One of the best pieces of advice I ever got was this: “Don’t tell the market what it’s supposed to do, let the market tell you what you’re supposed to do.”

That is profound.  And it really makes me wish I could remember the name of the guy who said it.  Sorry dude.  Anyway, whoever and wherever you are, thank you Sir.

Think about it for a moment.  Consider all the “forecasts”, “predictions” and “guides” to “what is next for the stock market” that you have heard during the time that you’ve followed the financial markets.  Now consider how many of those actually turned out to be correct.  Chances are the percentage is fairly low.

So how do you “let the market tell you what to do?”  Well, like everything else, there are lots of different ways to do it.  Let’s consider a small sampling.

Basic Trend-Following

Figure 1 displays the Dow Industrials, the Nasdaq 100, the S&P 500 and the Russell 2000 clockwise form the upper left.  Each displays a 200-day moving average and an overhead resistance point.

Figure 1 – Dow/NDX/SPX/RUT (Courtesy AIQ TradingExpert)

The goal is to move back above the resistance points and extend the bull market.  But the real key is for them to remain in an “uptrend”, i.e.,:

*Price above 200-day MA = GOOD

*Price below 200-day MA = BAD

Here is the tricky part.  As you can see, a simple cross of the 200-day moving average for any index may or may not be a harbinger of trouble.  That is, there is nothing “magic” about any moving average.  In a perfect world we would state that: “A warning sign occurs when the majority of indexes drop below their respective 200-day moving average.”

Yet in both October 2018 and May 2019 all four indexes dropped below their MA’s and still the world did not fall apart, and we did not plunge into a major bear market.  And as we sit, all four indexes are now back above their MA’s.  So, what’s the moral of the story?  Simple – two things:

1. The fact remains that major bear markets (i.e., the 1 to 3 year -30% or more variety) unfold with all the major averages below their 200-day moving averages.  So, it is important to continue to pay attention.
2. Whipsaws are a fact of life when it comes to moving averages.

The problem then is that #2 causes a lot of investors to forget or simply dismiss #1.

Here is my advice: Don’t be one of those people.  While a drop below a specific moving average by most or all the indexes may not mean “SELL EVERYTHING” now, it will ultimately mean “SEEK SHELTER” eventually as the next major bear market unfolds.  That is not a “prediction”, that is simply math.

The Bellwethers

I have written in the past about several tickers that I like to track for “clues” about the overall market.  Once again, nothing “magic” about these tickers, but they do have a history of topping out before the major averages prior to bear markets.  So, what are they saying?  See Figure 2.

Figure 2 – SMH/Dow Transports/ZIV/BID (Courtesy AIQ TradingExpert)

The bellwethers don’t look great overall.

SMH (semiconductor ETF): Experienced a false breakout to new highs in April, then plunged.  Typically, not a good sign, but it has stabilized for now and is now back above its 200-day MA.

Dow Transports: On a “classic” technical analysis basis, this is an “ugly chart.” Major overhead resistance, not even an attempt to test that resistance since the top last September and price currently below the 200-day MA.

ZIV (inverse VIX ETF): Well below it’s all-time high (albeit well above its key support level), slightly above it’s 200-day MA and sort of seems to be trapped in a range.  Doesn’t necessarily scream “SELL”, but the point is it is not suggesting bullish things for the market at the moment.

BID (Sotheby’s – which holds high-end auctions): Just ugly until a buyout offer just appeared.  Looks like this bellwether will be going away.

No one should take any action based solely on the action of these bellwethers.  But the main thing to note is that these “key” (at least in my market-addled mind) things is that they are intended to be a “look behind the curtain”:

*If the bellwethers are exuding strength overall = GOOD

*If the bellwethers are not exuding strength overall = BAD (or at least not “GOOD”)

A Longer-Term Trend-Following Method

In this article I detailed a longer-term trend-following method that was inspired by an article written by famed investor and Forbes columnist Ken Fisher.  The gist is that a top is not formed until the S&P 500 Index goes three calendar months without making a new high.  It made a new high in May, so the earliest this method could trigger an “alert” would be the end of August (assuming the S&P 500 Index does NOT trade above it’s May high in the interim.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

For the record, “tutorial” may not actually be the right word. The word “tutorial” implies that “this is how you do something.”  In reality, when it comes to trading options, there is no “one way” to do anything.  So, think of what follows as more of an “example of one way to play” and NOT as the “only or best way.”

For Openers: Catalyst and Expectation

We will walk through an example that buys a call option on ticker CGC.  For openers, when looking to buy a call option on anything you will ideally have two “thoughts” in place:

*A “catalyst”

*An “expectation”

A “catalyst” is simply something (anything) that prompts you to want to take a trade in the given underlying security in the first place.  Be it overbought/ oversold, trend-following, Elliott Wave, reversion to the mean, an indicator crossover, an indicator/price divergence, etc., (the potential list is essentially infinite).  But the point is, you need something that says to you, OK, now’s the time.”

An “expectation” involves any thoughts you might have regarding how far you expect the underlying security to move and any timeframe you might have in mind.  For example, if you expect the underlying security to “rally 2% in the next 5 days” that is a different proposition than saying “well I expect it to trend higher in the months ahead”.

Month and Strike Selection

The next step is to select the option that offers the preferred tradeoff between reward and risk given your particular “expectation”.

In the first instance, you can buy the shorter-term option that offers the maximum return if the underlying does indeed rally 2% in 5 days.  In the second instance, you would likely need to buy a much longer-term option and will need to consider carefully which strike to buy (to mitigate time decay, etc.)

Trade Management

Once a trade has been identified and entered the trade needs to be managed (for the record, the trade management plan should already be figured out before you actually enter the trade).  This basically involves setting parameters on:

When you will take a profit:  If your expectation is that the underlying security will rise 2% in 5 days and it rises 2% in 5 days you should (presumably) just go ahead and take the profit.

When (and if) you will cut a loss: A long call (or put) can lose no more than the premium paid, so depending on how you size your trades it may not be necessary to cut an open loss.  However, in many cases, if a trade is not working (ex., the underlying security is not moving as expected) out it makes sense to have some plan to conserve some capital by exiting rather than just sitting around waiting for the option to lose 100% of its premium.

When you might consider adjusting the trade (typically to improve the overall reward-to-risk profile): If you buy 10 calls and get a nice profit it can make a lot of sense to sell some of those calls to lock in some profit and then “let the remaining position ride” in hopes of the “Big Score”.

Example

We will look at ticker CGC.  Figure 1 displays a bar chart from ProfitSource by HUBB with a Bullish Wave 4. The target range is $56.86 to $63.50 by August 28^th.

(click to enlarge any of the Figures below)

Figure 1 – CGC with Elliott Wave count (Courtesy ProfitSource by HUBB)

IMPORTANT: There is NO GUARANTEE that any “wave count” is going to pan out as projected.  As such, please note that while I do use and heartily endorse ProfitSource, I am not suggesting that this signal (or any other signal) generated will lead to a profit and of course – as always – I AM NOT “recommending” the example trade that follows.  All of this is presented merely as an “example” of “one way” to play.

Figure 2 shows that implied volatility for CGC options is on the low end of the historical range.  This suggests that options are “cheap” and may be conducive to buying call options.  CAVEAT: CGC has only been around for a short time so the historical IV range could certainly expand (higher or lower) in the future.Figure 2 – Implied volatility on CGC options is “low” (Courtesy www.OptionsAnalysis.com)

Figure 3 displays an input screen from www.OptionsAnalysis.com.  In this example we are looking for the call option with “Highest Probability of Touching it’s % to Double Price” (i.e., how far does the underlying stock have to move in price in order for the option to double in price AND what is the mathematical probability of the stock hitting that price).

Figure 3 – Looking for Highest Probability of Touch % to Double price at www.OptionsAnalysis.com (Courtesy www.OptionsAnalysis.com)

Figure 4 displays the output screen and lists the October 42.5 call as the top choice.  The next to last column tells us that the stock must rise +23.76% by 30 days prior to option expiration in order for this option to double in price.  The far right column tells is that there is a 36.56% chance of this happening.

Figure 4 – Probability of Touch % to Double Output (Courtesy www.OptionsAnalysis.com)

Figure 5 displays the particulars for this trade.  Note that the entry price is $4.75.  If we place a market order we would presumably get filled at the “ask” price of $4.95.  So, this example assumes that we used a “limit order” to buy at the midpoint of the bid/ask spread.  Traders need to remember that a “market” order guarantees a fill, but likely at the highest possible price.  A “limit” order can allow you to buy the option at a lower price, however, there is no guarantee that you will be filled at your price (or at all).  Just one more decision a trader must make.

One tip: If a trader absolutely wants to enter a trade, one possibility is to place a limit order to try to get filled at a better price, and if not filled near the end of the day to cancel the limit order and (bite the bullet) and buy via a market order (in order to avoid missing the trade altogether).

Figure 5 – CGC trade particulars (Courtesy www.OptionsAnalysis.com)

Figure 6 displays the risk curves through October expiration (the black line represents the expected P/L at the time of October expiration).  The most obvious thing is the “unlimited profit potential/limited risk” nature of the trade.

Figure 6 – CGC call option risk curves (Courtesy www.OptionsAnalysis.com)

A mentor of mine – a gentleman named Mitch Genser – was fond of pointing out the importance of looking more closely at “where this trade lives.”  Let’s consider that concept here.

On the downside, the reality is that if CGC drops to say $35 or below the likelihood of things working out profitably are quite low.  So, we might consider using that as an arbitrary “bail out” point.

On the upside, the Elliott Wave count in ProfitSource showed $56.86 a share as a target.  The count also suggested the move  if it is going to happen – should happen by August 28^th.  So, Figure 7 shows us “where this trade lives”, i.e., between $35 a share and $56.86 a share through August 28^th.

Figure 7 – CGC call option risk curves through August 28^th (Courtesy www.OptionsAnalysis.com)

When analyzed this way, this example trade basically comes down to giving CGC roughly 2 ½ months to move higher to $56.86 – which would generate a profit in the $1,000 range – or to drop down to $35 a share – which would result in a loss in the -$420 range.

Summary

The purpose of this article is NOT to suggest that you trade options on CGC nor is it intended to suggest that you should rely solely on Elliott Wave projections to target trades.  The purpose is simply to highlight one example of a set of steps that may help traders improve their odds on a trade-by-trade basis:

*A trading catalyst

*An expectation regarding the underlying security

*Identifying the option that offers the best tradeoff between reward and risk based on one’s “expectations”

*Deciding how to enter a trade (market versus limit)

*A plan to manage the trade once entered (i.e., when to take a profit, cut a loss, and/or adjust the initial position)

*The emotional wherewithal to follow the plan

In the immortal words of Sean Connery as Malone in the Untouchables, “Here ends the lesson.”

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

If I had a dollar for every time I’ve heard “gold is set to soar in the coming days/weeks/months/years ahead” since I started in this business, Jeff Bezos would be bringing me coffee.  You would think at some point investors would just tune out all the gold hype and move on.  Yet the allure remains.

And now here we are again.  Go onto any financial news aggregating site and you will find plenty of “gold is ready to move” material.  Actually, it seems to usually appear with a question mark attached, as in “Is Gold About to Soar?” (reminding us once again of that important market forecasting adage which states: Nobody knows anything”) rather than in declarative form, i.e., “Gold is Set to Soar.”  But it doesn’t rally matter, the effect is the same.  Call it “Gold Angst”.  Investors sit there and wonder “should I or shouldn’t I” take the plunge?

Here is one way to get the whole gold angst thing off your plate:  Buy the January 2021 GDX 22 strike price call.  Now – and as always – this is not an actual “investment recommendation”.  I have no firm opinion as to whether or not this position will ultimately make money.  But here is what it does do:

*It gives an investor a position in gold (OK, sort of, since we are merely buying shares of an ETF that tracks gold stocks)

*It gives gold about a year and a half to decide whether or not it finally wants to make a move.

*It doesn’t cost very much

As you can see in Figure 1, the implied volatility for options on GDX is still at the low end of the historical range.  What this means to option trader is that the time premium built into GDX options is relatively low, i.e., options are “cheap”.  If volatility picks up  at some point in the next year and a half, the time premium built into the options will increase, which could boost the profitability of a long position (or at least reduce the downside loss in the interim).Figure 1 – Long Jan2021 GDX 22 call (Courtesy www.OptionsAnalysis.com)

Figure 2 displays the trade particulars and Figure 3 displays the risk curves.Figure 2 – GDX Jan 2021 22 call (Courtesy www.OptionsAnalysis.com)

Figure 3 – GDX Jan 2021 22 call risk curves (Courtesy www.OptionsAnalysis.com)

It’s pretty straightforward.  If gold does not rally in the next year and a half this position can lose up to $348.  If gold does rally in the next year and a half, this position can make good money – potentially a lot if the people screaming “Gold is About to Soar” ever actually turn out to be right.

Summary

Bottom line: Gold has rallied many times in the past several years only to peter out and sink, so there is reason to doubt the recent “pop” in price.  What happens from here?  I am offering no opinion.  So, don’t go out and buy GDX options solely because you read this article.

But if you find yourself suffering from “Gold Angst” do consider the possibilities.  By buying a cheap call option (risking maybe 1% to 3% of one’s investment capital) an investor has a position in gold and the “should I or shouldn’t I jump into gold” angst is relieved.  If the bullish forecasts actually turn out to be correct in the next 19 months the possibility to make a decent return exists.  And if not, the investor has sacrificed 1% to 3% of his or her investment capital.

In sorting things out, this simple two question quiz may help:

1. Are you feeling angst because you think gold may make a big move and you will be left out?
2. Do you have $348 bucks?

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

There sure are a lot of ETFs out there.  I mean let’s face it, the marketing and product development people stay up late.  If they discern even a hint of potential interest in a small-cap growth fund that invests only in marijuana companies whose ticker symbol starts with the letter “A” then by god, there will be an ETF that “affords investors the opportunity to invest in this unique niche” (those marketing folks sure can turn a phrase can’t they).  They might even create a “series of ETFs” – POT-A, POT-B, POT-C, etc.  Then another ETF provider will copycat and launch BUZZ-A, BUZZ-B, BUZZ-C and so on.  Next comes the large-cap, value and dividend-paying versions.  You get the idea.

So, the reality is that there are roughly – and I am just spit-balling here – a bazillion ETFs in existence now.  And the reality is that alot  of them never gain any real traction and fail to garner any meaningful trading volume.  And sometimes a nugget gets lost in their midst.  Take ticker SDYL for example.  But first…

The S&P 500 High Yield Dividends Aristocrats Index

The S&P High Yield Dividend Aristocrats Index (apparently the folks who create indexes are staying up late too) is comprised of the 50 highest dividend yielding constituents of the stocks of the S&P Composite 1500 Index that have increased dividends every year for at least 25 consecutive years.  Data for the index goes back to January 2000.  Figure 1 displays the theoretical growth of $1,000 invested in the index versus the growth of $1,000 invested in the S&P 500 Index starting in January 2000.

Figure 1 – Growth of $1,000 invested in the S&P High Yield Dividend Aristocrats Index and the S&P 500 Index; 12/31/1990-5/31/2019

As you can see, since inception the index has significantly outperformed the S&P 500 Index, posting a gain of +551% versus +173% for the S&P 500.  Of course, you can’t trade an index, you must trade a fund or ETF that attempts to track the given index.  So, we turn our attention to…

Ticker SDY

Ticker SDY is the SPDR ETF (SPDR S&P Dividend ETF) that tracks the S&P High Yield Dividend Aristocrats Index.  The first full month of trading for SDY was December 2005.  So, Figure 2 displays the growth of $1,000 invested in ticker SDY starting in December 2005 versus the growth of $1,000 invested in ticker SPY – an ETF that tracks the S&P 500 Index.

Figure 2 – Growth of $1,000 for SDY and SPY since 11/30/2005

Since SDY started trading it has slightly outperformed ticker SPY (+201% verus +189%).  Combined with the index performance prior to SDY inception, this is pretty good all by itself.  But it’s NOT good enough for the marketing person in the wee hours!  And then it hit them – what we need is a leveraged version!  Which leads us to…

Ticker SDYL

Ticker SDYL is the ETRACS Monthly Pay 2xLeveraged S&P Dividend ETN, an Exchange Traded Note linked to the monthly compounded 2x leveraged performance of the S&P High Yield Dividend Aristocrats® Index (the “Index”), reduced by the Accrued Fees. The first full month of trading for SDYL was June of 2012.  Figure 3 displays the growth of $1,000 invested in SDYL, SDY and SPY since 5/31/2012.

Figure 3 – Growth of $1,000 for SDYL, SDY and SPY since 5/31/2012

Since 5/31/12:

SDYL = +418%

SDY   = +143%

SPY   = +148%

So does this mean SDYL is the best choice?  Not necessarily.  While it has made more than twice as much as the other 2 ETFs, that performance comes at the price of an average standard deviation and a maximum drawdown that is also twice as large. So, the risk factor is something to consider.  But that’s no even the real problem.  The real problem is that SDYL barely trades at all.

As you can see Figure 4, SDYL has failed to gain any traction with investors and holds only $16.6 million in assets and trades a paltry 1,734 shares a day.  SDY trades 332 times as many shares per day as SDYL and SPY trades 42,302 time as many shares per day as SDYL.

Figure 4 – $’s in assets and average daily trading volume

Summary

For investors looking for profit potential, SDYL – at first blush looks – terrific.  But will enough investors ever take notice enough for SDYL to trade with any real volume?

I don’t know.  Maybe the marketing people need to stay up even later and figure out how to whip up some interest.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

Options are foreign to many investors.  And yes, there is a degree of complexity and a necessary learning curve involved.  But understanding  even a few basic option strategies can open a world of opportunity.

In a nutshell I typically describe options as offering 3 basic avenues:

*Expressing a market opinion (i.e., profiting if a security moves in the direction you think it will go), typically at a fraction of the cost of trading shares of stock

*Hedging an existing position or portfolio (i.e., the ability to protect yourself without having to sell your stock holdings)

*Taking advantage of unique situations (selling premium to make money in a neutral market, buying a straddle to profit if a move takes place in either direction, and so on.)

What follows is NOT a recommended trade or opportunity.  It is simply an example that compares buying stock versus buying an option to illustrate the relative pros and cons.

Ticker CMCSA

According to the Elliott Wave count from ProfitSource by HUBB, Comcast (CMCSA) is setting up for a Wave 4 advance in price.  Now the caveats: I like and use ProfitSource and I find the built in Elliott Wave count to be useful.  That being said, no given “setup” or “Wave count” is EVER guaranteed to pan out.  I have no idea whether this latest count for CMCSA will ultimately be a good one or a bad one.  In this instance I am simply using it as a potential catalyst for a hypothetical trade for illustrative purposes.

Figure 1 – Potentially bullish Elliott Wave count for CMCSA (Courtesy ProfitSource by HUBB)

This wave count is projecting that CMCSA will rise to somewhere between $45.67 and $48.30 by the end of July.

Let’s assume that we believe the wave count in Figure 1 will play out and that we want to speculate on this opportunity.  The simplest approach would be to buy 100 shares of CMCSA stock.  With the stock trading at $41.40 a share, this would involve spending $4,140 to buy 100 shares.  This position appears in Figure 2.  Note that for every $1 the stock goes up the position makes $100 and vice versa.  A 100 shares of stock position has a “delta” of 100.

Figure 2 – Buy 100 shares of CMCSA (Courtesy www.OptionsAnalysis.com)

Another possibility (among many) would be to buy the September 37.50 strike price call for $470.  This is only about 10% of what the stock trader must put up.  This trade appears in Figure 3.

Figure 3 – Buy 1 Sep2019 37.5 strike price call (Courtesy www.OptionsAnalysis.com)

A few things to note:

*The worst-case loss for the option trade is -$470

*The trade has a “delta” of roughly 78.  While delta value can and will change over time, for now it means that this position is essentially equivalent to holding 78 shares of stock.  In other words, the option buyer in this example buys 78 deltas for $470 versus the stock trader who buys 100 deltas for $4,410.

How will this all play out?  It beats me (and remember I am NOT suggesting that CMCSA is bullish nor am I recommending either of these positions).

Figure 4 displays the expected dollar profit or loss from the two positions at various prices for CMCSA stock as of the end of July.

Figure 4 – Expected $ P/L at various price at end of July

Note that at higher price the call option makes almost as much total $ return as the stock position while committing 90% less capital.  Likewise, as price sinks progressively lower the stock position just keeps losing more and more, while the option position cannot lose more than $470.

While the number are helpful, still probably the best way to illustrate the relative tradeoffs is to overlay the two position on one chart.  See Figure 5.

Figure 5 – Comparative Risk Curves for stock versus option (Courtesy www.OptionsAnalysis.com)

Summary

So, is better to buy the call option than the stock shares?  That’s for each trader to decide in each situation.  While in this illustration the option appears to have some advantages, another scenario involves the stock “going nowhere” for a while before making a move higher.  In that scenario the stock trader can simply hold the stock shares and wait.  The option will expire in September and the option trader will have to make another trading decision.

In any event, remember that the purpose of this article is NOT to prompt you to take action regarding CMCSA.  The purpose is simply to illustrate the relative pros and cons of options versus stocks in certain situations.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

Real Estate Investment Trusts (REITS) have held up well during the May selloff.  As we will see in a moment, this probably should not come as a surprise.  Based on the typical seasonal trend for REITs it might make sense to hold on a little longer.

A Bullish Stretch

Let’s keep it simple.  Figure 1 displays the cumulative growth of $1,000 invested in Fidelity Select Real Estate fund (FRESX) ONLY during the months of March through July every year starting in 1987.

Figure 1 – Growth of $1,000 invested in FRESX March through July 1987-2019

As you can see – while nothing is ever perfect – the sector has showed a strong tendency to perform well from late-winter into mid-summer.

Figure 2 displays the year-by-year results and Figure 3 displays a few key facts and figures.

Figure 2 – Year-by-Year Results

Figure 3 – Facts and Figures

Summary

FRESX has showed a gain since the end of February 2019.  Can we be sure that things will improve between now and the end of July?  Not at all.  But history seems to suggest that that may be the way to bet.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

One thing that keeps me slightly optimistic these days is all the gloom and doom forecasts I read regarding the economy.  Not that there isn’t plenty of truth to what is getting written.  But it just seems like everyone wants to be the first one to “call the top” in the economy.  Is there a way to be objective?  Maybe so.

Where We Are

First let’s get the “politics” out of the way.  The Democrats on one hand want Obama to get the credit for the “roaring” economy while on the other hand claiming that the economy is “not that great”.  Republicans just hope to get to the next election before the next recession kicks in.  All that uselessness aside, we are presently doing very well economically.  Improved growth and profitability, more entrepreneurs taking the plunge, low unemployment and low inflation.  We should all be happy, right?  What, are you crazy?  Debt, deficits, trade wars, overheated housing prices (in some areas) and a slowdown in housing sales (in other areas), an inverted yield curve and so on and so forth are all causing great angst among people who, um, choose to focus on things that cause them angst.

Despite current economic growth, pretty much anyone who knows anything about economic cycles know that “nothing lasts forever”, especially economic growth.  Consider the unemployment rate.  When people hear that unemployment is low they think “great!”  But when they look at the history of unemployment in Figure 1, they tend to think “things can’t get any better so they are likely to get worse.”  And history appears to be on their side.Figure 1 – U.S. Unemployment (Source: www.yardeni.com)

The U.S. and world economy seem to run on a never-ending cycle of “boom” followed by “bust”.  Therefore, since things are “booming” now then we must be closing in on the next “bust” – hence the reason for all the recent negativity.  And there is good reason to pay attention and remain vigilant.  But that is different than just perpetually lamenting that “the end is near”.

So, what can we look at to get an objective handle on – and be able to speak  intelligently about – “the economy”?

What to Follow to Assess “the Economy”

What follows is NOT intended as a “comprehensive” guide to economic forecasting.  Not at all.  What follows is simply a few key things that investors can watch for clues of an actual impending downturn.  In other words, if these factors are not flashing warning signs, for gosh sakes, stop worrying incessantly about the economy and get back to enjoying your life for crying out loud.

But just as importantly, when they do start flashing warning signs, you must absolutely, positively resist the urge to stick your head in the sand and pretend that “all is well” (pssst, which is usually what happens at the top).

Factor #1: Leading versus Coincident Indicators

Figure 2 is from www.Yardeni.com (a source of a tremendous amount of free and useful information).  It displays the ratio of the leading economic indicators to the coincident economic indicators.Figure 2 – Ratio of Leading to Coincident Indicators (Source: www.yardeni.com)

There are three things to note:

1. The blue line rises and falls regularly

2. The grey vertical areas represent period of economic recession in the U.S.

And most importantly:

3. (With the caveat that anything can happen) Every recession in the past 50 years was preceded by a clearly declining trend in this ratio

The point: The line displayed in Figure 1 has stopped advancing in recent months and has begun to “squiggle”.  OH MY GOD THAT MUST MEAN THE ECONOMY IS DOOMED TO FALL APART!!!!!  Oh wait, no that’s not what it means.  It means we should be keeping an eye on it for signs of further weakness and if further weakness does unfold we should then be alert to the fact that the economy may then come under pressure.

But let’s be honest, that’s not nearly as fun or dramatic as shouting OH MY GOD THAT MUST MEAN THE ECONOMY IS DOOMED TO FALL APART!!!!!

Factor #2: Housing Starts

There are several different ways to measure this and – unfortunately – no one best way to objectively identify a turning point.  Figure 3 – also from www.Yardeni.com (I told you it is a great source for useful information) displays “Housing Starts” and “Housing Completions”.  For our purposes we will focus solely on “Housing Starts”.Figure 3 – Housing Starts (Source: www.yardeni.com)

What we see in Figure 3 is that Housing Starts is an extremely volatile data set.  Big swings from lows to highs and vice versa, without a lot of “noise” along the way.

The point: Once again – just as with Factor #1 – every recession in the past 50 years was preceded by a clearly declining trend in this set of data.  So that’s what we should be looking for.

As you can see in Figure 3, the blue line (Housing Starts) has sort of started to “chop around” of late.  While one can choose to wring one’s hands if one so chooses, the more prudent thing to do is to keep a close eye and see if a clear downtrend ensues.  THEN it will be a meaningful sign.

Factor #3: The Yield Curve

Nothing has generated more universal angst about “inevitable” economic disaster as the fact that certain parts of the yield curve have “inverted” (i.e., a longer-term interest rate is below a shorter-term interest rate) of late.  For example, the key 10-year treasury yield has recently fallen below the 2-year yield , the 3-month and Fed Funds rate.  Oh, the horror!

But here is the irony: Yes, it is absolutely, positively true that an inverted yield curve is a potential warning sign of impending economic trouble.  Just not the way it is typically presented of late, i.e., OH MY GOD THE 10-YEAR YIELD DROPPED BELOW THE 2-YEAR YIELD THAT MUST MEAN THE ECONOMY IS DOOMED TO FALL APART!!!!!  However, take a close look at Figure 4 from – where else – www.Yardeni.com that displays the difference between the 10-year treasury yield and the Fed Funds rate.Figure 4 – 10-year treasury yield minus Fed Funds rate (Source: www.yardeni.com)

There are two important things to note – unfortunately most people only seem to focus on #1:

1. Every recession in the past 50 years has been preceded by an inversion (i.e., a negative reading on this chart) of the yield curve

2. However, also note that the recessions did not actually begin until after the yield curve started to rise again after first inverting.

This second point is important. Why?  Consider Figure 5 from www.BullMarkets.co (another terrific source of information) which shows the action of the stock market after the yield curve first inverts.Figure 5 – S&P 500 Index performance after yield curve first inverts (Source: www.BullMarkets.co)

The fact that every previous instance was followed by higher stock prices 2, 3,  6 and 9 months later does NOT mean that things can’t be different this time around.  But the information in Figure 4 does suggest that a lot of the fear and loathing and gnashing of teeth presently occurring may be misplaced.

Summary 

Again, the above list is not intended to be the “be all, end all” when it comes to divining the future course of the economy.  Many other indicators (Initial Unemployment Claims, Purchasing Managers Index to name just two)

I can’t tell you if the economy is about to top out and if all the current “gloom and doom” is warranted.  But I would still like to offer some advice. So here goes: forget all the noise of economic prognostications and keep an eye on the indicators presented above.  If either or both of the first two start to tank and/or if the yield curve begins to “un-invert” it will be time to raise your level of concern.

Until then go ahead and try to enjoy your life.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

Some industries are cyclical in nature.  And there is not a darned thing you – or they – can do about it.  Within those industries there are individual companies that are “leaders”, i.e., well run companies that tend to out earn other companies in that given industry and whose stock tends to outperform other companies in that industry.

Unfortunately for them, even they cannot avoid the cyclical nature of the business they are in.  Take Halliburton (ticker HAL) for example.  Halliburton is one of the world’s largest providers of products and services to the energy industry.  And they do a good job of it. Which is nice.  It does not however, release them from the binds of being a leader in a cyclical industry.

A Turning Point at Hand?

A quick glance at Figure 1 clearly illustrates the boom/bust nature of the performance of HAL stock.Figure 1 – Halliburton (HAL) (Courtesy AIQ TradingExpert)

Which raises an interesting question: is there a way to time any of these massive swings?  Well here is where things get a little murky.  If you are talking about “picking timing tops and bottoms with uncanny accuracy”, well, while there are plenty of ads out there claiming to be able to do just that, in reality that is not really “a thing”.  Still, there may be a way to highlight a point in time where:

*Things are really over done to the downside, and

*For a person who is not going to get crazy and “bet the ranch”, and who understands how a stop-loss order works and is willing to use one…

..there is at least one interesting possibility.

It’s involves a little-known indicator that is based on a more well-known another indicator that was developed by legendary trader Larry Williams roughly 15 or more years ago.  William’s indicator is referred to as “VixFix” and attempts to replicate a VIX-like indicator for any market.  The formula is pretty simple, as follows  (the code is from AIQ Expert Design Studio):

*hivalclose is hival([close],22).

*vixfix is (((hivalclose-[low])/hivalclose)*100)+50.

In English, it is the highest close in the last 22-periods minus the current period low, which is then divided by the highest close in the last 22-periods. The result then gets multiplied by 100 and 50 is added.

Figure 2 displays a monthly chart of HAL with William’s VixFix in the lower clip.  In a nutshell, when price declines VixFix rises and vice versa.

Figure 2 – HAL Monthly with William’s VixFix (Courtesy AIQ TradingExpert)

Now let’s go one more step as follows by creating an exponentially smoothed version as follows (the code is from AIQ Expert Design Studio):

*hivalclose is hival([close],22).

*vixfix is (((hivalclose-[low])/hivalclose)*100)+50. <<<Vixfix from above

*vixfixaverage is Expavg(vixfix,3).  <<<3-period exponential MA of Vixfix

*Vixfixaverageave is Expavg(vixfixaverage,7). <<<7-period exp. MA

I refer to this as Vixfixaverageave (Note to myself: get a better name) because it essentially takes an average of an average.  In English (OK, sort of), first Vixfix is calculated, then a 3-period exponential average of Vixfix is calculated (vixfixaverage) and then a 7-period exponential average of vixfixaverage is calculated to arrive at Vixfixaverageave (got that?)

Anyway, this indicator appears on the monthly chart for HAL that appears in Figure 3.Figure 3 – HAL with Vixaverageave (Courtesy AIQ TradingExpert)

So here is the idea:

*When Vixfixaverageave for HAL exceeds 96 it is time to start looking for a buying opportunity.

OK, that last sentence is not nearly as satisfying as one that reads “the instant the indicator reaches 96 it is an automatic buy signal and you can’t lose”.  But it is more accurate.  Previous instances of a 96+ reading for Vixfixaverageave for HAL appear in Figure 4.

Figure 4 – HAL with previous “buy zone” readings from Vixfixaverageave (Courtesy AIQ TradingExpert)

Note that in previous instances, the actual bottom in price action occurred somewhere between the time the indicator first broke above 96 and the time the indicator topped out.  So, to reiterate, Vixfixaverageave is NOT a “precision timing tool”, per se.  But it may be useful in highlighting extremes.

This is potentially relevant because with one week left in May, the monthly Vixfixaverageave value is presently above 96.  This is NOT a “call to action”.  If price rallies in the next week Vixfixaverageave may still drop back below 96 by month-end.  Likewise, even if it is above 96 at the end of May – as discussed above and as highlighted in Figure 4, when the actual bottom might occur is impossible to know.

Let me be clear: this article is NOT purporting to say that now is the time to buy HAL.  Figure 5 displays the largest gain, the largest drawdown and the 12-month gain or loss following months when Vixfixaverageave for HAL first topped 96.  As you can see there is alot of variation and volatility.  

Figure 5 – Previous 1st reading above 96 for HAL Vixfixaverageave

So HAL may be months and/or many % points away from an actual bottom.  But the main point is that the current action of Vixfixaverageave suggests that now is the time to start paying attention.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

Once you have been in this business for a while, you start to think you have heard it all.  Then of course, you are reminded that you are wrong.  Which can be a little unsettling – kind of the “I am an Old Dog, and this is a New Trick” challenge.

Anyway, in this article from BullMarkets.co they reference the “Boom/Bust Barometer” tracked by well-known market analyst Ed Yardeni (by the way, I highly recommend his book).  This barometer “takes the CRB Raw Industrial Index and divides it by Initial Jobless Claims.  This is essentially using commodities vs. labor market as a means to gauge the overall health of the economy.”

The article also contained a link to a spreadsheet with the data.  The file contained month-end readings for the Boom/Bust Barometer (or BBB for short) going back to May 1981.  A few notes:

*From doing a little more digging, I believe Mr. Yardeni tracks this on a daily basis, and that there are people who use it as an active market timing tool.  I have no knowledge of the steps they take in order to do that

*For our purposes here all we have is the month-end reading, so we will go with that

*What follows is NOT a “recommended” trading strategy, it is presented solely as a simple example of one potential way to use the data as a bullish/bearish “confirmation tool”

Figure 1 displays the month-end reading for the BBB along with a 48-month exponential moving average.  As you can see, sometime the data trends “up” – i.e., the month-end value is above the moving average, and vice versa.

Figure 1 – Yardeni Boom/Bust Barometer month end values (blue) with a 48-month EMA (orange); 1981-2019

Figure 2 displays the difference between the two lines in Figure 1 (positive means the BBB is above its 48-month EMA and is “trending higher” and negative means the BBB is below its 48-month EMA and is trending lower) along with the month end price for the S&P 500 Index.  From a cursory glance it appears that the BBB does a good job of being on the right side of the market.  This approach would have suggested being out of the market during most all of the 2000-2002 and 2008-2009 bear markets.

Figure 2 – S&P 500 Index (blue) with Boom/Bust Barometer minus 48-month EMA (orange); 1981-2019

Figure 3 displays two equity curves:

*The blue line represents the growth of $1,000 invested in the S&P 500 Index (using month-end price data) when the BBB is ABOVE its 48-month EMA

*The orange line represents the growth of $1,000 invested in the S&P 500 Index (using month-end price data) when the BBB is BELOW its 48-month EMA

Figure 3 – Growth of $1,000 invested in S&P 500 Index when Boom/Bust trend is “+” (blue) versus when Boom/Bust trend is “-” (orange); 1981-2019

Results:

*When the BBB was in an “uptrend” the S&P 500 Index gained +1,460%

*When the BBB was in a “downtrend” the S&P 500 Index gained +42%

Notes:

*As a standalone strategy (which again, is not recommended) this “strategy” would have underperformed a buy and hold approach.  However, as a “perspective” indicator it appears to offer some potentially good value.

*As you can see in Figure 4, this simplistic approach to using BBB is still well into positive territory, i.e.,  bullish – or at the least, not yet flashing a bearish warning ala 1981, 1990, 2000 and 2008.

Figure 4 – Boom/Bust Barometer minus 48-month EMA; 1981-2019

Summary

It should be pointed out that the “method” presented here is almost certainly NOT the way Mr. Yardeni intended this indicator to be used.  So if you do not see any real value in what you just saw, don’t think any less of the indicator itself.

But I do think I will keep an eye on this one for a while.  My thanks to Ed Yardeni and www.BullMarket.co for teaching this Old Dog a New Trick.

Woof.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

The “barbell” approach to bond investing typically involves buying a long-term bond fund or ETF and a short-term bond fund or ETF.  The idea is that the long-term component provides the upside potential while the short-term component dampens overall volatility and “smooths” the equity curve.  This article is not intended to examine the relative pros and cons of this approach.  The purpose is to consider an alternative for the years ahead.

The Current Situation

Interest rates bottomed out several years ago and rose significantly from mid-2016 into late 2018.  Just when everyone (OK, roughly defined as “at least myself”) assumed that “rates were about to establish an uptrend” – rates topped in late 2018 and have fallen off since.  Figure 1 displays ticker TYX (the 30-year treasury yield x 10) so you can see for yourself.

Figure 1 – 30-year treasury yields (TNX) (Courtesy AIQ TradingExpert)

In terms of the bigger picture, rates have showed a historical tendency to move in 30-year waves.  If that tendency persists then rates should begin to rise off the lows in recent years in a more meaningful way.  See Figure 2.Figure 2 – 60-year wave in interest rates (Courtesy: www.mcoscillator.com)

Will this happen?  No one can say for sure.  Here is what we do know:  If rates decline, long-term treasuries will perform well (as long-term bonds react inversely to the trend in yields) and if rates rise then long-term bond holders stand to get hurt.

So here is an alternative idea for consideration – a bond “barbell” that includes:

*Long-term treasuries (example: ticker VUSTX)

*Floating rate bonds (example: ticker FFRAX)

Just as treasuries rise when rates fall and vice versa, floating rate bonds tend to rise when rates rise and to fall when rates fall, i.e., (and please excuse the use of the following technical terms) when one “zigs” the other “zags”.  For the record, VUSTX and FFRAX have a monthly correlation of -0.29, meaning they have an inverse correlation.

Figure 3 displays the growth of $1,000 invested separately in VUSTX and FFRAX since FFRAX started trading in 2000.  As you can see the two funds have “unique” equity curves.

Figure 3 – Growth of $1,00 invested in VUSTX and FFRAX separately

Now let’s assume that every year on December 31^st we split the money 50/50 between long-term treasuries and floating rate bonds.  This combined equity curve appears in Figure 4.

Figure 4 – Growth of $1,000 50/50 VUSTX/FFRAX; rebalanced annually

Since 2000, long-treasuries have made the most money.  This is because interest rates declined significantly for most of that period.  If interest rise in the future, long-term treasuries will be expected to perform much more poorly.  However, floating rate bonds should prosper in such an environment.

Figure 5 displays some relevant facts and figures.

Figure 5 – Relevant performance Figures

The key things to note in Figure 5 are:

*The worst 12-month period for VUSTX was -13.5% and the worst 12-month period for FFRAX was -17.1%.  However, when the two funds are traded together the worst 12-month period was just -5.0%.

*The maximum drawdown for VUSTX was -16.7% and the maximum drawdown for FFRAX was -18.2%.  However, when the two funds are traded together the worst 12-month period was just -8.6%.

Summary

The “portfolio” discussed herein is NOT a recommendation, it is merely “food for thought”.  If nothing else, combining two sectors of the “bond world” that are very different (one reacts well to falling rates and the other reacts well to rising rates) certainly appears to reduce the overall volatility.

My opinion is that interest rates will rise in the years ahead and that long-term bonds are a dangerous place to be.  While my default belief is that investors should avoid long-term bonds during a rising rate environment, the test conducted here suggests that there might be ways for holders of long-term bonds to mitigate some of their interest rate risk without selling their long-term bonds.

Like I said, food for thought.

Jay Kaeppel

 Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.