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.

Likely to remain volatile into next week. + US 10 Year + Is Greece hotting up again?

The US equity markets continues to behave in a volatile nature, this is not surprising given the weight of news and data over the next week. A QE story seems to hit the wires about every 5 minutes, it appears that opinion remains strongly divided both within the Fed and outside. My call is that Bernanke, being the sly old fox, will pander to both sides, perhaps not doing as much as the most extreme expectations, but none the less providing a strong boost, but within that also allowing flexibility for the future so that of he needs to hit it heavy and hard he can, or if he needs to ease back he can. - I do not expect the issue to actually be resolved fully next week, thus this will likely remain an on-going theme for the next several months, adding to increasingly volatile markets. I do not think much, direction wise, will be resolved until next week at least, but clearly the news will have the ability to slice a chunk off of the market, or give it an extra boost, which is why we are seeing increasingly volatile short-term action.

Moving on to US 10 Year yields. This is obviously a central theme in the on-going QE debate, since these are likely to be one of the main tools used by the Fed in the QE operations. However, an awful lot has been priced in on these, and in the past few weeks some of the froth has started to disappear from the 10 year t-note futures markets: Yields have seen a decent pick-up, rallying almost 40bps from the low 2.30s to the low 2.70s yesterday. I had been expecting this to move lower towards 2.00%, however whilst I do not rule this out for a later trade, short-term it looks like a low is in, and the risk of a rally towards the low 3 handles is a real possibility in the next few months. The first chart below shows US yields over the past couple of years.

The chart above shows how the yield has been forming a 'Falling Wedge' pattern in recent months, whilst momentum as measured by the 10 day RSI has been diverging upwards. The past couple of days has seen a breakout from the wedge, the yield may comeback to re-test the top of the wedge, but the risk is that it holds and moves higher. - The 10 Year t-note continuation future chart is also supporting these assertions. The top chart below shows this on a weekly basis. A couple of observations which I have highlighted:

• Firstly the strong similarity between the recent price and momentum action and the price and momentum action at the interim top in early 2008, both highlighted within the mauve ellipses. Note the sharp correction led to an extended consolidation, after which the main rally re-asserted itself. 

• Secondly the similarity between the bigger picture price action and the next chart below which shows Gold weekly 2006 - 2010, in particular the price behaviour as highlighted by the large red ellipses on both charts. On both occasions the breakout of these large patterns led to strong dynamic rallies. In the case of the Gold the rally eventually led to the Gold price being well overbought in late 2009. This saw a sharp correction followed by consolidation, eventually however the rally in Gold, as we know re-asserted itself.

The market is likely to see some rebound I think before and possibly around next week's news, however the move to higher yields could be a theme in the next few weeks.  Will this affect stocks? I am not sure, historically these markets move inversely, however the relationship between these two has not been consistent in recent years. However, if stocks were to suffer a sharp drop, then it is likely that bonds rally and yields drop, thus if the above scenario above were to occur, it is likely it would happen against a steady or rallying stock market environment.

Finally with regard to Greece; there has been a lot of negative talk hitting the wires these past couple of days. One theme seems to be how, with economic conditions weaker than expected (not helped by the EURUSD recovery), tax revenue is coming up short of projections in parts of Europe, and as a result countries struggling with high deficits are now confronting the prospect that they will miss the budget deficit targets forced upon them this year. In the past couple of days things have started to stir in Greece whilst Ireland has had mounting issues in the past couple of weeks. The charts below show the 5 Year CDS for Greece and Ireland over the past 6 months, below that is a chart of the SP500 Index and the EURUSD. I have highlighted the two prior occasions when the 5 year CDS prices moved up sharply in the past 6 months, and how this saw sharp drops in the SP500 and the value of the EURUSD. In addition I have placed emphasis on the action of the past week. - If this whole Euro Sovereign Debt issue were to explode again, then the above analysis is likely to be wrong on the T-note, as US yields should drop as a safe-haven bet while equities would once again probably turn ugly. 

 

Fear and Risk-off v Risk-on.

         Last week I wrote a blog about whether fear was abating (can be seen here), I used an Investors Intelligence piece highlighting how Newsletter writers were at a level of bearishness which had previously seen the market rally strongly, I also pointed to the correction occurring in Japanese Government Bond yields, after their huge summer rally. - However, as I look at the bigger picture, this does not yet to me reflect a climate in which fear is abating, last week's stock market bounce, strong though it was, is just one of many sharp moves in recent months as equities have continued to gyrate in a wide range. Also the jump in Japanese Government Bond yields from 0.90% to 1.20% last week was a large move in a very short term, however it had dropped from 1.40% over the past 5 months. At the moment, a move such as this appears to me to be corrective (See chart below), though how it unfolds from here going forward will determine whether this is merely a short-term correction or the start of something more meaningful in a positive direction.

 

However when I look at various other indicators of fear I start to question whether fear is abating, or whether it is getting ready to re-assert itself.  The initial fear has certainly abated, in this case the fear that led to a sharp increase in volatility (as measured by the VIX index) through May and June, however US equity markets have not recovered, they have remained range-bound (though now nearer the top of the range) since initially rebounding in early July. 

Elsewhere, other measures of fear remain high. By this I mean the measure of fear as gauged by where investors are willing to park their capital. Over the summer, we have seen investors favouring a number of very low yielding products and markets, this surely would only occur if fear was high and people seeked certainty over return: Looking at 10 Year Government Bond Yields for most major western economies, these have seen yields drop sharply over the course of the summer; 

Japan      1.40% to 1.14%  (Low 0.90%) 

US          4.00% to 2.60%  (Low 2.41%)

Germany 3.20% to 2.23%  (Low 2.11%) 

UK         4.08% to 2.91%. (Low 2.79%)

Amongst FX markets, Japanese Yen and Swiss Franc (The traditional safe haven, and lowest yielding currencies) have been 2 of the strongest currencies over the summer. The charts below show the performance of the USD, AUD and EUR versus the JPY and CHF fx crosses.

 

Gold, Silver and Copper have remained strong over the course of the summer, and are currently pushing up against recent highs. But most strikingly the European PIIGS issue has failed to go away, in fact it has continued to trend higher, though it remains shy of the May and June spikes higher. See charts below; top chart is Greek 5 Year Credit Default Swaps (CDS), middle chart is Spain 5 year CDS over the past few months, lower chart is Spain 5 year CDS over past 3 years. (Note; I have highlighted a possible bullish Symmetrical Triangle on the Spain 5 Year CDS chart, which may be a precursor to this breaking out to a new higher level)..

I think it is still fair to say that 'risk-off' remains very much in vogue when it comes to the major western economies. This is probably holding back stock markets, which despite a number of attempts to rally and try and retrace the May/June losses (DAX excepted), become dizzy every time they try to break higher above the top of the recent range. - I would guess that until the fear of risk starts to abate, stock market will continue to struggle to make gains and hold on them. -- I would also be slightly concerned that the PIIGS issue continues to stir in the background, and is showing some signs that it may be preparing to move to a new accelerated level. Another major flare up of the PIIGS issue, could lead to a new flight from risk going forward.