By Jason Pearce

Numbers Deception

Mark Twain allegedly said, “Figures don’t lie, but liars figure.”  This can certainly be a true statement when investigating a market’s ROI.

Suppose you find a market that has averaged a positive annual return over the last decade.  Based on this information, does that mean the investor who owned it for the entire ten years made money?

Not necessarily.  It is quite possible he could have lost money on the investment, even though the average annual return was positive.  We’re not even talking about the impact of various account fees, commissions, etc., either.

It is possible for a market to have a positive annual return and simultaneously produce a negative compounded return.  For example, consider a market that gains +20% one year, loses -18% the second year, gains +20% the third year, and then loses -18% the fourth year.

At the end of four years, the average return on this market is a +1% gain.  However, the compounded return on the investment shows a -3.17% loss.

Volatility = Destruction

The higher the market’s volatility, the lower the compound returns.  If the size of the annual changes in the prior example were doubled to show two years with +40% gains and two years with -36% losses, the average return would double to a +2% gain, while the negative compounded return on the investment would increase just over six-fold to a -19.72% loss.

Even if the losses were smaller in proportion to the gains, the higher volatility would still be accompanied by an increase in the damage.  What if the market gained +40% in year one, lost only -30% in year two, gained +40% in year three, and lost –30% in year four?

The good news is that the average return on the market jumped substantially to a +5% gain.

The bad news is that the negative compounded return on the market still increased to a -4% loss.

So even though the average return is five times bigger than the market with two years of +20% gains and two years of -18% losses, the negative compounded return still increased as well.

Also, it does not matter one bit what order those returns are in.  If the market had gained +40% for two consecutive years before experiencing the two -30% losing years, the end result would be the exact same average and compound returns.

Leveraged ETFs

Warren Buffett once said, “Derivatives are financial weapons of mass destruction.”  If we’re talking about ETFs, I am inclined to agree with him.  Especially leveraged ETFs.

Many ETFs are constructed to match the daily returns of an underlying market.  Therefore, they have to be re-balanced every day.  Using the same math as above, if the market gains +25% and then loses -20% the average return is a positive +2.5%, but the compounded return is 0%.  Despite the fact that the percentage gain is larger than the percentage loss, you still would not have any gains to show for it.

But it gets even worse with leverage!

Many ETFs offer leverage that reflect two or even three times the daily returns of an underlying market.  If the underlying market gains +25% and then loses -20%, a double-leveraged ETF would gain +50% and then lose -40%.  As you would expect, the average return is a positive +5%, which is double the average return of the underlying market.

But the compounded return is where you take the hit.  Instead of treading water like the compounded return of the underlying market, the double-leveraged ETF sports a -10% loss.

Triple-leveraged ETFs are like jumping out of the frying pan into the fire.  The results of the triple-leveraged ETF in this same situation would be a gain of +75% and then loss of -60%.  The average return jumps to a positive +7.5% and the compounded return soars to a -30% loss.

How awful is that?  The 3x ETF has an average return that is only 50% bigger than that of the 2x ETF, but the compounded return is three times bigger than that of the 2x ETF.

Real World Examples

Let’s take a look at how an ETF performed vs. its leveraged version.  In particular, we’ll track the most popular ETF on the planet, which is the S&P 500 Index SPDR (SPY).  This ETF simply tracks the S&P 500 Index and uses no leverage.

We are going to look at the returns for 2007 thru 2012 to show the performance during a major bear market and the recovery that followed.

SPY posted a +3.2% gain in 2007, a -38.2% loss in 2008, a +23.4% gain in 2009, a +12.8% gain in 2010, a -0.2% loss in 2011, and +13.4% gain in 2012.

The average annual return over this six-year period was a +2.4% gain.  However, the compounded return was only a +0.5% gain.

When it was all said and done, a Buy and Hold strategy for this ETF would have been basically flat over this six-year timeframe.  Of course, we’re only talking about the money here.  If we take into consideration loss of opportunity, loss of sleep, loss of hair, etc. then the SPY investors probably suffered greatly!

If you think you can handle the heat and want to get double the leverage in the S&P ETF, the “astute” investor could have bought the Ultra S&P 500 Proshares (SSO) instead.  This ETF targets double the daily return of the S&P 500 Index.

SSO posted a -4% loss in 2007, despite the fact that the underlying market posted an annual gain.  There’s the first big red flag right there!  This ETF then posted a -68.2% loss in 2008, a +45.5% gain in 2009, a +25.6% gain in 2010, a -3.4% loss in 2011, and +30% gain in 2012.

The average annual return over this six-year period was a +4.25% gain.  However, the compounded return produced a -30% loss.  This is a much different outcome than the investor who held the non-leveraged ETF experienced.  While his million dollar nest egg was now sitting at $1,005,000, the leveraged investor’s million dollar nest egg has shrunk to $700,000!

So what if the investor had held a bearish double-leveraged ETF instead of a bullish one?  Well, the results would be even worse.

The Ultrashort S&P 500 ProShares (SDS) ETF targets double the inverse of the daily return of the S&P 500.  If the S&P gains 5%, SDS should lose 10%.  If the S&P loses 5%, SDS should gain 10%.  Capisce?

SDS posted a -6.8% loss in 2007, a +30.9% gain in 2008, a -50.5% loss in 2009, a -32.2% loss in 2010, a -18.8% loss in 2011, and -29.8% loss in 2012.

As a result, the average annual return over this six-year period was a -17.8% loss and the compounded return resulted in a devastating -76.7% loss.  You probably shouldn’t even calculate what would have happened to the leveraged investor’s million dollar nest egg with this debacle.

Fool’s Gold

Here’s a recent example for the gold bugs and the commodity investors.  Let’s look at an ETF for gold miners.  This has been a popular one over the last few years.

The Gold Miners ETF (GDX) tracks the NYSE Arca Gold Miners Index and uses no leverage, but that doesn’t mean it’s not volatile.  This ETF posted a -13% loss in 2014, a -25.3% loss in 2015, and +52.4% gain in 2016.

Although the average annual return for GDX during this three-year hold period was a +4.7% gain, the compounded return was a -1% loss.

The triple-leveraged version of this ETF is the Gold Miners Bull 3X Direxion (NUGT).  If you’re looking for trouble, you will certainly find it here!

NUGT posted a -59.2% loss in 2014, a -78.2% loss in 2015, and +57.2% gain in 2016.

The average annual return for NUGT during this three-year hold period was an atrocious -26.7% loss and the compounded return was an unbelievable -86% loss.  That’s certainly a lot more than triple the -1% loss that the GDX unleveraged ETF experienced during the same period.

Using the WMDs

Leveraged ETFs do have their place in a trader’s arsenal.  A trader can amplify their gains in a strong trending market by using leveraged ETFs (provided that he’s on the right side of that trend, of course!)

As a matter of fact, the returns on a leveraged ETF can even overshoot the target returns when a trend is strong enough.

Once a market starts to get a little choppy or breaks trend, though, things go south quickly.  The losses on the leveraged ETFs can accelerate.  Therefore, traders must remain vigilant and be willing to bail out at the drop of a hat.  Leveraged ETFs may not be the ideal instruments for a long-term trader to trade and it’s definitely not the right instruments for an investor to allocate their investment capital to.

Having investigated the dangers of buying them, leveraged ETFs can actually offer a great trading opportunity for the trader who’s willing to follow Robert Frost’s advice and take the road less traveled by.  That path is found on the short side of the trade.

Think about it: if an ETF is going to take it on the chin through leveraged decay and volatility, why shouldn’t a trader take advantage of it by being positioned on the short side?  A lot of the leveraged ETFs reflect the daily percentage change of the underlying market, so it works against the investor over time.  The longer the hold period, the bigger the losses on the ETF.  This works directly in favor of the short seller because he is betting on depreciation in the value of the ETF.

Clarification

It’s important to understand that a strategy of shorting ETFs is not based on the idea of being bearish on the underlying market.  Rather, it is based on the idea of being bearish on the value of the ETF itself.

Traditionally, if an ETF trader is bullish on a market he would buy the ETF or even some of the leveraged ETFs.  If the trader used the strategy we are discussing, however, he would short the bear ETFs in lieu of buying the bull ETFs.  Conversely, a trader with a bearish opinion of the underlying market would short the bull ETFs instead of entering a long position in the bear ETFs.

Know When to Tap Out

Despite the fact that the short side of a leveraged ETF has extremely favorable probabilities for the trader, it does not mean that it is a risk free trade.  You have to make sure you have position size limits and an exit strategy for the trades that are unprofitable.  Even many casinos still impose limits despite the fact that they have the house advantage.  It’s not done to protect the gambler; it’s to protect the casino!

Even the best fighters know when they should tap out.  This is why they will live to fight another day.  So when you are trading leveraged ETFs, it’s important to know where to tap out.  To that end, I’m going to give you a couple of exit techniques that you may want to investigate to see if they fit your trading strategy.

The first is to set an exit level on a percentage move.  First, you would want to measure the sizes of all the countertrend rallies that have occurred in the last year or so.

If you see consistency in the size of the bounces, say a series of 5%, 4.6%, 4.2%, 5.5%, and 4.8%, you could use the number that is two or three times the average as your exit point.  In this case, the average size bounce is 4.82%.

In the same way that many trend followers use a multiple of a market’s Average True Range (ATR) for an exit signal, a trader could exit a short ETF position if a countertrend rally is some multiple of what the market has been experiencing during the decline.  In the case where the average size bounce is 4.82%, perhaps the exit signal would be triggered by a countertrend rally of 9.6% (double the average) or 14.5% (triple the average).

Another exit technique that a trader could employ would be classic technical tools like moving averages, Bollinger bands, price envelope breakouts, etc.  Simply put, a violation of resistance (preferably on a closing-basis) would tell you that the downtrend is being challenged and that the bears are not in complete control.  If the profits from your short ETF position are no longer “easy money” it’s time to get out and look for better opportunities.

Market Neutral Position

Another idea for traders to consider instead of traditional trend following is to construct a market neutral position.  After all, both the bullish and bearish leveraged ETFs can lose money over the same period.

A trader could construct a market neutral position by allocating half of the capital into a bullish leveraged ETF and the other half into its corresponding bearish leveraged ETF.  That way, the trade is making money on both ETFs if the market stays choppy and trends fall apart.  But even if the underlying market starts to form a strong trend at some point, at least one of the ETFs will continue to erode in value and at least partially offset the other ETF that is increasing in value.

In a market neutral position, a trader could set stops/exit points for the entire position (the bullish and bearish ETFs combined) or the exit criteria could be determined individually for each side of the position.  There is no right or wrong answer here.  Each trader needs to do the research to figure out what is best for their own strategy.

Don’t Tolerate Losers

A trading strategy that focuses on shorting leveraged ETFs can put the odds squarely in favor of the trader.  A majority of trades should work out profitably.  But keep in mind that shorting leveraged ETFs is still not a risk free trade!  It is important that a trader still manage the risk on the trade by setting loss limits.

Given the favorable probabilities of shorting leveraged ETFs, it makes sense that the trader should have even less tolerance for losses from this strategy than that of another strategy where the playing field is level.  If a trade is not working, especially if it’s showing a growing loss, it’s time to cut bait and fish elsewhere.  You’ve got much bigger fish to fry.  The next one should be easier to catch, too.

Editor’s Note: We had access to the institutional database at ETF Global for researching this article.

ETFG offers a 2-week free trial to their research.

By Jason Pearce

Prices in the North Could Head South

Everybody loves a good market bubble story!  If that’s you, you’re in luck because it looks like we may have one in play just over the border.  Although it doesn’t grab all the headlines here in the US, the housing market up in Canada is certainly a hot topic.

There are some analysts who liken the current Canadian housing market situation to that of the US housing market a little over a decade ago.  That’s not entirely accurate, though.  Don’t expect to see a foreign version of The Big Short in theaters anytime soon.

On the other hand, there are enough parallels between the US housing market demise and the current situation in the Canadian housing market that that one has to wonder if a major shakeup is imminent.

To the Moon

We all remember how ridiculous the housing prices got when the bubble in the US peaked in 2005.  But did you know that Canadian housing prices experienced a run-up, too?  Even better, the Canadian market did not collapse when ours did.  It stayed elevated until 2007 before the financial crisis finally pulled the rug out from under everything.

Fast forward to a few years later and the Canadian housing market has fully recovered.  It surpassed the prior peak by a country mile.  Here’s the real kicker: Canadian housing prices have exceeded the 2005 US housing prices by a large margin!

Some might immediately think that the higher price reflects the exchange rate.  The Canadian dollar is significantly lower than the US dollar, so Canadian houses should naturally show a higher price tag.  But when you compare the average house prices for Canada and the U.S. with both denominated in U.S. dollars, it reveals just how expensive the Canadian housing market is.  It has surpassed the U.S. bubble’s peak.

Adjusted for inflation, not only has the Canadian housing market blown past the peak of the US housing bubble, but it has now matched the real estate bubble of Japan from the 1980s.  That certainly didn’t end well.

The Lead Sled Dogs

Vancouver and Toronto are the two Canadian markets leading the charge in this housing bubble.  Their price gains out-paced the rest of the country.  So you can’t say that someplace like Ottawa is just as frothy as Toronto.  However, these top growth markets are still having an impact on the entire Canadian housing market.

To get a feel for how far things have gone, compare the Vancouver and Toronto markets to places like Miami or San Francisco during the US housing bubble.  You quickly surmise that these two Canadian cities have outperformed the cities that led the charge during the US boom.

The Bigger They Are…

Since Vancouver and Toronto went up more than the rest of the metro areas, it stands to reason that they should also go down the most.  But that does not mean the other areas will not also go down decline.

But it is possible that the negative psychological effect of a falling housing market could increase the rate that other metro areas go down with Vancouver and Toronto.

What we are talking about here is beta.  For example, if one metro area went up 50% as much as Vancouver and Toronto, we’d say it has a beta of 0.5.  But what if the beta increases to 0.6 or 0.7 during a decline?  It would mean declines of 60% or 70% as much as Vancouver and Toronto.  It’s certainly not a guarantee that we would see a beta increase, but you can’t rule it out either.

No Subprime Crisis

One major difference between the US housing bubble and the current Canadian housing market is that Canada doesn’t have a major chunk of the real estate market tied up in subprime garbage.  The higher lending standards of the Canadian banks are the whole reason that they didn’t suffer the same fate as the US when the last housing bubble popped.

Currently, subprime loans make up about 5% of all mortgages issued in Canada.  When the crisis hit the US market, roughly 21% of all U.S. mortgages were subprime.  Therefore, the Canadian housing market is not quite as risky as the US housing market was a little over a decade ago.

But notice that I did not say that the Canadian housing market is risk free.

Home Owners Are Stretched

Predicting where a bubble will peak is a tough business.  But you can get a sense of how mature the run is when the buying capacity is stretched.  When there’s no one left to buy, there’s no more upside for the market.

Right now, buying capacity is spread pretty thin.  The Canadian household debt-to-income ratio is well beyond what it was at the 2007 peak.  Ominously, the Canadian household debt-to-income ratio of nearly 170% is getting awfully close to where the US household debt-to-income ratio peaked during the US housing bubble.

The household debt-to-income ratio does not take mortgage fraud into account, either.  Lending agency Equifax Canada reported that the number of “suspicious” mortgages have increased 52% over the last three years.  With two-thirds of the mortgages in Ontario flagged as “suspicious” it is conceivable that households are stretched even further than the official numbers state.

Wheels Set In Motion

The housing market may have finally peaked as the government took action to douse the speculative frenzy.  Last summer, British Columbia passed a law to make foreign buyers of Vancouver real estate pay a 15% tax.   Furthermore, the federal government changed the rules for all insured mortgages that make it more difficult for buyers to qualify.

Not surprisingly, the changes in Vancouver had a major impact on the market.  Over the last 12 months, home sales have plunged 40 percent and home prices have started softening as well.

The Next Shoe

Ontario has yet to reign in the out-of-control housing market.  Therefore, prices in Toronto are up nearly 23% from a year ago and supply is only half of what it was then.  Ironically, experts are saying that the crisis is actually the shortage of supply!

Despite the supply shortage, you have to wonder how much more housing prices can increase if there is not a corresponding increase in the buyer’s income.  As we’ve already seen, buyers are already stretched thin with a household debt-to-income ratio that rivals that of the US household debt-to-income ratio at the peak of the housing bubble.

History Repeats

When the Toronto housing market bubble finally pops, it won’t be a new experience for homeowners.  If history is any guide, it will not be a pleasant event.

Toronto housing prices peaked in 1958, softened for years, and finally bottomed out in 1964.  In 1966, prices finally returned to the 1958 peak.  That was an eight-year round trip.

The next major top occurred in 1974.  Housing went into an eleven year bear market and posted the final low in 1985.  It wasn’t until 1987 when the housing market finally matched the prior peak.  That’s a thirteen-year wait to breakeven for Canadian homeowners who bought in 1974.

The rebound off the 1985 low turned into a full-blown bubble.  It finally popped in 1989 and began a multi-year decline that didn’t end until 1996.  Adjusted for inflation, this decline knocked a whopping 40% off the housing prices.  Furthermore, it took a little over twenty years for the Toronto housing market to return to the 1989 peak.

Adjusted for inflation, current Toronto housing prices are substantially higher than where the last bubble peaked.  If history were to repeat, this will be followed by a multi-year bear market.  Investors who believe that “It’s different this time” are in for a rude awakening.

Nothing to Worry About

Logically, more housing market price gains similar to what has already occurred are economically unsustainable.  Besides, the housing market in Vancouver –one of the leaders in this bubble- is already slowing down significantly.

Despite these facts, there still isn’t much concern for the potential downside.  When people aren’t prepared for an adverse an event, that’s when they are the most vulnerable.

For example, while saying that the Canadian housing market growth may slow down, Moody’s Analytics said nothing about the growth actually stopping or even reversing.  Their big warning is that national house price growth will drop to from about 8% right now to about 2% by the end of 2018.

This is unsettling.  It reminds of the summer of 2005 when Ben Bernanke, the Chairman of the Council of Economic Advisers, said,” Housing prices are up quite a bit; I think it’s important to note that fundamentals are also very strong. We’ve got a growing economy, jobs, incomes. We’ve got very low mortgage rates. We’ve got demographics supporting housing growth. We’ve got restricted supply in some places. So it’s certainly understandable that prices would go up some. I don’t know whether prices are exactly where they should be, but I think it’s fair to say that much of what’s happened is supported by the strength of the economy.”

Then in February 2006 when he was the new Fed chairman, Bernanke said, “The housing market has been very strong for the past few years . . . . It seems to be the case, there are some straws in the wind, that housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise, but not at the pace that they had been rising. So we expect the housing market to cool, but not to change very sharply.”

So much for the assuring words of the experts…

More Potential Catalysts

We already covered the reasons that the Canadian housing market bubble may have started to deflate.  Heck, it could even pop.  But what we did not get into are the other potential events that could raze the Canadian housing market.

What if the bull market in stocks pauses or even comes to an end?  Household wealth levels would decline.  Home values would likely get dragged down with it.

Canada is a big-time commodity producer.  Another break in the price of crude oil, gold, or the grain markets would have an adverse effect on Canada’s economy.  Housing markets would likely feel the impact.

If Ontario finally wakes up to the danger of the housing market bubble and changes the rules like BC did, we should expect the same outcome: a drop in both home sales and home prices.

What if the economy, the stock market, and commodities all stay strong and the boom times last?  Eventually, that could drive the Bank of Canada to decide that tighter monetary policy makes sense.  An increase in interest rates could become the proverbial straw that breaks the camel’s back.

How to Play It

It’s not like a trader or investor can “go short” on a Toronto condo or a Vancouver house.  And although the CME has futures contracts on major US cities like Miami, San Francisco, New York, Las Vegas, etc. there currently aren’t any for Canadian cities.  But perhaps one way to trade a decline in the Canadian housing market is to short their banks.

Right now, this may sound crazy.  Moody’s Investor Service says the Canadian banks would perform better in a housing market downturn than the US banks did.  The big Canadian banks have been around forever.  They have weathered the prior financial crises and came out on the other side.  Furthermore, they pay generous dividends and most of them have recently reported increased income.  What investor would want to sell their shares in a bank with such a great track record?

But that doesn’t mean that they haven’t experienced setbacks.  And it sure doesn’t mean that they won’t in the future.

According to the Toronto Stock Exchange, Canada’s banks are already being heavily shorted right now and in a much bigger way than similar-sized companies.  But according to the stock price of these banks, the short positions have been mostly wrong for months.  Why?  Because the price has been trending higher for months.

Trend Change Afoot

Despite the case for the Canadian housing bubble to pop, a trader should look for price confirmation before acting on any theories.  This is that timing part of the equation.

Right now, we may be finally getting that confirmation as many Canadian bank stocks have started to deteriorate over the last couple of weeks.

First off, some of the banks stocks may be establishing a classic Double Top pattern by trading within pennies of their prior highs and then stating to pullback.  Royal Bank of Canada (RY) and Bank of Montreal (BMO) both fit this bill as they neared the 2014 record highs and retreated.

Both of these stocks are now dangling just above technical support between their rising 50-day Moving Average and last month’s low.  A close below the 50-day MA and a break of a prior month’s low –neither of which have happened since November- could put further pressure on the stocks and drive it down to the widely-watched 200-day Moving Averages.  This could increase the odds that a major top is in place.

Toronto Dominion (TD) is even more intriguing.  This stock surpassed the 2014 record high by nearly $1-per-share and then pulled back sharply.  This is what I have coined the Wash & Rinse sell pattern.  By definition, this is a failed breakout pattern where a prior high is surpassed and then the market quickly reverses lower.  The Wash & Rinse can often lead to major declines.

Furthermore, Toronto Dominion got crushed on Friday as it dropped 5.31% and broke the rising 50-day Moving Average for the first time in five months.  The stock also plunged below a prior month’s low for the first time in nine months.  Ideally, a bounce back to last month’s low or the 50-day MA (old support, once it is broken, becomes new resistance) would materialize and allow for a nice entry point.  If successful, the position size could be increased aggressively if new corrective lows follow.

Finally, there are a couple of stocks that never got close to their prior highs.  They become short sale candidates by virtue of comparative weakness.  They are the worst-performing of the bunch and vulnerable to getting hit the hardest.  Bank of Nova Scotia (BNS) and CIBC (CM) are the two that I am talking about.  Is it any coincidence that CIBC has the highest real estate exposure and it’s one of the worst looking Canadian bank stocks?!

Bank of Nova Scotia already cracked support at the 50-day Moving Average and prior month’s low, while CIBC has not.  This means that Bank of Nova Scotia is currently more qualified for a short sale than CIBC.  Once CIBC has violated these same technical levels, it will show that it is also ripe for the picking.

Be Smart

Sometimes, traders think they’ve found the once-on-a-lifetime trading opportunity.  One that’s almost a sure thing.  One that could create the kind of fortune that lasts for generations.  Maybe shorting Canadian banks will be the most talked about trade next year and you’ll hear all the stories of the next John Paulson’s of Canada who made billions of dollars betting on it.

If you get into a trade and it starts to go your way, great!  You can short even more Canadian bank stocks if they keep dropping and your current positions are all showing open profits.  The winners take care of themselves so we don’t need to go too deep into a detailed discussion.

The problem, however, is that we could always be early.  Worse yet, we could even be completely wrong.  One never knows that a trading opportunity is a sure thing until it has gone on the record books as a matter of history.

How many people were shorting European bonds once the yields dropped to near zero percent?  Here we are a few years later and yields are now negative.  Although it seemed like a no-brainer at the time to bet on rising yields, it was completely wrong.  A lot of good traders broke their axe on that stone.

So do the smart thing and focus on managing your risk.  This should be your top priority.  There’s a great Wall saying, “Bulls make money, bears make money, but pigs get slaughtered.”  Don’t ever bet the farm on any trade idea and don’t add to a losing position.  As a matter of fact, the only thing you should do with a losing position is liquidate it.

By Jason Pearce

Anos de los Muertos

Every year at the end of October, Mexico has a three-day festival known as Dia de los Muertos.  This Day of the Dead is a celebration where the people remember and honor those who have departed.

This year, you may want to prepare for Anos de los Muertos, which translates to Year of the Dead.  It is not going to be a celebration, either.  You see, the odds are higher-than-normal that the multi-year equities bull market could come to an end in 2017.

In this post, I am going to reveal a convergence of data that could be pointing to a major disruption, maybe even an abrupt end, to the current bull market.  But let’s get one thing straight right up front: this is not a prediction of what will happen in 2017; it is an assessment of the most probable outcome of what will happen in 2017.  We cannot know the future.  We can only know the likelihood of what’s to come.  There is an important difference.

Let’s go ahead and revise a prior statement to read “It’s not going to be a celebration for most people.”  After all, some people –hopefully you are one of them! – will be well-prepared and positioned on the right side of the market if/when that time comes.

It Ain’t Cheap

The P/E ratio of the S&P 500 recently hit 27:1.  Think about that for a second.  If you bought the companies in the S&P 500 and wanted to pay it off from what those companies currently earn, it will take you one quarter of a century to get your initial investment back.

Just how patient are you?

Patience isn’t the main issue, either.  Investors need to consider the size of the return their getting on their money.  Warren Buffett has reminded investors time and time again that “the price you pay determines your rate of return.”

The historical average P/E ratio for the S&P 500 is 16:1.  That means that the current P/E ratio of nearly 27:1 is 69% above the average.  Based on Buffett’s logic, this historically high-priced market should lead to a period of historically low returns.

Looking at nearly 150 years of stock market history, there are only a handful of times when the P/E ratio hit 25:1 or higher:  Around the Panic of 1893, the start of the Roaring Twenties, the Great Depression in the early 1930s, the end of the Dot Com bubble in 2000, and during the Great Financial Crisis of 2008-2009.  As we all know, these were not optimal times to be invested in the stock market.

Furthermore, let’s remember that price was plunging during these bear markets, even though the P/E ratio soared.  The reason for this was because earnings dropped at an even faster rate than the price!  As a matter of fact, earnings were negative in Q4 of 2008 for the first time in history.  This is why the P/E ratio rocketed into triple-digit territory for the first time ever.

Accounting for Inflation

Economist Robert Shiller decided that the P/E ratio can sometimes be misleading because it does not reflect where the market is in the business cycle.  In response, he created a ratio that measures the current prices to average earnings over the past 10 years adjusted for inflation.  His Cyclically Adjusted Price/Earnings (CAPE) ratio reveals a market that is even frothier that what the standard P/E ratio shows!

Currently, the CAPE ratio stands at a nosebleed level of 29:1.  Going back to 1881, there are only two other times when the CAPE ratio was at 29:1 or higher: Right at the end of the Roaring Twenties in 1929 and right at the end of the Dot Com bubble in December 1999.  I would not consider this to be a good omen for today’s stock market.

In light of the current P/E valuation, I think it’s an understatement to say that the stock market is certainly not a bargain for investors right now.  One could even say it’s getting into overpriced territory.

It is important to remember, though, that the P/E ratio only tells us about the market’s value.  It does not tell us anything about timing.  We need to look elsewhere for that.

Dog Years and Bull Years

The equities bull market that began off the March 6, 2009 low celebrated its 8th birthday on Monday.  Eight years may not sound like much, but in dog years the bull market would be a mature 56. It’s certainly not young anymore.

But we’re not talking about a dog here.  We’re talking about a bull.  And in bull market years this one is beyond old; it’s now ancient!

Over the last 130 years, there have been 15 different bull markets in the US.  The average lifespan of these fifteen bull markets was 2 years and 11 months.  Therefore, our eight-year-old bull market is nearly 175% longer than the average.

As a matter of fact, the current bull market is the third-longest in history.  It will move up the ranks to being the second-longest bull market if it can last beyond St. Patrick’s Day on March 17.

As a note of interest, the current bull market duration ranked in the #2 spot ended in September of 1929.  We all know that wasn’t exactly a gentle landing.

Maybe this current bull market is destined to match the nearly nine and a half year record bull market duration that peaked at the Dot Com bubble top of 2000.  Heck, it could even set a new record.  But knowing the typical lifespan of prior bull markets, you can see that the odds are against it.

Sizes Really Does Matter

In addition to the maturity of the bull market, we also need to consider how big it is.  So far, this bull market has gained 260% from the lows.  That’s an average annual return of roughly 18%!

When we examine those 15 US equity bull markets that have occurred since 1888, we discover that the average size of a bull market is 120%.  Therefore, the current bull market is a little more than double the average size.

As far as rankings go, the 260% gain from the 2009 low is the fourth-largest in history.  If the S&P 500 just adds another 46 points to the current record high of 2400.98, it will match the 267% gain of the 1949-1956 run that occurred during the Nifty Fifties.  All it would take to make that happen is a favorable Tweet from the President!

The largest and second-largest bull markets in history were substantially bigger than the current one.  The second-largest was the 427% advance off the 1990 low that ended when the Dot Com bubble burst.

The largest bull market in history was a mind-blowing 504% gain that ended with the 1929 stock market crash.

The takeaway from this study is a paradox of sorts.  On the one hand, most bull markets don’t gain much more than our current one.  Therefore, we should not be complacent or unrealistic in our expectations going forward.  Average annual returns of 18% don’t last forever.

At the same time, we know that in the couple of instances when the current size of gains was trounced, it was done by a huge margin.  Why?  Because some bull markets experience a blow-off stage at the end where prices go parabolic.

You have to remember that the improbable is not the same as the impossible.  The informed trader/investor needs to bet with the odds, yet not fight the trend.

Will the Honeymoon Be Over This Summer?

Another potential headwind for equities right now is where we are in relation to the Presidential Election Cycle.

The S&P 500 is up nearly 13% since the Friday before the election as Donald Trump is supposed to be the best thing since sliced bread for the US economy.  Stocks have not been shy about pricing that in.

However, history indicates that the market could hit a rough patch in the second half of 2017.

Looking at the stock market since 1897, the typical year following the US Presidential election is bullish for the first half.  But the second half of the year is where the trouble begins…

On average, the stock market peaked out in the summer after the Presidential election.  It then declined sharply into November and wiped out several months’ worth of gains.  After a bit of a recovery, the market was then locked into a choppy trading range for nearly a year.  At best, it would stabilize and then tread water for nearly a year.

Using a shorter data set makes this pattern look even uglier.

If we start the data at 1928 instead of 1897, the summer peak and November bottom still show up.  However, the final low does not hit until autumn of the following year.

If the data set begins with 1965, the stock market once again peaked in the summer and dropped into November.  This time, however, the market hit new lows for the year before it finally bounced off a November low.

No matter how you cut it, the Presidential election cycle indicates that prices will peak this year when the temperatures peak.  A bottom would not be expected until November at the earliest.

Not-So-Lucky “7”

An additional cycle that investors and traders need to be aware of is the Decennial Cycle.  Everyone either remembers or has at least read stories about the Crash of 1987.  But do you know what happened in many of the other “7” years?  For some reason, the US stock market has a bad history with the “7” years.  Consider the following list:

2007 – Although the financial crisis occurred in 2008, the market peaked in October of 2007.  It dropped nearly 58% over the following eighteen months before all was said and done.

1997 – Although it was a short-lived event of just a few weeks, the stock market still experienced an “unlucky” 13% drop from the top during the Asian Contagion in October of 1997.

1987 – This infamous stock market crash racked up a 36% loss in just two months.

1977 – A modest 20% bear market was torturous, due to the fact that it stretched out for nearly a year and a half before it was finally over.

1957 – The stock market lost 20% over a three-month timeframe.

1937 – Stocks dropped a whopping 46%.  The wipeout lasted for nine months.

1917 – After peaking in 1917, the bears dominated for thirteen months and knocked 40% off the stock market.

1907 – This was the start of a 45% price markdown that lasted for ten months.

Amazingly, this Decennial Cycle even had an influence in the 1800s!  The stock market lost 50% after the peak of 1857 and it lost 53% from the 1807 top.  These bear markets lasted nine months and thirteen months, respectively.

Despite how this year has started out, history indicates that 2017 could have some bad juju in store for investors.  But if you prepare yourself ahead of time and know what to look for, you can sidestep disaster.  If you play your cards right, you could even be in a position to profit from it!  There’s certainly wisdom in the old saying, “One man’s misfortune is another man’s fortune.”

Synergy Effect

We are only days out from becoming the second-longest bull market in US history.  The age factor alone suggests that it could be nearing the end of the line.

Furthermore, the size of this bull market also indicates that there may not be a whole lot of upside left.  Add another 60 points or so to the current S&P 500 high and this will rank as the third-largest bull market in history.  Although there were a couple of prior bull markets that were substantially larger than the current one, that’s precisely the point: Only two of them in history gained more than this!

In addition, the US Presidential cycle indicates that the “Trump rally” could reach its completion this summer.  From there, sizable reversals tend to follow.  This was corroborated by data with three different starting points.

Finally, the Decennial cycle is casting a dark shadow over the stock market this year.  There are way too many “7” years that have experienced corrections, bear markets, and even crashes to ignore or dismiss as mere coincidence.  In five of the last six decades, the “7” years handed out double-digit losses to investors.  Don’t bet against this streak.

When you know the valuation history of a market, you can determine what levels are unsustainable because of being too expensive or too cheap.

When you have a metric, such as the historical sizes and durations of prior market moves over the last century, you can calculate the probabilities of what may occur in the future.

When you have seasonal or cyclical patterns, you can also begin to draw out a market roadmap that’s a bit better than a random guess.

But when you put all of this data together and find that they are all pointing to the same thing, you have a synergy effect.  With several non-redundant measurements coming to the same conclusion, it seems that the probabilities set by a unanimous consensus of the group are higher than the probabilities of each metric on their own.

Those probabilities are pointing to a bearish event in 2017.  So even if you agree with the current bullish market fundamentals or you have a positive outlook based on President Trump’s agenda for the country, you should not dismiss the unanimous conclusion compiled from several decades of data.  Caution is definitely warranted here.

Watch the Weather

Despite all the dark clouds looming on the horizon, the market price behavior should be the final judge and jury of whether or not the bear market comes out of hibernation.  Don’t liquidate your stocks, buy portfolio insurance, put on hedges, and/or go short unless the price indicates that it is the right time to do so.  Being right but early can have the same effect on your account as being dead wrong.

A couple of things that one could use to gauge the weather in the current market environment are the market’s price structure and the trend relative to moving averages.

On the long-term timeframe, the price structure is bullish.  The S&P 500 has made higher monthly highs for five consecutive months and it has not broken a prior month’s low since November.  A series of higher highs and higher lows is an uptrend.

On the daily timeframe, the market is well above the most widely-watched moving averages.  The day after the election, the S&P 500 rocketed higher and has closed above the rising 50-day Moving Average every single day since.  In addition, the market has only closed below the 200-day Moving Average once in nearly a year.  (That was the short-lived break right after the Brexit vote.)  Staying above the moving averages and posting a string of new record highs is not what you see in a market that’s bearish.

The combination of P/E ratios, market stats of prior size and duration, and market cycles are forecasting a major storm ahead.  But when we observe the current price behavior of the market, there’s nothing in sight but blue skies.

Our first indication that the storm clouds are moving in would be a close below the 50-day Moving Average.  Once that happens, a trader could start looking for setups on the short side.

A break below the 200-day Moving Average (one of Paul Tudor Jones’ favorite metrics) would tell us that we’re in a downpour.  You don’t want to have any long exposure when that happens.  Also, a break of a prior month’s low would be a lightning strike.  If it hits at the right place and time, major damage can occur.

As storms start rolling out across the US this spring, remember that the deadliest storms for the stock market are expected to hit in the second half of the year.  When it rains, it pours.  So it’s best to start prepping for it now!

By Jason Pearce

A Noteworthy Setup In Treasuries

Everybody seems to hate the bond market right now.  All the cool kids own stocks and commodities.  After all, the new US President is going to Make America Great Again and he’s willing to spend whatever it takes to get us there.  That’s not good for bonds.

However, there may be a good reason to consider a contrarian approach and start thinking about owning US Treasuries once again.  Whether you are looking at cash bonds, futures, or ETFs, things may be shaping up for a major trend change.  If so, the investor/trader who gets in early will be the one to reap the biggest reward.

Ebb and Flow

Last July the long end of the US Treasury market peaked at record highs.  The yield on the 10-year note sunk to a record low of 1.33% as investors were snapping them up hand over fist.  At the time, it made perfect sense.  First of all, the yields on comparable treasuries in Japan and parts of Europe were negative.  So an investor would pay the governments to take their money!  In that context, it made the still positive yield in the US Treasury markets seem like a pretty good deal.

Also, the world had just been sucker-punched by the outcome of the Brexit vote a few weeks earlier.  Stock markets made a quick and nearly immediate recovery after the vote, but the damage was already done.  Due to the negative surprise and ensuing whiplash in equities, investment safe-havens were now in high demand.

In a case of bond market déjà vu, July of 2016 was somewhat reminiscent of the July exactly four years earlier.  That was when the Greek debt crisis caused turmoil in the markets and safe-haven buying sent the US 10-year note yield to a then-record low of 1.39%.  As Mark Twain once said, “History doesn’t repeat, but it often rhymes.”

As is often the case, that turned out to be the very top of the bond market and low for yields.  At the time, nobody could imagine that Treasuries could decline in such an uncertain environment.  Yet that’s exactly what happened.  It reminds me of the classic Wall Street observation: People are the most bullish at the top and the most bearish at the bottom.

After reaching its zenith last summer, Treasuries have been hammered by continued improvement in the US economy, Trump’s election victory, a continued surge to record highs in the stock market, a rate hike from the Fed back in December, and the expectation of even more rate hikes for this year.  Now it seems that nobody can imagine that Treasuries could rally in such an environment.  It may be a good time to reread that Wall Street observation in the prior paragraph.

The Pendulum Has Swung Again

Bond market sentiment is at an extreme right now.  But it is not the extreme bullish sentiment that we saw last summer; it is now extreme bearish sentiment.  My, how rapidly things can change in just a few months.

Market speculators seem to think that Treasuries can only decline in the current environment.  This bearish sentiment accelerated right after the election as stocks rebounded.  The yield on the 30-year US Treasury bond made the biggest single day spike since at least 1977, driving the point home.

The general consensus has been that the Trump administration will be a big boon to the economy as they go on a massive debt-fueled spending spree.  If it materializes, it would cause a significant uptick in inflation and interest rates.  Also, a major tax overhaul is being promised.  Naturally, the bond market would suffer under the weight of all this economic stimulus.

A Stretched Rubber Band

Just how bearish is the prevailing market opinion right now?  Fortunately, we can measure this opinion with more than just cheap words.  According to the weekly CFTC reports, speculators reached the biggest net short position on record just a few weeks ago.  Not just a short position in one particular instrument, but short across the entire yield curve.  From Eurodollars (short-term deposits)…to 5-year notes…to 10-year notes…to 30-year bonds.  They’re betting heavy on the short side.

These Commitment of Traders (COT) reports are used as an indicator to determine when markets are vulnerable to major trend reversals.  Traditionally, one should look to take a contrarian approach to how the speculators are positioned.  It is important to remember, however, that these reports are not to be used as a timing mechanism.  Record positions can and often do continue to grow.  As Keynes said, “The market can remain irrational longer than you can remain solvent.”

That being said, I believe that these COT reports are one of the better sentiment indicators out there.  This is because the data doesn’t just show the market participants opinions, it shows their positions.  In other words, we find out if they’re putting their money where their mouth is.  And right now, all their money is highly-leveraged on a short bet on US treasuries.

Of further interest, Deutsche Bank pointed out that the size of this massive net short speculative position is a four sigma event.  Experienced traders should know that the market does not fit neatly within the confines of a Gaussian bell curve.  History has proven that market events create tails that are much fatter than should be expected.  But you still have to admit that a market move of four standard deviations away from the mean is one heck of an extreme!  This is not a sustainable situation.

Even if the spec crowd is right on the treasury market, they are currently so heavily short that a simple bear market rally could cause massive short-covering as buy stops are triggered.  It may be starting already, as they have been trimming back a bit on some of the short positions on the long end of the yield curve over the last couple of weeks.  Of course, this may be offset by the fact that they have added to short positions on the short end (Eurodollars).

If the short-covering does start to get some traction, it could have a domino-effect of pushing prices even higher and triggering buy stop orders, causing bonds to overshoot on the upside.  Wash, rinse, repeat.  The situation is akin to a rubber band that has been stretched to the point of breaking or snapping back violently and suddenly.  This means that there may be serious money to be made by the contrarian who finds a good setup on the long side of Treasuries.

Trumped Up Hopes

The US stock market made an about-face when the election results came in.  Donald Trump’s surprise victory was the catalyst for a multi-month run to new record highs.  As stated earlier, this is predicated on the idea that Trump will be a very pro-business President.  He has promised to lower taxes, roll back cumbersome regulations, and build infrastructure.

But here’s the problem with that: the markets seem to have already priced most of these expectations in.  This makes it vulnerable to corrections if progress occurs slower than expected.  After all, it will take at least a couple of years to get the infrastructure spending implemented.

Worse yet, what would happen if Trump doesn’t deliver on all of his promises?  Or what if the focus shifts negatively from building the economy to starting a trade war?  Then the stock market goes from being vulnerable to a correction to being vulnerable to a bear market.  In light of this, it appears that the market has currently put the cart before the horse.

Gimme Shelter

As most investors already know, a meltdown in the stock market usually results in a melt up in the bond market.  They don’t always move in opposite directions, but they certainly do during times of financial duress.  This is due to the safe-haven status of US Treasuries.  So when the stock market stumbles and Mick Jagger, a graduate of the prestigious London School of Economics, starts to sing Gimme Shelter, it will be high time to make a B-line to the bond market.

The odds of a setback in the stock market are increasing.  Regardless of what you believe Trump’s effect on the economy will be, there are other reasons that the stock market could be in for a reversal this year.  The duration of the current bull market, the size of the current bull market, and the convergence of different stock market cycles all indicate that this record bull market is long in the tooth.  By extension, this argues that the odds favor a recovery in the treasury market.   (We’ll go into more details about the stock market’s vulnerability in a later article).

Are Rate Hikes Good For Bonds?!

Back in December the Fed raised rates for the first time in a year and the second time in a decade.  With the US economy in expansion-mode for the last seven years and the unemployment rate dropping low enough to achieve the full employment level, it’s widely-expected that the Fed will raise rates even more this year.  Some analysts are even projecting two or three more rate hikes in 2017.  This should continue to drag the bond market lower as rates and bond prices are inversely related.

However…

Higher yields on bonds could actually be the very thing that brings demand back into the Treasury market!

If the Fed raises rates a full percentage point in 2017, bond funds will suffer likely a loss for the year.  But the next year could produce positive cumulative returns.  This is because the interest and principal will be reinvested at a higher rate.  If you were to extrapolate the effect of the higher rate further into the future you will see that the annual return grows even more in each successive year.  Again, this is because the higher interest rates will compound the growth on the capital growth at a faster rate.

We all know what happens when a security offers a higher return: demand increases as more investors want in on the action.

The Fed’s Folly

Another way that further rate hikes could potentially be a boon for bonds would be if the Federal Reserve were to get too far ahead of the curve.  Tightening monetary policy too swiftly could choke off economic growth.  This would send rates right back down.  As a matter fact, treasury yields could go back down even before the Fed even starts to throttle back.

Before you go thinking that modern day central bankers are just too educated and experienced to do something that crazy, I’ll remind you of a central bank episode from just a few years ago.

Back in 2011, the ECB hiked rates two different times because of a temporary pickup in inflation.  The first rate hike was done in April.  This smashed the 10-year Euro bund down to a one and a half year low.  However, the rate hike was done during an economic crisis.  Remember the PIIGS?  Not a smart move.  The Treasury market even said as much.  When the ECB hiked rates again just a few months later in July, the Euro bund rallied to a multi-month high.  Not surprisingly, the rate hikes were undone before the year was out as the ECB had to backtrack and start cutting rates again.

Did you notice the part where the Treasury market rallied when the ECB continued to raise interest rates?  This is because the bond market is smarter than the central bankers.  The Fed may be able to change rates on the short end of the yield curve, but the long end of the yield curve is driven by market forces.

There are obviously a lot of differences between Europe in 2011 and the US in 2017.  The US is certainly in a much better position to justify rate hikes than the ECB was.  But my point here is that the track record for central banks is not one to put your faith in.  They have a knack for repeating their mistakes and the mistakes of others.  The bond market will not hesitate to call them on their folly and even run contrary to their mistakes in monetary policy.

Building a Base

Many ‘experts’ are saying that the 35-year bull market in bonds has finally come to an end.  Of course, many of these same ‘experts’ shouted this from the rooftops in 2011, 2012, 2013, 2014, and 2015 as well.

But just for fun, let’s suppose that the boy who cried “Bear!” is finally right.  What if this multi-decade bull market in bonds actually did come to an end at last year’s top?  Does that mean bonds will accelerate into freefall mode?

Not necessarily.  There is no historical precedent that indicates that T-bonds have to go into a death spiral from here even if the bull market is over.  If you want to get ‘macro’ for a moment, look at the last two hundred years of history for the US interest rates.  What happened when prior multi-generational bond bull markets came to an end?  They were followed by multi-year basing periods.

After the sizable rally off the 2016 low in yields and the pullback from the record high price, history suggests that there should eventually be some significant retracement of the move.  It takes time for markets to adjust to a new paradigm after a multi-decade trend.  If so, it means that bonds could establish a buyable bottom -if it hasn’t already done so- even if this is the start of a secular bear market.

Focus On Price

Anyone can call for a rally in bonds and be right…just as long as they don’t predict when it will happen.  But if you want a forecast to translate into profits, you have to be accurate on your timing.

One if the best ways to time the markets is to focus on the simplest and purest data set that we can find: price.  This is where you know longer care about the why; you only focus on the what.  Tune out all of the news, fake or otherwise, and simply focus on the price behavior of T-bonds.  You will see that the behavior of this market has been remarkably consistent.

I’m going to show you the simple pattern that has helped me identify many of the major tops and bottoms in T-bonds over the last decade or so.  It’s the macro view for Treasuries.  A lot of traders miss this view completely because they are so focused on the short-term zigs and zags.  In a world full of day traders, plagued by ADHD and Twitter addictions, having a macro view on things will give you a major advantage over the other market participants.

For the last thirty years, T-bonds have been trending higher in an upward channel.  Unfortunately, the price charts for the T-bond futures contracts is not as clean as I’d like it to be.  It does not adjust for when the Chicago Board of Trade changed the notional coupon for all Treasury futures from eight percent to six percent, which started with the March 2000 contracts.

Since the futures price data is not up to snuff, we can examine the inversion of the price pattern by looking at a chart of the 30-year bond yield.  Remember that price and yields move inversely.  Therefore, the bond bull market means that the yield has been trending lower in a downward channel for the last few decades.

Observations of ‘Interest’

Bond yields have basically been moving in a pattern of descending Major Swing Highs and Major Swing Lows for over three decades.  Every Major Swing High was lower than the last and every Major Swing Low was lower than the last.

The Major Swing Lows were established in July 1986 (7.12%), October 1993 (5.78%), October 1998 (4.69%), June 2003 (4.14%), December 2008 (2.52%), July 2012 (2.45%), and quite possibly July 2016 (2.10%).

The Major Swing Highs that followed were established in October 1987 (10.25%), November 1994 (8.17%), January 2000 (6.75%), May 2004 (5.60%), June 2009 (5.07%), and December 2013 (3.97%).

The next thing to investigate is the size of the rallies from the Major Swing Lows to the Major Swing Highs.  There are two ways to look at this: in basis-point terms and in percentage terms.

Measuring in terms of basis points, the size of the rallies from the Major Swing Lows to the Major Swing Highs was 313-bps. (1986 to 1987), 239-bps (1993 to 1994), 206-bps (1998 to 2000), 146-bps (2003 to 2004), 255-bps (2008 to 2009), and 152-bps (2012 to 2013).

Since rates were moving progressively lower during the last three decades, the sizes of the rallies off the Major Swing Lows were getting smaller as well.  The 2008 to 2009 rally was an outlier in the series, of course.  This is not a surprise since it occurred during –and because of- the Great Financial Crisis.

Measuring in terms of the percentage gain, the runs start to look even more uniform.  The rally off the 2008 financial crisis low was once again the exception in the bunch.  The yield on the 30-year bond increased 44% from the 1986 low, 41% from the 1993 low, 44% from the 1998 low, 35% from the 2003 low, 101% from the 2008 low, and 62% from the 2012 low.

Next, let’s look at the duration of these moves.  Knowing how long the rising yields took to complete the journey can help us set realistic expectations going forward.

The rallies from the Major Swing Lows lasted one year and three months (1986 to 1987), one year and one month (1993 to 1994), one year and three months (1998 to 2000), eleven months (2003 to 2004), six months (2008 to 2009), and one year and five months (2012 to 2013).

As you might have guessed already, the 2008 to 2009 event was an aberration as it only lasted half a year.  The rest of the rallies lasted between just under a year to just under a year and a half.

A Technical Takeaway on Treasuries

If this thirty-year pattern of the 30-year bond yield persists, here’s what we might expect going forward:

The rally off the July 2016 record low of 2.10% should last about a year or a little more.  Aside from the 2008-2009 rally, the durations lasted anywhere from eleven months to one year and five months.  If so, the ideal timeframe for a final high in yields and low in bond prices will be the second half of 2017.

In basis-point terms, the rally could add 150 to 200 basis-points from last summer’s record low.  That would project a peak in the yield between 3.6% and 4.1%.

In percentage terms, 30-year bond yields should increase 35% to 62% from the low.  That puts the target yield range between 2.84% and 3.4%.

Finally, the rally should not significantly exceed the 2013 Major Swing High at 3.97%.  In the last three decades, not one prior Major Swing High has been surpassed.

Bottom line: US Treasuries have already dropped precipitously from last summer’s peak and market speculators are record short down here at the lows.  Equity and bond markets are pricing in major infrastructure spending, tax cuts, and more interest rate hikes. 

If the stock market retreats or the Trump administration disappoints, a contrarian long position in Treasuries could offer a huuuuge (read  in Donald Trump’s voice) payoff. 

Watch the price action to determine the timing.  If the 30-year bond yield ever makes it up to either side of 3.5%, it’s time to watch closely for any signs of a reversal. 

By Jason Pearce

Birds of a Feather

This blog post focuses on the Australian dollar/New Zealand dollar spread.  However, there are points that will also benefit readers who are interested in the Australian dollar on its own merit and also readers who are interested the overall view of the commodity markets.  Thanks for reading!

There is a very strong correlation between the Australian dollar (often referred to as the “Aussie”) and the New Zealand dollar (nicknamed the “kiwi” after the bird that is the nation’s icon).  That’s to be expected.  Most of New Zealand’s exports go directly to Australia, so the Kiwi economy basically acts like a mini version of the Australian economy.

The currencies of these two countries are joined at the hip.  Look at the weekly price plot of the last two decades and you will see that they move together.  However, one can sometimes move faster than the other.  This can create spread trade opportunities.

Historic Spread Levels

The Australian dollar trades at a premium over the New Zealand dollar.  Perhaps this is due to the fact that it’s the bigger of the two economies.  Whatever the reason, the size of that premium fluctuates.

Over the last two decades, the Aussie/Kiwi spread has provided good buying opportunities whenever it has dropped below 4 cents (premium Aussie).  It has only happened a handful of times, but each occurrence was followed by a rebound over the following months.

When the spread sank below 4 cents in 2003, it quickly recovered and rallied 729-basis points (about seven and one-quarter cents) into the spring of 2004.

In September 2004, the Aussie/Kiwi spread traded below 4 cents again.  It then surged a little more than four cents over the next two months.  However, the spread quickly backed off again and was confined to a trading range for the next year.

After a final low of 3.60 cents was established at the beginning of December 2005 the spread began an eleven and three-quarter cent rally over the next five months.

The Aussie/Kiwi spread breached the 4-cent level again in December 2014.  It didn’t bottom until the second half of April 2015 when it hit a historic low of 0.61 cents.  Despite the fact that new lows were made in the spread and it was argued that, because of changes in the fundamentals, “it’s different this time”, the spread reversed sharply and rallied nearly nine cents in just over two months.

2016: Third Time Is the Charm?

The spread fell back below the 4-cent mark last October.  From there it rallied a little over three cents.  It wasn’t the start of a new bull market, though.

The Aussie/Kiwi spread sank below 4 cents again at the start of this year and then rallied to 8.7 cents by the end of Q1.  Still, it was not the sustained move we would hope for.

On Thursday, June 9th the nearest-futures Aussie/Kiwi spread traded to a thirteen-month low of less than 3 cents (premium Aussie) and cracked the similar October and January lows of 3.65 cents and 3.7 cents.  This was attributed to the Kiwi surging as much as 2% after the Reserve Bank of New Zealand left interest rates unchanged and then said they expect inflation to accelerate.  Now that the magical 4-cent level has been breached for the third time, perhaps the turnaround that eventually follows will be the real deal and not just another multi-week bounce?  Perhaps.  After all, this spread has been stuck in a wide trading range for months now.  A sustained breakout is overdue.

Historic Ratio Levels

As always, we like to use the ratio as a confirmation tool for spreads that we discuss.  The ratio helps normalize a spread relationship.  This is especially valuable when analyzing markets that are trading near their historic highs/lows.

In terms of identifying the bargain levels for the ratio, you want to look for a level that the ratio hits infrequently.  Moreover, you want it to be at a level where the ratio does not spend too much time there when it does get hit.

In this case, a ratio of 1.1:1 (this is where the Aussie is priced 10% over the kiwi) seems to be the point where traders should start looking for buying opportunities.  Sometimes the ratio will tag 1.1:1 and immediately turn around and rocket higher for months/years afterwards.  That is what happened in late 1997, mid-2007, and Q4 of 2008.

At other times, the ratio hits 1.1:1 and chops around for months or even years before the inevitable trend reversal happens.  This occurred in late 2002 and again in the second half of 2004.

Our current situation falls into the second category.  The Aussie/Kiwi ratio hit 1.1:1 in December 2013.  For the last two and a half years, it has been tethered to this level as it has not yet made a sustained move away from it.  Considering how long this has been going on, the consolidation period is getting long in the tooth.  A trend should manifest sooner rather than later.

Sinking Even Further

Now here’s where the situation gets even more compelling…

The Aussie/Kiwi ratio bottomed out at 1.05:1 in late 2005.  This proved to be a historic low as a multi-year bull market followed, even though there were some sharp corrections along the way.

The ratio broke the 1.05:1 mark last year and hit a multi-decade low of 1.01:1 last spring.  So not only do we have a consolidation period that’s longer than normal, but we’ve also got a new historic low established during this period.  When things get this extreme in terms of both price and time, the pendulum will inevitably swing the other way.

Currency Trend Change

Many times, the Aussie/Kiwi spread will follow the trend of the Australian dollar.  Therefore, it can be beneficial to know what’s going on in the underlying currency.

There are currently a couple of things that lend itself to the argument that the Aussie dollar has finally bottomed.  If so, this would be a supportive factor for the Aussie/Kiwi spread.

First of all, the Aussie dollar peaked out at a record high in July 2011.  So if the current multi-year low that was established back in January marks the bottom, then this bear market will have lasted for four years and six months.  The longest bear market that precedes this one occurred between December 1996 and April 2001.  The duration of this bear market was four years and four months.  This time symmetry argues that the bear market is over.

Second, the Australian dollar crashed 38% from the highs during the 2008 financial crisis.  For a currency, that’s a pretty severe routing!  Now get this: the Aussie has once again decline 38% from the July 2011 top into the current bear market low.  This price symmetry also argues that the bear market may be over.

I will point out, however, that the Aussie dollar dropped nearly 42% during the 1996-2001 bear market.  That’s obviously a bigger percentage decline than the current bear market.  There’s no rule that says the current 38% decline can’t be exceeded or that the 42% decline won’t be bested.

But…

We should also consider the size of the price decline.  The 42 and a half-cent decline during this bear current market is larger than the 34-cent decline during the 1996-2001 bear market and the 37.7-cent decline during the 2008 bear market.  From this perspective, the current Aussie dollar bear market is bigger than the last two.

Another Sign of the Times

One technical indicator that we can monitor for confirmation of a trend change is the monthly 20-bar Moving Average.  The Aussie dollar has closed below the monthly 20-bar MA every single month for over three years now.  The bounce into the 2014 high ended after the Aussie tagged the monthly 20-bar MA and backed off.  The currency poked its head above the monthly 20-bar MA again just two months ago, but quickly reversed and shed almost seven cents from the top.  Needless to say, the monthly 20-bar MA has proven to be stiff technical resistance.

If the Aussie dollar finishes the month above the monthly 20-bar MA for the first time since April 2013 it will signal a bullish trend change.  That could happen as early as three weeks from now.  The 20-bar MA is currently at .7518 and the nearest-futures Australian dollar is trading at .7475, so it’s less than half a penny away.

And if the trend change doesn’t happen this month, the 20-bar MA will be even lower when the month of July starts!

Keep in mind that a close above the monthly 20-bar MA is not a sure thing buy signal.  Nothing works all the time.  If some claims that they have a magical Holy Grail signal that works every time, they are either liars…or just plain stupid.  However, when this same signal was triggered after the 1996-2001 bear market and again after the 2008 bear market, multi-year bull markets in the Aussie dollar followed.  So it’s certainly worth paying attention to.

Commodity Connections

There’s one more reason that the Aussie may be on the cusp of a major trend change and, therefore, the Aussie/Kiwi spread may be ready to finally leave its nest and fly north.  That reason is the turnaround in the commodities markets.

The Australian dollar and the New Zealand dollar are often referred to as commodity dollars.  Although we’re not currently discussing it in this post, the Canadian dollar is also considered a commodity dollar.  This is because their economies are major commodity producers.  As a matter of fact, Australia is the world’s third-largest gold producer.

To get a macro view of commodity prices, simply look at a commodity index.  Comparing the price action of the last couple of decades of the Goldman Sachs Commodity Index to the Aussie dollar confirms the accuracy of the commodity dollar title.  It is immediately obvious that the overall price trends are the same and the major turning points are often synched up together.  If one can identify where commodities are going, the Aussie dollar can often be traded as a proxy for commodities.  This is good news because the currency is a lot more liquid than the commodity indices.

The Commodity Bull Returns

Many commodity indices –including the Goldman Sachs Commodity Index– bottomed at multi-year lows in January.  As a matter of fact, the CRB index even hit a multi-decade low!  As it turns out, the commodity bear market that started from the 2011 top was the longest commodities bear market that has occurred in the last 115 years.

Furthermore, the size of the decline made it the third or second-largest commodity bear market in history, depending on which commodity index you’re looking at.  After the rubber band has been stretched this far for this long, the odds are that the inevitable trend reversal in commodities would immediately be followed by a sizable new bull market.

Back in April, the Goldman Sachs Commodity Index made a month-end close above the declining monthly 10-bar Moving Average for the first time in nearly two years.  This was a bullish development, especially when you consider that the rally into the 2015 spring highs –which marked the top for the year- was established after the GSCI neared the monthly 10-bar MA and backed down.

This same bullish trend change signal also alerted traders to the beginning of multi-year bull commodity markets in 1999, 2002, and 2009.

In addition, the GSCI is on the cusp of closing above the monthly 20-bar Moving Average for the first time in two years.  The 20-bar MA obviously moves at half the speed of the 10-bar MA, but the trade-off is that it provides a higher accuracy trend change signal.  This is because it is not as sensitive to monthly price changes, which helps smooth out the price trend.  At any rate, a month-end close above the monthly 20-bar MA will confirm the trend change in commodities.

As goes commodities, so goes the Aussie dollar.  As goes the Aussie dollar, so goes the Australian dollar/New Zealand dollar spread.  By all appearances, it’s about to go NORTH.  Trade accordingly.