn in the rate environment or a mere correction? - Personally I think this is too early to come to any firm conclusion, however it is something I am going to try and focus on over the next few days and weeks as this is likely to be a barometer of the level of fear and/or confidence running through the global economic environment.

My initial feeling is that this is a correction in rates for now, which probably still has further room to run. - Regarding the issues above, the PIIGS issue has not gone away, Credit Default Swap (CDS) levels remain elevated, though price levels have eased a touch over the past few days. Double Dip fears have eased slightly in the face of marginally better data over the past couple of weeks, (but still remain elevated), stock markets have recovered there poise and QE2 has not yet materialised, though it remains a very strong possibility. - The charts below show US 2 year and 10 year yields, German, Japanese and Australian 10 year yields. --- I have highlighted the Japanese 10 year yield level of 1.20%, this has been a pivotal level for the past few years, the recent collapse in yields across the G7 really accelerated upon the confirmed breakdown through 1.20% in June, and the rebound of the past couple of weeks in JGB yields moved from 0.90% to 1.20% before easing back to current levels around 1.6%

SP500 Index

Last Thursday's 'Shooting Star' candle failed to turn the markets down, with futures levels currently suggesting cash trading around 1118/19, it would appear that this signal is a fail. Unless today's likely stronger opening turns round to produce a weak losing close, then the focus is likely to switch back towards the 1130/32 key resistance area from June and early August.

The chart below shows the patterns which I think are likely to have the greatest influence on the market going forward. I believe the market may be preparing for a breakout higher, I have listed below my reasons for this below. However, as long as the 1130/32 continues to offer strong resistance, and until we see a clear and sustained break over this level, the risk of further consolidation or a move lower remains a possibility.   

Clues as to why a breakout higher may be due soon :

1) The large 'Falling-Wedge' pattern (highlighted above): I covered this many times over the past couple of months, including this posting from the 2nd August (Click here). I am re-posting some work I have done on 'Falling Wedge' patterns below.

 

I have long favoured that we have a Type 2 pattern (as per the above), though I have had doubts, which have led me to question that we may actually have a Type 3.  However the re-test of the breakout, which has held well, does lead me to once again think that this is a Type 2 pattern, which has bullish connotations whereas a Type 3 has a very bearish connotation. - Note: Type 2 patterns usually morph from failed Head + Shoulder pattern, which in its own right is a Bullish pattern.

2) The Higher Low (highlighted in above chart) is another supportive factor.

3) The internal 'Inverted Head + Shoulders' pattern. - I am loathe to actually call this a true 'Inverted Head & Shoulder pattern' as these would normally occur at the end of a sustained trend, however when combined with other signals, these can act as continuation patterns.

4) My own Long-Term trend following system remains in Bullish posture, it failed to produce a sell signal on the May/June sell-off. I posted a blog on this a couple of months ago (can be seen here). This system is not a forward looking system, hence I do not consider it as a trading signal, however it should not be ignored either.

5) 1970's redux. I posted about this in July, the price action since then has actually re-enforced this even further.  Below is an updated chart of the near-term comparisons, note history does not repeat itself, but it does rhyme.  (Click on the Highlighted link at start of this paragraph to see full item for bigger picture).

6) AUDJPY -- This has been one of my main risk barometers over recent months. I have previously highlighted the Symmetrical Triangle on this FX cross. The price appears to be breaking out of the top of the pattern (see chart below), if this is maintained, this would be bullish for the AUDJPY, who's moves have been well correlated with moves with the SP500 over the past couple of years.

Of course, all this will be 'by the by' if the SP500 fails to clear 1130/32, or makes a short-false break. In the meantime, I would not be surprised if selling pressure was to emerge ahead to this key area. 

Sp500 - My system retains Bullish Environment posture.

Much has been written regarding the 50/200 moving average crossover on the SP500 in recent weeks. The 50/200 sma crossover produced a bearish signal in early July. Since that signal the SP500 has rallied strongly, there is nothing that unusual in this, the 50/200 crossover is a lagging indicator and it is not uncommon for adverse moves to occur after a signal. - The chart below shows the recent crossover; it is noteworthy that the SP500s rise has been constrained twice by the 200 day sma since breaking through it to the downside in May. Although my outlook for the SP500 is currently bullish, this bullishness will be tempered if the price fails to clearly break above the 200 day sma soon.

In relation to the 50/200 moving average crossover, I have looked back at its track record since 1970 (A generous 40 years worth of data). In that time it has produced 40 signals, 22 winners and 18 losers, in other words just over half the signals have been successful, not a particularly impressive performance. In terms of returns, its annualised return has been around 6.82%, which is better than a 'Buy and Hold' strategy during that time, though only just (I have calculated simple annualised return on Buy and Hold at 6.24%). The return also exceeds the return had an investor placed his money at the US 3 year Treasuries rate on a rolling annual basis (6.68% according to my calculations), though again only marginally better, and not great considering the amount of drawdown and uncertainty suffered during that time, relative to such a safe investment.

Further to this, for the past couple of years I have been monitoring my own system which I use to gauge whether we are in a Bullish or Bearish environment for the SP500.  The model is similar to the 50/200 in that it is a lagging indicator, however it differs in a number of ways. For a start it is a momentum indicator of the 50 day simple moving average. I then have a number of entry and exit rules for bullish or bearish signals, in addition a neutral signal can also be created. I do not use this system as a trading system, since like the 50/200, it is a lagging not forward looking indicator, and is therefore liable to significant adverse swings, which could seriously damage the wealth of a leveraged trader such as myself. However, I do use it to gauge the overall trend environment of the market, and will always be aware of the trending environment as indicated by my system. -  For the record, had I used it since 1970 as an investment tool, its performance would have been significantly superior to the 50/200 crossover method. It has generated 32 signals in that time 15 winning signals and 5 losing signals, a 75% success rate winners to losers (The remainder have been neutral signals, although they have been for shorter periods, just over 2 months on average.).  The annual average return would have been 8.48% (Though this does not include interest on balances during neutral periods, which would have slightly increased the return).

The last signal generated by my system was early July 2009 when it turned bullish. Throughout the past three months of negative price action it has remained in bullish mode, though being a lagging indicator it would anyway take its time to turn neutral or bearish. Despite being in bullish mode, it currently is in an oversold position, and moving lower, which highlights a risk of turning bearish, however the market would need to start turning seriously lower over the next week or two to generate a bear signal. Unless that occurs soon it will likely continue to signal a bullish environment.

The first set of charts below shows the SP500 over the past decade or so, with my indicator below. The coloured areas on the chart shows the nature of the environment (bullish/bearish/neutral) as indicated by the system.

The next chart shows the SP500 on a log-scale since 1970, with the coloured areas on the chart reflecting the nature of the environment (bullish/bearish/neutral) as indicated by the system.

Finally below is  a table showing some performance statistics for the system, compared to the 50/200 crossover method, 'Buy and Hold', and an investment at the 3 Year Treasury rate.