In Part 1 I detailed the 40-Week Cycle and the 212-Week Cycle and spelled out specific rules for designating each of these cycles as “Bullish” or not.

For the 40-Week Cycle since 9/14/1962:

*The Dow gained +3,219% during “bullish” phases (+4,255 if 1% of annual interest is earned while out of the market)

*The Dow lost -12% during “non bullish” phases for the 40-Week Cycle

For the 212-Week Cycle since 7/24/1950:

*For all trading days for the Dow Industrials since 7/24/1950 the average daily % gain is +0.00031% (or +8% annualized).

*During the “bullish” phase of the 212-week cycle since 7/24/1950 the average daily % gain for the Dow Industrials is +0.00095% (or +27% annualized)

Now let’s look at market performance when we combine these two cycles.

Jay’s “Cycle System”

*If 40-Week Cycle is “Bullish”* then Cycle Model adds +1

*If 212-Week Cycle is “Bullish”** then Cycle Model adds +1

For any given day Cycle Model can read 0, +1 or +2

*40-Week Cycle starts a new bullish phase every 280 calendar days.  The next bullish phase starts at the close of 8/7/2015.  A bullish phase lasts 140 calendar days or until the Dow loses -12.5 on a closing basis from its price  at the lose of the cycle start date.

**212-Week Cycle starts a new bullish phase every 1484 calendar days (no, seriously) and the bullish phase last for 6 months.  the next 212-week bullish phase starts at the close of 7/27/2015.

Figure 1 displays the growth of $1,000 invested in the Dow only when the Cycle Model = 0 from 10/1/62 through 7/10/15.Figure 1 – Growth of $1,000 holding Dow Industrials only when Cycle Model is equal to 0 (10/1/62-7/10/15)

Now let’s look at the other extreme, i.e., when both cycles are bullish at the same time (i.e., when the Cycle Model is equal to +2).Figure 2 – Growth of $1,000 holding Dow Industrials only when Cycle Model is equal to +2 (10/1/62-7/10/15)

Notice a difference between Figures 1 and 2?  (If not, may I suggest you consider a professional money manager to handle your affairs.)

Creating a Cycle Model System

So let’s take what we have so far and create an actual trading “system” with actual trading rules:

Rule #1. If the Cycle Model is greater than 0 (i.e., if EITHER the 40-week or 212-week cycles are “bullish” then hold the Dow Indutrials.

Rule #2. If the Cycle Model is equal to 0 then hold cash (this test assume 1% of interest per year).

The results for this “system” starting on 10/1/62 versus buy-and-hold appears in Figure 3.Figure 6 – Growth of $1,000 holding Dow Industrials only when Cycle Model is equal to +1 or +2 (red line) versus Buy-and-Hold (blue line); (10/1/62-7/10/15)

 Results of Note (since 10/1/1962):

*Cycle Model = 0; Dow lost (-48%)

*Cycle Model > 0; Dow gained +5,833%

*If we add 1% of annual interest when out of the market, the Cycle System gained +7,426% versus +3,005% for buying-and-holding the Dow.

*The maximum drawdown for the Cycle System was -23.5%

*The maximum drawdown for buy-and-hold was -53.8%

Upcoming Cycle System Readings

*7/13/15 through 7/27/15 = 0

*7/27/15 through 8/7/15 = +1 (Bullish)

*8/7/15 through 12/24/15 = +2 (Bullish)

*12/24/15 through 1/27/16 = +1 (Bullish)

*after 1/27/16 = 0

Summary

As I am wont to say, the difference between +7,426% and -48% is what we “quantitative analyst” types refer to as “statistically significant.”  That being said, does it really make sense for investors to throw away all other forms of analysis and rely solely on two (OK, let’s jut go ahead and say it out loud – “somewhat arcane” – ) cycles to decide when to be in or out of the  stock market?  Probably not.

Still, it seems like a good time to invoke the school mantra from my alma mater, “The School of Whatever Works” – that being:

“Hey, whatever works.”

Jay Kaeppel

If I were to say to you the following:

“The only thing that matters in the stock market is whether the 40-week cycle and/or the 212-week cycle is bullish”, chances are you would say either:

a) “Wow Jay, that’s very interesting analysis.  Have you considered taking some time off?”

OR, if you were in less of a convivial mood:

b) “That’s the dumbest thing I’ve ever heard in my life.”

Either response is understandable so no offense taken.   For the record, I am not actually stating that this theory is true.  I am just raising the issue.  Now let’s look at a few numbers to back up the theory.

The 40-Week Cycle

I have written about this cycle on several occasions (for example here and here) in the past.  For our purposes we will start our test at the close on 9/14/1962.  From that date forward:

*A new “bullish phase” begins exactly every 280 calendar days

*Each new “bullish phase” lasts exactly 140 calendar days and is followed by…

*…A new “non bullish phase” which also lasts 140 calendar days.

*For trading purposes a 12.5% stop loss is used (i.e., if the Dow Industrials closes 12.5% or more below its price at the start of a new bullish phase, the current bullish phase ends there.  This does not, however, alter the start date for the next bullish phase, which still occurs 280 calendar days after the start of the previous bullish phase).

*Also for trading purposes, we assume that 1% of annualized interest is earned while out of the stock market.

Sounds ridiculous, no?  Still as a proud graduate of The School of Whatever Works I submit to you Figures 1 and 2, which display the growth of $1,000 invested in the Dow only during “bullish” (Figure 1) versus “non bullish” phases since 1962.Figure 1 – Growth of $1,000 holding Dow Industrials only when 40-week cycle is “Bullish”; in Cash earning 1% annually while out of the market (blue line) versus Buy-and-Hold (red line);  (9/14/62-7/10/15)

Figure 2 – Growth of $1,000 holding Dow Industrials only when 40-week cycle is NOT “Bullish”; (9/14/62-7/10/15)

For the record:

*The System gained +4,255% holding the Dow during the “bullish phase” and cash during the “non bullish” phase.

*The Dow lost -12% during “non bullish” phases.

NOTE: The next 40-week cycle “bullish” phase begins at the close on 8/7/2015 and extends through the close on 12/24/2015.

The 212-Week Cycle

The 212-week cycle is something I learned from Peter Eliades, one of the pioneers of cyclical analysis and the Editor of Stock Market Cycles, way back in 1982.  Using a starting date of 7/24/1950:

*A new “bullish phase” begins exactly every 1484 calendar days later (212 weeks times 7 days a week).

*For my purposes, a new “bullish” phase last for exactly 6 months at which point the 212-week cycle is once again “neutral” – i.e., there is no “bearish” or “non bullish”, phases, only “bullish” or “neutral”.

Figure 2 displays the growth of $1,000 invested in the Dow Industrials only during the 6 months following each new cycle start date.Figure 3 – Growth of $1,000 holding Dow Industrials only when 212-week cycle is “Bullish”; (7/24/50-7/10/15)

This “method” is only in the market 6 months every four year and four weeks, so is not meant to be a standalone strategy.  Still, for the record:

*The average daily % gain for all trading days for the Dow Industrials since 7/24/1950 is +0.00032% (or +8% annualized)

*The average daily % gain for the Dow Industrials during the “bullish” phase of the 212-week cycle since 7/24/1950 is +0.0095% (or +27% annualized)

NOTE: The next 212-week cycle “bullish” phase begins at the close on 7/27/2015 and extends through the close on 1/27/2016.

In Part 2 we will put the two cycles together and measure Dow performance.

In the meantime, try to remain calm…

Jay Kaeppel

There is a lot of Good News and Bad News in the energy stock sector these days.  To wit:

First the Bad News:

Between June 2014 and January 2015, energy stocks (using ETF ticker XLE as a proxy) suffered a roughly 30% decline.

See also A Mid-Summer’s Night(mare for) Beans

Then the Good News:

As you can see in Figure 1, XLE gave all the signs of a classic “bottoming out”, including:

1) A head-and-shoulders bottom formation and

2) A break above the neckline

3) A pullback and successful downside retest, followed by;

4) A breakout above a down trending trend line drawn during the previous decline.

So, #5) time to pop the champagne corks, pile into energy stocks and enjoy the new energy stock bull market, right?  Right?Figure 1 – The “Classic” Bottom (or Not) in XLE

Then More Bad News:

Er, well, #6) as you can also see on the right hand side of Figure 1, the “classic” upside bull run lasted for about a month and about 8% from the point of the “classic” upside trend line breakout. Since then, XLE – oops – has fallen a little over 11% in a pretty straight line decline.

The (Potential) Good News:

Energy stocks are very oversold and are now near the support area created by the head-and-shoulders formation that formed in December and January.  So we could be setting up for an important bottom.  Um, or not.

The (Potential) Bad News:

In Figure 2 we see that a fairly significant long-term upward trend line (if you’re into that sort of thing) was broken during the recent decline.  If you believe in chart patterns this is an ominous – and potentially significant – occurrence.Figure 2 – A potentially ominous trend line break for XLE

The Bottom Line

The price level of $71.70 for ticker XLE represents a critical support level.  If it holds we could have something of a “mega bottom” in place.  If it fails, the next meaningful support level for XLE is $67.77 and from there $61.11.

My advice: Grab an “energy” drink (har, good one) because you’ll want to stay awake on this one.  Keep a close eye on XLE in the days and weeks ahead for an important long-term clue.

Jay Kaeppel

See also Ominous Energy

Grain prices have a long record of exhibiting seasonal price trends.  This is due primarily to the fact that the planting, growing and harvesting cycle in the Midwest remains the same year in and year out.

In a nutshell:

*Planting begins in early spring

*Growing takes place during the summer

*Harvesting occurs in the fall

*Repeat, ad infinitum, every year, ad nauseum, this year, next year, the year after that and so on and so forth…because it simply can’t be done any other way (at least not here in the Midwest where – trust me on this one – it gets really cold in the winter, and nothing can grow in the frozen ground).

This allows us to anticipate certain things on an annual basis:

*Prior to planting season there are exactly zero beans growing or even in the ground, thus there is “doubt” and “uncertainty” regarding the crop yield for the upcoming year.  At this point all we have are weathermen offering “predictions” regarding whether planting and growing season weather will be good or bad (and what could go wrong with following their advice?).  As a result, prices tend to rise late winter into early spring – especially during years with harsh winters.

*If there is trouble planting in the fields in spring we can anticipate a lower crop yield and thus higher prices (please do not make me explain the whole “supply and demand thing” again – that’s what God invented Google for) for beans.

*If there is a drought in the summertime – or too much rain – same thing…higher prices in anticipation of a lower crop yield.

*On the other hand, if planting and growing season experience good weather then we can anticipate that the crop yield will be abundant and as a result, bean prices will likely decline.

*In any event, usually by mid-summer the “bean counters” (no, seriously) have gone out into the fields and assessed state of the crops (and you think your job is boring) and are able to make a pretty good estimate (their job may be boring but they are pretty good at it) of whether the crop yield will be large or small.  Either way, once the “doubt” and “uncertainty” is pretty much removed, bean prices have showed a tendency to weaken during mid-summer.  This is true even during a bad year for growing beans as most of the “fear” buying already occurred during the winter into early summer months.

*By fall, the harvest is coming in – usually pretty much as projected months ago and nobody cares about soybeans for awhile and everyone loses interest until next year (come to think of it, it’s sort of like being a Cubs fan).  Thus bean prices tend to weaken in late summer to early fall.

So are there ways to take advantage of all of this boring repetitiveness?

Would I write an article and ask the question, if the answer was “No”?

Beans Bearish Seasonal Summer Bias

Soybean prices have showed a strong tendency to weaken between:

*The end of July Trading Day #9, and;

*The end of August Trading Day #6

Can I be any more specific than that?

This year this unfavorable period extends from the close on 7/14 through the close on 8/10.  Does this matter?  You be the judge.

The Historical Results

The following results were generated using November soybean data from July Trading Day 9 through August Trading Day 6. I manually checked the data from 2000 forward, prior year results are from “sources believed to be accurate.”  Here is what it shows:

*# of years showing a gain = 7 (18.9%)

*# of years showing a loss = 30 (81.1%)

*Average gain during 7 UP years = +3,234

*Average gain during 30 down years = (-$2,778)

*Average of all years = (-$1,640)

*Median of all years = ($-1,400)

*Largest gain = +$7,375 (1983)

*Largest Loss = (-$18,925) (2008)

Figure 1 displays the year-by-year results of holding a long 1-lot position in soybeans during the unfavorable July into August period from 1978 through 2014.

Figure 1 – Annual $ change in 1-lot of soybean futures during unfavorable summer period (1978-2014)

Figure 2 displays the cumulative results of holding a long 1-lot position in soybeans during the unfavorable July into August period.

Figure 2 – Cumulative gain/loss holding long 1-lot of soybean futures during unfavorable summer period (1978-2014)

So the bottom line is that holding a long position in soybeans during this period is a whole lot like “swimming upstream”.  On the other hand, a speculator who plays the short side of the bean market during this period may find “the wind at his back.” (That being said, please note the use of the word “may” and the lack of the words “are” and “certain” and “to.”)

Summary

Are soybean prices sure to plummet between 7/14 and 8/10?  Hardly.  Remember that in 1983 beans gained over $7,000 a contract during this supposedly “bearish” period.  Also, it should be noted that 3 of the past 6 years have seen beans gain ground during this time.  So maybe this “cycle” has “run its course” and “lost its edge.”  In truth only time will tell.

The only things we do know for certain at the moment is that beans are non-existent in winter, are still planted in the spring, still grow in the summer and are still harvested in the fall.

Same as it ever was.

Jay Kaeppel

Apparently today is “Update Example Option Trade Day” here at JayOnTheMarkets.com. This article is an update of this previous article.

Trading Silver (using options on ETF ticker SLV)

In the initial article I highlighted the fact that as of mid-June the daily Elliott Wave count for ticker SLV (the ETF that tracks the price of silver) was bullish and that the weekly Elliott Wave count for Silver was bearish.  Based on nothing more than this (can you say “speculation”?) I highlighted a long straddle using August SLV options that might stand to make money if either of the Elliott Wave projections panned out.

The initial risk graph at the time I wrote about this position initially appears in Figure 1.

Figure 1 – Initial risk curves for August SLV straddle

The price for ticker SLV has subsequently broken to the downside.

The current risk curves for the August straddle appear in Figure 2.Figure 2 – Risk curves for initial position as of close on 7/7/15

Key Things to Note:

*In general, there are two basic approaches to straddles:

Approach 1: Wait for a trend to develop (or a breakout) and then close the opposite leg and try to ride the winning leg as far as possible.

Approach 2: Set a profit target and if it is hit, sell immediately and take the money and run.

(A third approach involves entering a straddle prior to an earnings announcement and exiting shortly thereafter is another choice.  But that approach is a whole separate topic)

*Approach 1 is generally more of a longer-term strategy whereby a trader expects a breakout from a range or chart formation but is, a) not sure which way the breakout will go, and b) expects a decent move in price once the breakout does occur.

*Approach 2 is more of a “hit and run” strategy.

*The primary downside to Approach 1 is that not every breakout follows through in a meaningful way.  Therefore, you could enter a straddle, wait for the breakout, exit the losing leg, and then watch price reverse, creating a loss in the remaining leg.  Bottom line, you’d better have some reason to be pretty confident that a meaningful trend will follow the expected breakout.

*The primary downside to Approach 2 is a psychological one. Using Approach 2 you could sit with a straddle that is losing a little more money day after day (as time decay eats away at both options while price meanders) – which can drive a lot of traders crazy.  And then all of a sudden one day, there is a big price move, the trade hits the profit target and you are out.  While that doesn’t sound like (and is not) a bad thing, the reality is that this can be leave a lot of individuals “unsatisfied” as they never got to “ride a winner.”

In other words, people instinctively like to ride a winning trade for awhile because, well, let’s be honest, it feels good.  That does not happen if you trade straddles with a set profit target.  Either you are:

A) Losing, losing, losing, losing, losing and eventually close the trade with a loss, OR

B) Losing, losing, losing, losing, losing and then suddenly – BOOM – you are out of the trade with a profit, without the psychological gratification that comes with “riding a winner”.

For my own purposes I prefer Approach 2, but it took a long time to get there. As a trader who came to options from a futures trading background, I was “programmed” to “cut losses”.  So I would put on a straddle, watch it decay a little day after day, and finally I couldn’t take it anymore and “pulled the plug.”  I am sure you can guess what happened in many cases shortly after I got out (BOOM).

What to Do Now

For the record, this is a hypothetical trade intended as an example, so in reality there is nothing to actually “Do Now”.  In any event, in the initial article I suggested using the initial Elliott Wave price targets of 17.31 And 13.26 as areas to consider profit taking.  While this criteria is reasonable, typically for a long straddle I suggest setting a profit target of 15-20% of the amount paid to enter the trade and exiting the entire position when that level of profit it reached.

For this example trade:

*The cost to enter this particular SLV straddle was $992.  So a 20% profit target would be roughly $198.

*This level of profit would have been hit early in the day on 7/7/15 as SLV gapped down from a 7/6 close of $14.99 to $14.56 and then plunged all the way to $14.03.

*Note that price then rebounded and closed at $14.43, so a trader would have had to,

a) act quickly when the profit target level was reached, or,

b) already placed a good-till-cancelled limit order to exit the entire position if the profit level is reached (this means that the trader must do some homework initially and learn how to place unique orders such as this).Figure 3 – SLV gaps down; 20% profit target hit, trade exited, Show’s Over, there’s nothing more to see here folks.…

Jay Kaeppel

In a couple of recent articles (here and here) I wrote about natural gas and crude oil. Now seems like an exceptionally good time for an update.  In Update #1, I discussed natural gas.  Now let’s look at crude oil.

Crude Oil

In the initial article, I highlighted the fact that as of mid-May the daily and weekly Elliott Wave counts for crude oil were projecting sharply lower prices.  While I did not necessarily trust the magnitude of the projected price move, I made the argument that there is nothing wrong with a speculator “risking a couple of bucks” once in awhile.

So the example trade I detailed in the article involved trading put options on ticker USO, an ETF that ostensibly tracks the price of crude oil.  The trading in the original article was:

*Buying USO Aug 15 put @ $0.14

In the original article I listed a 10-lot, but just to make it interesting let’s assume that a trader was willing to commit $1,000 to the trade. In that case the trade could have bought 70 Aug 15 puts for a total risk of $980.

As you can see in Figure 1, USO has declined sharply and the Weekly Elliott Wave count is still projecting significantly lower prices (although for the record, the daily count is NOT).

Figure 1 – Weekly Elliott Wave count for ticker USO still pointing lower (Courtesy: www.ProfitSource.com)

On 7/6 USO closed at $17.73.  During the day on 7/7, USO traded as low as $16.95 – which created the opportunity to sell part of the position at a double – then rallied to close at $17.76.  As you can see in Figure 3 below, in the early plunge experienced by USO on 7/7, this option registered a “double” (i.e., hit a price of $0.28).

So let’s assume the following.  The trader:

1) Sold 40 of his original 70-lot at $0.28

2) Continues to hold the remaining 30-lot

The current status of the trade appears in Figure 2 and 3.Figure 2 – USO Aug 15 puts  (Courtesy www.OptionsAnalysis.com)

Figure 3 – USO Aug 15 puts  (Courtesy www.OptionsAnalysis.com)

The current situation is this:

*The ProfitSource Weekly Elliott Wave count is projecting a target price of $12.02 to $6.50 for USO.

*The worst thing that can happen with this trade is that USO closes above $15 a share at August expiration, in which case this trade will have a profit of $140 (on a $980 investment).

*If by some chance USO does hit $12.02 a share prior to August option expiration this trade will show a profit in the $8,000 range.

OK, two important mitigating factors to consider:

1) The Weekly Elliott Wave count is projecting this price range to be hit sometime between October of 2015 and May of 2016, meanwhile;

2) We are holding an August put options

So is it realistic to expect to make $8,000 by August option expiration?  My own answer: Very highly unlikely. Still, we are now sitting with a “free position” with 45 days left until expiration.  Two choices at the moment are:

A) Let it ride for a while

B) Exit this position and roll out to a further out expiration month.

Summary

As I mentioned in the previous “Energetic” article, there are no right or wrong answers.  So the following is nothing more than one man’s position: the original purpose of the trade was simply to “take a shot” that crude would decline in price based on nothing more than daily and weekly Elliott Wave counts that were in bearish agreement.  To “roll out” now (i.e., to sell the August puts and buy puts in a further out expiration month would cost money and increase risk.  At this point I (personally) would be more inclined to let the current risk free August position “ride” for a little while.

As August expiration nears a trader can reassess things, but for now I would simply sit back and hope for the best (or in the case of crude oil, the worst) in the near future secure in the knowledge that this trade cannot lose money (thanks to selling 40 of the 70 put options purchased originally).

Jay Kaeppel

In a couple of recent articles (here and here) I wrote about natural gas and crude oil. Now seems like an exceptionally good time for an update.  Let’s start in this piece with natural gas.

Natural Gas

In the initial article I highlighted the fact that natural gas has showed a tendency to be weak from mid-June into late July (except of course for the one previous time that I actually mentioned this trend…$%^&. But I digress).

Anyway, the example trade I detailed in the article involved:

*Buying UNG Oct 13 put @ $0.92

*Selling UNG Jul 13 put @ $0.27

The “quirk” was that the trade was done in a 3 by 2 ratio (i.e., 3 Oct 13 puts were bought for each 2 Jul 13 puts that were sold).  If we assume the trade was entered using a ratio of 30 by 20, then the current status of that position appears in Figures 1 and 2 (click images to enlarge).

Figure 1 – UNG Oct-Jul 13 put spread (3×2 ratio);  (Courtesy www.OptionsAnalysis.com)

Figure 2 – UNG Oct-Jul 13 put spread (3×2 ratio);  (Courtesy www.OptionsAnalysis.com)

As you can see in Figure 2:

*The price of UNG is about exactly where we would like it to be (i.e., right around $13).

*The trade has an open profit of $420 (or 18.9% on an initial outlay of $2,220).

*The profit could approach $1,000 by July expiration (10 days away) if price stays around $13.

Of course price could move substantially between now and July expiration.  This creates two potential “problems”:

1) If price rises back above $13.93 the trade could still end up losing money.

2) If price drops below $13 a share there is the risk of “early exercise” because the short July puts would be “in-the-money.”

So here is the conundrum of a choice in a nutshell:

A) Close the trade and take a 19% profit, but forego the potential to increase that profit significantly 10 day from now, or;

B) Hold the trade and hope price remains relatively unchanged.

C) There are also many ways that this trade could be adjusted.  However, remember that our original goal was to exit by July 21, so rolling out of July options into say August options gets away from the original intention of taking advantage of the seasonal tendency for natural gas to show weakness in July (which by the way, it already has).

Summary

There are no “right” or “wrong” choices in deciding what to do with this position (or most any option position for that matter).  The key is to identify your priorities and act accordingly. Sometimes it pays to be patient, other times it pay to run like hell.

From my own personal point of view, I would probably look to close this trade now, take the profit and move on.  The “objective” of the original trade was to make money from any (not necessarily major) weakness in natural gas during July.

Profit maximized?  Not necessarily.

Mission Accomplished?   Maybe so.

Jay Kaeppel

Why is that people are always so surprised…..when the stock market declines, that is?

We’ve had a rip-roaring bull market for years on end (granted, thanks primarily to an orgy of printed money, borrowed money and artificially low interest rates, all of which is almost certain to end badly at some point, but I digress), the market averages have been building classic multiple top formations for months (See Figure 1) and seasonally we are smack dab in the worst time of the year.

And then just as it has always done, the stock market experiences a decline and lots of people freak out!  Oh well, same as it ever was I guess.Figure 1 – Major long-term advance followed by an extended topping formation, followed by, well, what else?

Now I make no claims to have “called the top”, nor am I in the “wildly bearish” camp.  My only point is that there has been ample warning that a pullback was quite possible.  Investors and hedgers have had ample opportunity to act (to sell or hedge) and ample warning as the major averages struggled to make any real headway.

If you are new to the financial markets, I advise you to memorize the following.  Look at Figure 2 and repeat after me:

Jays Trading Maxim #77: If price tries to breakout multiple times but fails, something bad usually follows.  So don’t just sit around and wait for the “something bad.”

Figure 2 – When price tries time and again to breakout but cannot the market is (usually) telling you something important

Where we are Now, Seasonally Speaking

Figures 3 and 4 are from www.EquityClock.com.

Figure 3 shows the seasonal annual trend for the S&P 500.  Simply note that as I have written about in the past, the end of May into September and October period is not typically “High Season” for the stock market.

In Figure 3 note the relative performance for the S&P 500 Index during the summer months compared to the rest of the year.

Figure 3 – Seasonal annual trend for S&P 500 Index (Courtesy: www.EquityClock.com)

Also note in Figure 4 that stock market volatility has showed a historically seasonal tendency to spike higher starting at the end of June.Figure 4 – Volatility “spikes” are not uncommon during the summer months (Courtesy: www.EquityClock.com)

Summary

The bottom line is threefold:

1) It pays to learn to recognize “the warning signs” and to act to hedge (or to do some selling) before the scary stuff starts to happen.

2) Given that it is a pre-election year (which tend to be bullish), I am willing to give the bullish case the benefit of the doubt.

3) In the meantime you might want to “strap yourself in”, it could be an interesting few months.

Jay Kaeppel

I learned yesterday that one of my contemporaries – for whom I had the utmost respect – passed away in his sleep the other night.  Nelson Freeburg was for as long as I can remember the editor of Formula Research, a newsletter he published which detailed any and all manner of objective trading methods.

Although I considered him my friend, the odd truth is that we never once managed to actually meet in person.  But we had mutual respect or one another’s work, and communicated by email and phone fairly often a number of years ago.  Nelson took a few “obscure” ideas I wrote about many years ago and turned them into actual systems with full-fledged objective buy and sell signals.  He gave me full credit for the initial idea and allowed me to gain a little notoriety primarily by virtue of his work.  He also took the time to help me flesh out and improve upon a number of ideas on my own.  In truth, we didn’t have much contact in recent years, but I remained and remain ever grateful for his selfless input.

Beyond all that, my recurring thought regarding Nelson was that when it came to developing well thought out, objective (not mention kicka#$) trading systems – in my opinion he was simply the best.  And I know for certain – because I have seen and heard comments to the effect over the years – that I am not the only person who believes that statement to be true.

As I mentioned, we never met in person.  But I have heard from many others that he was an excellent speaker and a heck of nice guy.

Nelson, thank you for the vast contributions that you shared so generously with us.  You will be sorely missed.

Jay Kaeppel

IMPORTANT NOTES:

In case you missed my updates to Part 1 and Part 2: the data that I had for ticker ULPIX (which is a ProFunds mutual fund that tracks the S&P 500 Index times 2) contained bad days of data, which as it turned out, overstated the returns that I showed in the articles.

That’s the Bad News.  The Good News is that the goal of the articles was to ultimately demonstrate that “combining” two different methods can oftentimes prove very worthwhile.  As it turns out, that is the case here – granted, not as dramatically so as I had originally thought, but, well see for yourself………

In Part 1 and Part 2 I detailed two separate methods for trading a stock index mutual fund (or ETF) using the relationship between the S&P 500 Index and junk bonds as the catalyst.

The natural question that might pop into most people’s head is “so which one is best?”  In this case, I think the proper response is “why choose?”  For here’s the interesting thing when it comes to trading.  Sometimes (though granted, not always) “combining” two systems can offer a better tradeoff between reward and risk than simply “choosing” one or the other.  So in this article let’s take a look at what might have happened had a trader combined the methods I detailed in Parts 1 and 2.

The Premise

We will combine the “44-Day SPY/HYG Ratio System” (System 1 for short) and the “252-Day Rate-of-Change System” (System 2 for short) and measure the results.

The Particulars

*For our “stock” component we will use ticker SPY (the ETF that tracks the S&P 500 Index”

*For our junk bond component we will use ticker HYG (the iShares high yield corporate bond ETF, which started trading in April of 2007)

*Because we are shooting for maximum returns I originally used data ticker ULPIX (which is the leveraged ProFunds mutual fund that seeks to track the daily change for the S&P 500 Index times 2).  Unfortunately, the data that I have for ULPIX contains errors on enough days to make a difference.  So for performance purposes I will simply multiply the daily return for ticker SPY times 2 as a proxy for ULPIX.

*When we are out of ULPIX we will simply hold cash.  For our purposes, an annual rate of 1% of interest is used.

We will start our test on 4/11/2008 (rather than 12/31/2007 for the test in Part 1) because HYG started trading on 4/11/2007 and we need 252 trading days to make our first 252-day rate-of-change calculation.

The Calculations

System 1: The 44-day Ratio Moving Average

A = SPY / HYG (each trading day)

B = 44-day simple moving average of A

C = (A – B)

If C > 0 then at the next close Buy (or continue to hold if already long) ticker ULPIX

If C< 0 then at the next close Sell ticker ULPIX and move to cash (or remain in cash if C was previously less than 0).

System 2: The 252-day Rate-of-Change

A = SPY today / SPY 252 trading days ago

B = HYG today / HYG 252 trading days ago

C = (A – B)

If C > 0 then at the next close Buy (or continue to hold if already long) ticker ULPIX

If C < 0 then at the next close Sell ticker ULPIX and move to cash (or remain in cash if C was previously less than 0.

Combined Model:

*If System 1 is”bullish” we will add +1 point to the Combined Model.

*If System 2 is “bullish” we will add +1 point to the Combined Model

*If the Combined Model reading is greater than 0 (i.e., if EITHER system is bullish) then at the next close Buy (or continue to hold if already long) ticker ULPIX.

*If the combined reading is equal to 0 (i.e., if NEITHER of the systems are bullish at the same time) then at the next close Sell ticker ULPIX and move to cash (or remain in cash if the combined reading was previously 0).

Figure 1 displays the growth of $1,000 achieved by holding SPY times 2 when System 1 is bullish and cash when it is bearish versus buying and holding SPY (no leverage).  $1,000 using System 1 grew to $1,635 versus $1,581 for buying and holding SPY.

Figure 1 – Growth of $1,000 using System 1 (blue) versus SPY (red); 4/11/2008-6/19/2015

Figure 2 displays the growth of $1,000 achieved by holding SPY times 2 when System 2 is bullish and cash when it is bearish versus buying and holding SPY (no leverage).  $1,000 using System 1 grew to $2,921 versus $1,581 for buying and holding SPY.Figure 2 – Growth of $1,000 using System 2 (blue) versus SPY (red); 4/11/2008-6/19/2015

Now let’s look at market performance when we combine the two systems.

Figure 3 displays the daily combine reading for all days from 4/11/2008 through 6/19/2015.

Figure 3 – Combined Model Readings;  4/11/2008 – 6/19/2015

When the blue line in Figure 1 is greater than 0 then the system is long ULPIX and when the blue line is at 0 the system is in cash.

The Results

*As you can see in Figure 3, throughout most of 2008 and much of 2009 the system was in cash.  Since that time the Combined Model has been above 0 with one brief exception. Given that the stock market fell hard in 2008 and has mostly advanced steadily since this is about what you would hope to see.

Figure 4 displays:

*The growth of $1,000 achieved by holding SPYx2 when the Combined Model reads +1 or +2 and holding cash when the combined model is 0 (red);

*The growth of $1,000 achieved by holding SPYx2 when the Combined Model reads) 0 (blue);

Figure 4 – Growth of $1,000 holding SPYx2 when Combined Model > 0 (red line) versus growth of $1,000 holding SPYx2 when Combined Model = 0 (blue line); 4/11/2008 – 6/19/2105

Finally, Figure 5 displays:

*The growth of $1,000 achieved by holding SPYx2 when the Combined Model reads +1 or +2 and holding cash when the combined model is 0 (red);

*The growth of $1,000 achieved by holding SPY on a buy-and-hold basis

Figure 5 – Growth of $1,000 holding SPYx2 when Combined Model > 0 (red line) versus growth of $1,000 buying and holding SPY  (blue line); 4/11/2008 – 6/19/2105

In sum;

*A original $1,000 invested in SPYx2 when the Combined Model is > 0 and in cash when the Combined Model is 0  grew to $3,305, or +230%.

*A original $1,000 invested in SPYx2 when the Combined Model is = 0 and in cash when the Combined Model is > 0 declined to $566, or a loss of -43%.

*For comparison sake, $1,000 invested in ticker SPY on a buy-and-hold basis grew to $1,581, or +58.1% during the same time.

As I am wont to say, the difference between +230% and -43% is what we “quantitative analysis types” refer to as “statistically significant.”

Figure 3 displays the annual returns based on:

*Holding SPYx2 when the Combined Model > 0 versus

*Holding SPYx2 when the Combined Model is = 0 verus

*Buying and holding SPY (no leverage)

Figure 6 – Annual Returns for Combined Model Readings of > 0 versus Combined Model readings of 0 and buying and holding SPY

*- Starting on 4/11/2008

** – through 6/19/2015

***Average annual return 2008 through 2014

Summary

So is this SPY/HYG Combined Model a “World Beater” system that everybody should adopt?  Probably not.  The test period is short (7+ years), the maximum drawdown was large (-42%) and much of the outperformance was based on using leverage and so on.

But the real purpose of this article is not to convince you to use this particular system.  The real purpose is simply to illustrate how combining two methods (one that gained +64% and the other that gained +192% can improve the overall net result (+230%).

The fact that this method produced an annual return of +22.7% versus +8.3% for the S&P 500 suggests that there may (at times) be some truth to the notion that “two ideas are better than one”.

Jay Kaeppel