In my last piece I wrote about a method for deciding when to hold basic materials stocks. In this piece, let’s take a look at another.

(See also We Are Living in a Material(s) World)

FSDPX is the ticker for Fidelity Select Basic Materials, whose first full month of trading was October 1986.  Our system (such as it is) for trading FSDPX is as simply to buy and hold FSDPX during the following months:

February/March/April/May/July/November/December

Not much of a “system” really.  Still, the results are interesting. For testing purposes we will assume that an annual rate of interest of 1% is earned while out FSDPX.  Monthly returns for FSDPX involve monthly total return data from Callan Associates.

Results

Figure 1 displays the growth of $1,000 invested in FSDPX only during the months listed above (blue line), versus buy-and-hold (red line).Figure 1 – Growth of $1,000 invested in ticker FSDPX during favorable months (blue line) versus buy-and-hold (red line)

For the record:

Figure 2 – FSDPX: Favorable Months vs. Buy-and-Hold

Summary

Over the course of 30 years this monthly system accumulated greater profits than a buy-and-hold approach (which, of course, does not in anyway guarantee that it will continue to in the future). Perhaps just as importantly, it reduced the volatility of the overall results – with 12-month standard deviation of 15.5% versus 20.24% for buy-and-hold, and a maximum drawdown of -15.7% versus -56.1% for buy and hold.

Jay Kaeppel

Basic materials.  Where would we be without them?  Outside mostly, I guess. Anyway, despite the undeniable importance – and tangible value of – basic materials, like everything else there is a time “hold ‘em” and a time to “fold ‘em.”  So let’s take a look at one – admittedly crude – method for determining what time it is at any given, er, point in time.

The First Key to Materials Price Trend

The first key to the price trend for materials is, well, the price trend for materials.  For our basic crude purposes we will use the 5-week and 30-week moving average for ticker RYBIX (Rydex Basic Materials fund). If the 5-week MA is greater than the 30-week MA our price trend indicator is bullish and vice versa.  As a “stand alone” indicator, this one ranks in the “Good, not great” category.  Figure 1 displays the growth of $1,000 invested in RYBIX when the 5-week MA is above the 30-week and vice versa.

(For the record there is a 1-day lag in trading – i.e. – if a crossover occurs on Friday’s close the trade in RYBIX takes place at the closing price of the next trading day).Figure 1 – Growth of $1,000 invested in RYBIX when RYBIX 5-week MA > RYBIX 30-week MA (blue line) versus 5-week MA < 30-week MA (red line); 4/14/1998-10/14/2016

For the record:

*$1,000 invested in RYBIX when the trend indicator is bullish grew to $2,508

*$1,000 invested in RYBIX when the trend indicator is bearish fell to $615

The Second Key to Materials Price Trend

The second part of our model is the action of the U.S. Dollar.  Materials prices tend to move inversely to the price of the U.S. Dollar (I would offer an explanation but it is one of those boring topics that runs the risk of causing readers to stop reading before they get to the good part – so I’ll not take that chance (may I suggest Google?).

From 1998 (when RYBIX started trading) until the end of 2008 I used U.S. dollar futures (ticker DX) as an “inverse” indicator – i.e., if DX 5-week MA is below its 30-week MA that is “bullish” for materials and vice versa.

Since at the end of 2008 I have used ticker UDN (Powershares U.S. Dollar Index Bearish fund). UDN and RYBIX trade with a high degree of correlation.  When the 5-week MA for UDN is above its 30-week MA that is “bullish” for materials and vice versa.

Figure 2 displays the growth of $1,000 invested in ticker RYBIX when our “Dollar Model” is bullish versus bearish.Figure 2 – Growth of $1,000 invested in RYBIX when UDN 5-week MA > UDN 30-week MA (blue line) versus 5-week MA < 30-week MA (red line); 4/14/1998-10/14/2016

For the record:

*$1,000 invested in RYBIX when the trend indicator is bullish grew to $3,308

*$1,000 invested in RYBIX when the trend indicator is bearish fell to $466

Putting the Two Together to create a “Materials Model”

For RYBIX: if the 5-week MA > 30-week MA then add +1

For UDN: if the 5-week MA > 30-week MA then add +1

So for any given day, the “Materials Model” can read 0, +1 or +2.  To make a long story short, the only time to bother holding materials is when the Materials Model reads +2.

Figure 3 displays the weekly charts for UDN and RYBIX with the 5-week MA and 30-week MA. Our “Materials Model” is bullish when the green line (5-week MA) is above the red line (30-week MA) in BOTH charts.Figure 3 – Tickers UDN and RYBIX with 5-week and 30-week moving (Courtesy AIQ TradingExpert)

Figure 4 displays the growth of $1,000 invested in ticker RYBIX when the Materials Model = +2 versus when the model is at 0 or 1.Figure 4 – Growth of $1,000 invested in RYBIX when “Materials Model” = +2 (blue line) versus when Model < +2; 4/14/1998-10/14/2016

For the record:

*$1,000 invested in RYBIX when the Materials Model is +2 grew to $3,965

*$1,000 invested in RYBIX when the Material Model is < +2 fell to $389

Summary

So this model is inarguably crude.  Still, as a proud graduate of “The School of Whatever Works” (good ole’ SWW) the difference between a return of +297% versus a loss of -61% is enough to get my attention.

As you can see in Figure 3, at the moment the price trend indicator is “bullish” and the dollar indicator is “bearish.”  Until they are both bullish I will stand athwart the “materials world.”

Jay Kaeppel

Timothy B. Lee has written an article published in VOX titled

27 Charts That Will Change How You Think About the American Economy

I cannot urge you strongly enough to take a few minutes to read it the whole way through.  And note that unlike a lot (dare I say, most) of the information regarding the economy that gets put out these days there is no “angle” or political agenda underlying the data (at least not that I could discern).

(See also Buy Real Estate Stocks (3 Times a Year))

The “times they are a changing” and this article provides an enlightening yet dispassionate look at “the way things are”.

Do yourself a favor and read it all the way through.

Jay Kaeppel

There is a season, turn, turn, turn.  OK, as a “rock n’ roll guy” I always found that song to be a little wimpy. But as a stock market analyst I find it to be a pretty useful phrase.

(See also The Best Bear Market Strategy)

The Real Estate Sector

There are many factors that affect real estate stocks.  The economy, interest rates, the availability of credit, and so on.  But the most valuable tool when it comes to trading real estate stocks might just be the calendar.  So let’s take a look.

The 3 “favorable” times of year for real estate are:

*From the close of March Trading Day #1 through the close of May Trading Day #8

*From the close of June Trading Day #17 through the close of July Trading Day #21

*From the close of November Trading Day #14 through the close of December Trading Day #22

For our first test, Figure 1 displays the growth of $1,000 invested in Fidelity Select Real Estate fund (ticker FRESX) only during these 3 periods since 9/30/1988, versus buying and holding FRESX during the same period.  We assume an annualized rate of interest of 1% is earned while not in FRESX.Figure 1 – Growth of $1,000 invested in FRESX during seasonally favorable periods (blue) versus buy-and-hold (red); 9/30/1988-10/7/2016

For the record, from 9/30/1988 to 10/7/2016:

*The 3 seasonally favorable periods gained+5,360% with a maximum drawdown of (-20.4%).

*Buy-and-Hold gained+1,730% with a maximum drawdown of (-76.3%).

One alternative for more aggressive traders is ProFunds Real Estate UltraSector (ticker REPIX) which uses leverage of 1.5-to-1 and has no switching restrictions.  This fund started trading on 8/8/2000. Figure 2 displays the growth of $1,000 invested in REPIX only during our 3 favorable periods since 8/8/2000, versus buying and holding REPIX during the same period.Figure 2 – Growth of $1,000 invested in REPIX during seasonally favorable periods (blue) versus buy-and-hold (red); 8/8/2000-10/7/2016

For the record:

*The 3 seasonally favorable periods gained+2,747% with a maximum drawdown of (-31.7%).

*Buy-and-Hold gained+172% with a maximum drawdown of (-91.2%).

Figure 3 displays the year-by-year results for REPIX using the seasonally favorable periods versus buy-and-hold.

Figure 3 – Seasonal REPIX versus Buy-and-Hold

*2000 – from 8/8/2000 through 12/31/2000

**2016 – from 12/31/2105 through 10/7/2016

***Average – includes only full calendar years

Summary

The real estate sector is a lot like the energy sector in that when it’s good it’s great and when it’s bad it is very, very bad.  Investing in sectors like these on a “part-time basis” might not be the worst idea in the world.

Jay Kaeppel

Coca-Cola is unquestionably one of the most – if not in fact the most – recognizable brands in the world.  Still, like everything it seems that there is a time to reap and a time to sow.  So let’s look at two upcoming periods that have witnessed very divergent results for KO stock.

(See also The Best Bear Market Strategy)

The Fourth Quarter “Fizz”

This favorable period extends from the close on the 12^th trading day of October through the 19^th trading day of November. Figure 1 displays the growth of $1,000 invested in KO stock only during this period starting in 1989.Figure 1 – Growth of $1,000 invested in KO during seasonally favorable 4th quarter period

For the record:

*This period has showed a gain 22 times (82%)

*This period has showed a loss 5 times (18%)

*The average gain = +6.8%

*The average loss = (-1.7%)

*The largest gain was +30.5% in 1999

*The largest loss was (-3.1%) in 1993

The Fourth Quarter “Fizzle”

This unfavorable period extends from the close on the 17^th trading day of December through the 20^th trading day of January. Figure 2 displays the “growth” of $1,000 invested in KO stock only during this period starting in 1989.Figure 2 – Growth of $1,000 invested in KO during seasonally unfavorable 4th quarter period

For the record:

*This period has showed a gain 5 times (18%)

*This period has showed a loss 22 times (82%)

*The average gain = +2.4%

*The average loss = (-4.6%)

*The largest gain was +6.4% in 1996-1997

*The largest loss was (-11.4%) in 2002-2003

Summary

Will these trends hold up this time around?  Ah, there’s the rub. As with any seasonal there are never any guarantees “this time around”.

Still, as the old saying goes – well, sort of paraphrasing here – 82% accuracy is 82% accuracy.

Jay Kaeppel

OK, I suppose I should refer to this as “my” best bear market strategy.  For the record, “the” best bear market strategy is to sell short at the top and buy back at the bottom.  Which reminds me, if you possess information on how to achieve this objective please feel free to pass your contact info on to me.  Barring that, what follows is a pretty decent approach to dealing with bear markets.

(See also JayOnTheMarkets.com: Tortoise v. Hare in September/October)

Also, I will grant you that this is not the most “timely” article in the world, since we are not technically now in a bear market.  Still it never hurts to “be prepared”, so I want to highlight one approach to trading a bear market.

First the bad news: this method involves a fair amount of trading – at least two trades a month to be specific.  While this may not be everyone’s cup of tea, ultimately – using here the ubiquitous, annoying and yet highly appropriate phrase for our times – “It is what it is.”

Jay’s Bear Market Method

There are three parts:

1. The Dow versus its 200-day moving average
2. Specific trading days of the month
3. Market Holidays

Dow versus 200-day moving average

For our purposes we will designate the stock market as being in a bear market when the Dow Jones Industrials Average is below its 200-day moving average.  To sum it up as succinctly as possible:

Dow > 200-day moving average = GOOD

Dow < 200-day moving average = BAD

One important note: For trading purposes I use a one-day lag when a crossover occurs.  If the Dow closes above the 200-day MA on Monday and then closes below it on Tuesday, then in theory the market turns bearish at the close on Tuesday.  However, for actual trading purposes it is pretty tough to get a trade off at the close on Tuesday when you don’t know for sure that you should until…the close on Tuesday.

So for the record, for our purposes a “bearish” period begins at the close on the day after the Dow first closes below its 200-day moving average.  Likewise, the bearish period ends at the close one trading day after the Dow closes back above its 200-day moving average.

Trading Days of Month

When our 200-day moving average indicator above is “bearish” we designate the following trading days of the month as “bullish”

*The last 4 trading days of the month and the first 3 trading days of the next month
*Trading days #9, 10, 11 and 12

In other words, when the Dow is below its 200-day moving average we want to be long the stock market on these days

Holidays

In addition to the trading days listed above, when our 200-day moving average indicator above is “bearish” we also want to be long the stock market on the 3 trading days before and the 3 trading days after each stock market holiday (New Years, Martin Luther King Day, President’s Day, etc.)

Results

So what does all of this do for us?  The results appear in Figure 1 below.  To review, these results measure the growth of $1,000 invested in the Dow Jones Industrials Average only when:

*The Dow is below its 200-day moving average (with a 1-day lag following the crossover before a bearish period begins or ends)

*Today is within 3 trading days before or after a market holiday OR today is one of the last 4 trading days of the months, one of the first 3 trading days of the month or falls within trading days #9 through 12.

The blue line depicts the growth using Jay’s Bear Market Method.  The red line depicts the growth from buying and holding the Dow Industrials Average while our 200-day moving average indicator is  “bearish.”Figure 1 – Growth of $1,000 invested in Dow using Jay’s Bear Market Method (blue line) versus $1,000 invested in Dow on all days when the Dow is below its 200-day moving average* (red line); 12/31/1938-9/26/2016

* – using a 1-day lag for crossovers

For the record, since 12/31/1938:

*$1,000 invested in the Dow only when the trend is “bearish” (i.e., below the 200-day moving average with a 1-day lag on crossovers) grew to $1,675 (or+67%)

*$1,000 invested in the Dow only when Jay’s Bear Market Method is bullish grew to $22,542 (or +2,154%).  Now that’s what I call “making the best of a bad situation”.

The Worst of the Worst

Figure 2 displays the performance of the Dow during the “Worst of the Worst” trading days.  In this scenario:

*The Dow is below its 200-day moving average (again with a 1-day lag for crossovers)

*Today is NOT one of the trading days of the month listed above and is NOT within 3 trading days of a market holiday.Figure 2 – Growth of $1,000 invested in Dow when Dow is below 200-day moving average AND today is NOT one of the favorable trading days listed above; 12/31/1938-9/26/2016

For the record, $1,000 invested in the Dow ONLY on these “Worst of the Worst” trading days by -88% to $114 since 1938. Now that’s what I call a bear market.

Jay Kaeppel

As the name implies, this article is written with option traders in mind. That being said, if you are looking for new and different ways to trade the markets, you may find the following interesting .

(See also Special Offer for JayOnTheMarkets.com readers from www.OptionsAnalysis.com)

My colleague in the American Association of Professioal Technical Analyts (AAPTA), Wayne Whaley of Witter & Lester (Wayne is probably the best analyst of seasonal trends that I know of) put out a piece to his subscribers in early September highlighting a study that shows that a particularly bearish setup had occurred in crude oil.  Because his subscribers pay money for his analysis I’ll not reveal the methodology.  But the point is that following this particular setup the price of crude oil has declined between September 6^th and December 6^th in 14 of the 15 previous instances.  Things that have been 93% accurate tend to catch my eye.

I did not immediately do anything with this information. From there crude oil rallied, declined and then rallied again.  Which led me to the following idea:

*Let’s say that based on Whaley’s research you are willing to risk a certain amount of money on the possibility that crude oil will decline over the next several months.

*To be clear, we are not predicting a “collapse” or even a sharp decline per se in the price of crude – just that the price of crude will be somewhat lower in then than it is now.

Based on this outlook, there is a particular – though less often used – option strategy that make sense.  I will refer to it as the “in the money bear put”.  The chart for spot crude oil on 9/22 appears in Figure 1.Figure 1 – Spot Crude Oil prices (Courtesy ProfitSource by HUBB)

A few things to note from Figure 1:

*We see the price for crude on 9/6 and want to enter a trade that stands to make money if crude is below this price (by any amount) on December 6.

*We can also see that there is a natural resistance level at the August high.  We can consider using this as a stop-loss point.

*Price has been “coiling” of late, and has hit the declining trend line for the triangle drawn in Figure 1.  Does this guarantee that price is about to fall?  Not at all. But for a trader looking to play the short side it is as good a time as any to “get in the game.”

The Trade

Rather than trading in the futures market, we will instead look at trading put options on ticker USO, an ETF that is designed to track the price of crude oil.

The trade highlighted below involves:

*Buying 22 Dec USO 12.5 puts

*Selling 20 Dec USO 11 puts

The particulars appear in Figure 2 and the risk curves in Figure 3Figure 2 – USO Dec 12.5-11 bear put spread (Courtesy www.OptionsAnalysis.com)

Figure 3 – Risk Curves for USO Dec 12.5-11 bear put spread (Courtesy www.OptionsAnalysis.com)

Important things to note:

*These options are not heavily traded at the moment and the position was entered using a limit order using the midpoint of the bid/ask spreads for each option.

*This trade cost $2,650 to enter.  To mitigate the risk of losing this entire amount I am choosing a stop-loss point of $11.60.  If USO rallied immediately to $11.60 this trade would get stopped out with a loss of -$686 to -$1,140, depending on whether this stop-loss is hit later or sooner (see Figure 4).  Note that this stop-loss is arbitrary.  It is not necessary to use a stop-loss. However, if you employ no stop-loss method at all then you risk the entire $2,650.

*The breakeven price for this position is $11.30, which is close to the August high for USO of $11.38. At any price below $11.30 this trade will show a profit.

*If crude oil were to fall two standard deviations (to $7.20) this trade would earn roughly +$1,400.

*If USO were to remain unchanged from its price at the time of entry ($10.53 a share), this trade will show a profit of $738

Zooming In

Figure 4 depicts a closer look at the risk curves – and the attendant profit/loss implications – shown in Figure 3.Figure 4 – Risk Curves for USO Dec 12.5-11 bear put spread (Courtesy www.OptionsAnalysis.com)

Assuming a stop-loss price of $11.60 or USO is used (and again this is arbitrary with the following pros and cons: Using a stop-loss it is possible to get stopped out and then have price reverse back down and miss a potentially profitable trade; Not using a stop-loss – or using a higher price for USO as a stop-loss point – exposes you to greater dollar risk):

*Our maximum likely profit potential is roughly $1,400 (if USO plummets two standard deviations to $7.20 a share.

*Our maximum likely dollar risk – assuming we use a stop-loss of $11.60 for USO shares, is roughly -$1,140 (although that dollar figure would get smaller as time goes by due to time decay).

Summary

So is this trade a good idea?  The truth is that that question can’t be answered except in hindsight.  Still, is this trade a good example of one way to:

*Play a situation where you expect a given security to decline – even if only slightly

*While allowing for larger profits if there is a larger decline

*While also limiting the amount of dollar risk to an acceptable level?

Well sure my opinion is a little biased, but I am going to go ahead anyway and say “yes.”

Jay Kaeppel

Let’s start with the caveats right away.  Make no mistake about it, the trading method I am about to discuss is fraught with risk (DO NOT STOP READING!).  To wit:

*It is presently configured to maximize return not to minimize drawdowns

*It uses a triple-leveraged bond ETF

*Bonds have essentially been in a 30+ year bull market; bear market results may not be as good

So there’s all that.  Still, the results are so compelling I have decided to pass them along and allow you to weigh the potential rewards and risks for yourself.

(See also JayOnTheMarkets.com: Seasonality in the Bond Market? You Bet)

The Framework

Part 1 – Ticker TMF

*For all tests we are using ticker TMF which tracks the daily performance of the 30-yr. t-bond times 3.

*The results of all tests run from 4/16/2009 (when TMF started trading) through 9/20/2016 (although the original backtesting used t-bond futures data which goes back to 1978).

*For the purposes of these tests, no interest is assumed to be earned while out of TMF.

Part 2 – Ticker EWJ

In this article I wrote about the potential for using ticker EWJ as a timing tool for bonds (no, seriously).  In a nutshell:

*It is bullish for bonds when the 5-week moving average for EWJ is BELOW the 30-week moving average for EWJ.

*It is bearish for bonds when the 5-week moving average for EWJ is ABOVE the 30-week moving average for EWJ.

Figure 1 displays the growth of $1,000 invested in TMF when EWJ is bullish for bonds (red line) versus bearish for bonds (blue line)Figure 1 – Growth of $1,000 invested in TMF if EWJ indicator is bullish (red line) versus if EWJ indicator is bearish (blue line)

For the record:

*$1,000 invested in TMF when EWJ is bullish grew to $2,854

*$1,000 invested in TMF when EWJ is bearish shrank to $759

*Average 12-mo. TMF return when EWJ is bullish = +22.2%

*Average 12-mo. TMF return when EWJ is bearish = +1.4%

*Maximum drawdown for TMF when EWJ is bullish = (-36.6%)

*Maximum drawdown for TMF when EWJ is bearish = (-52.7%)

Part 3 – Trading Days of the Month

In this article I wrote about the performance of t-bonds during the last 5 trading days of the month versus all other trading days (again, no, seriously).  In a nutshell:

*The last 5 trading days of the month are considered bullish for bonds.

*All other trading days of the month are considered bearish for bonds.

Figure 2 displays the growth of $1,000 invested in TMF only during the last five trading days of every month (red line) versus all other trading days (blue line)Figure 2 – Growth of $1,000 invested in TMF during last 5 trading days of month (red line) versus all other trading days of month (blue line)

For the record:

*$1,000 invested in TMF last 5 trading days of every month grew to $5,811

*$1,000 invested in TMF last 5 trading days of every month shrank to $373

*Average 12-mo. TMF return holding last 5 trading days of month = +28.2%

*Average 12-mo. TMF return holding all other days of month = (-2.6%)

*Maximum drawdown holding TMF last 5 trading days of month = (-22.9%)

*Maximum drawdown holding TMF all other days of month = (-71.5%)

Putting the Two “Models” Together

So here is the finished product – Jay’s Very Risky Bond Model (JVRBM):

Bullish for TMF if:

*EWJ 5-week MA < EWJ 30-week MA

OR

*Today is one of the last 5 trading days of the month

Bearish for TMF if:

*EWJ 5-week MA > EWJ 30-week MA

AND

*Today is NOT one of the last 5 trading days of the month

Figure 3 displays the growth of $1,000 invested in TMF only when JVRBM is bearish.Figure 3 – Growth of $1,000 invested in TMF only when EWJ indicator is bearish AND today is NOT one of the last 5 trading days of the month

Figure 4 displays the growth of $1,000 invested in TMF only when JVRBM is bullish.Figure 4 – Growth of $1,000 invested in TMF only when EWJ indicator is bearish AND today is NOT one of the last 5 trading days of the month

Anyone notice a difference?

For the record:

*$1,000 invested in TMF when JVRBM is bullish grew to $7,497

*$1,000 invested in TMF when JVRBM is bearish shrank to $289

*Average 12-mo. TMF return when JVRBM is bullish = +36.8%

*Average 12-mo. TMF return when JVRBM is bearish = (-8.5%)

*Maximum drawdown for TMF when JVRBM is bullish = (-30.9%)

*Maximum drawdown for TMF when JVRBM is bullish = (-71.9%)

Summary

This is a classic example of a high/risk/high reward strategy.  The mistake that too many people make in this situation is to look at the potential returns and to get stars (er, dollar signs) in their eyes, which causes them to mentally downplay the risk side of the equation.

In this backtest, the JVRBM strategy generated a maximum drawdown of -30.9%.  That is the figure that any trader should think long and hard about before ever contemplating taking any real-world action.

Jay Kaeppel

The September/October period has often been a difficult one for the stock market.  I wrote about this long-term trend here and here and discussed a simple hedging method here.

This time around?  No problem.  Since the close on 9/13, the stock market has been moving higher and the Nasdaq 100 has actually broken out to the upside.  So has all the angst and concern been for naught?

I have to go with my standard answer here: “It beats me.”

Still, here is one thing I do know: When September/October is good it’s not bad, but when it’s bad it’s very, very bad.  So remaining cautious is still not the worst idea in the world.

The History

Figure 1 displays the growth of $1,000 invested in the Dow Jones Industrials Average each year since 1955 only during the last 13 trading days of September and the first 19 trading days of October.Figure 1 – Growth of $1,000 invested in Dow Jones Industrials Average during last 13 trading days of September through October trading day #19; 1955-2016

As you can see, the long-term results are not pretty (a cumulative loss of -61%).  Still, it needs to be noted that the stock market does not go down every single year during this period.  In fact it is relatively close to 50/50.  It’s just that when there is a decline it tends to be “one of the painful kind”.

Here are the numbers for the last 13 days of September plus first 19 days of October (since 1955):

*Number of times up: 28 (47% of time)

*Number of times down: 32 (53% of time)

*Average up period: +3.7%

*Average down period: (-5.6%)

*Cumulative %+(-): (-61%)

The Current Year

Since the close on 9/13/2016 the Dow is up +1.3% and the Nasdaq 100 is up +2.8%.  Which way from here?  Once again, “It beats me.”  Believe me, I am not “rooting” for the market to decline. That being said, the QQQ hedge I wrote about on 9/8 Remains a good low-cost insurance policy.  The current status of that position appears in Figure 2.

Figure 2 – QQQ hedge position using options (Courtesy www.OptionsAnalysis.com)

As long as stock prices keep moving higher then “all is well.”  But if the current rally fails – particularly if the Nasdaq 100 reverses its upside breakout and moves back below the previous high  – then a bit of “caution” may definitely be inorder.

Jay Kaeppel

For those who are willing to see it, there is strong evidence that reasonably persistent seasonal trends exist in the stock market (see here, here and here).

But what about the bond market?  Do seasonal trends exist there?

Consider the following and decide for yourself.

Junk vs. GNMA

“Junk” bonds (more tactfully referred to as “high yield” bonds – and doesn’t that sound more appealing?) are issued by companies with less than a top flight credit rating and pay a higher rate of interest than investment grade corporate bonds in order to compensate for the fact that junk bond issuers are more likely to default than investment grade companies.

To track this segment we will use Vanguard High Yield Corporate (ticker VWEHX).

GNMA bonds are mortgaged backed securities.  For the record, yes I know that after the housing credit meltdown in 2008 most people reflexively recoil in horror at the mere mention of the phrase “mortgage-backed securities” (see, there you go again), but not to worry, the fund that we will use is the Vanguard GNMA Fund (ticker VFIIX), which deals only with government-backed GNMA’s (OK, yes I also realize that to a lot of people the phrase “government-backed” doesn’t hold quite the same meaning it used to.  But hey, we are just running a hypothetical test here people, can we please just move along now?  And just or the record, ticker VFIIX GAINED +7.2% in 2008).

The Test

For our test we will hold these two funds as follows:

*December through April hold VWEHX

*May through November hold VFIIX

We will also consider what would happen if we held the two funds separately and bought and held both funds.

For all tests we will use monthly total return data from PEP by Callan Associates starting in July 1980.

Figure 1 displays the growth of $1,000 achieved by simply buying and holding VWEHX and VFIIX since July 1980.  Through July 2016 $1,000 in VWEHX grew to $19,019 and $1,000 in VFIIX grew to $13,917.  Using monthly total return data VWEHX has a maximum drawdown  of -28.9% and VFIIX a maximum drawdown of -12.5%.Figure 1 – Growth of $1,000 in VWEHX and VFIIX (6/30/80-7/31/2016)

Figure 2 displays the growth of $1,000 split evenly between VWEHX and VFIIX.  The combined portfolio grew to $16,620 with a maximum drawdown of -13.5%Figure 2 – Growth of $1,000 split evenly between VWEHX and VFIIX (6/30/80-7/31/2016)

Now let’s apply our switching strategy and holding VWEHX only during December through April and VFIIX only during May through November.

Figure 3 displays the result generated using this strategy versus splitting money evenly between the two funds on a buy and hold basis.igure 3 – Growth of $1,000 using Jay’s Switching System (blue line) versus buying and holding both VWEHX and VFIIX (red line); 6/30/80-7/31/2016

$1,000 invested using the switching system grew to $34,016 versus $16,620 for buying and holding both funds.  The maximum drawdown for the switching system was -9.3% versus -13.5% for buy-and-hold.

Finally, to drive home the point about seasonality, consider the results if we did opposite.  Lastly Figure 4 displays the returns for the switching strategy versus doing the exact opposite, i.e., holding VFIIX during December through April and VWEHX from May through November.Figure 4 – $1,000 invested using Jay’s Switching System (blue line) versus doing the exact opposite (red line); 6/30/80-7/31/2016

$1,000 invested using the switching system grew to $34,016 and had a maximum drawdown of -9.3%.  Doing the exact opposite would have seen $1,000 grow to just $7,781 with a maximum drawdown of -28.6%.

Summary

So is this system the “Be All, End All” when it comes to bonds?  Not at all.  If and when interest rates once again rise, most all bond specific trading strategies will face much greater challenges than they have in the past 35 years.

But the point of this piece is not so much to tout a particular system but to alert you to the fact that simple seasonal trends – most of  which are hiding in plain sight for those who are willing to recognize them – can offer investors a unique edge.

Jay Kaeppel