March 7, 2018
One of my core beliefs in trading is that it pays to be able to think a few steps ahead and prepare for various market outcomes. This helps a trader to carefully analyze different scenarios and plan the most rational plan of action. Advance planning greatly helps to avoid emotional and often costly snap judgements. With the recent heightened market volatility, here are 5 key markets and data points that I am monitoring. Please keep in mind, I only trade the chart in front of me, and do not trade off of fundamental data or trade one market based on what another market is doing. It does benefit me however to monitor various markets for possible advance notice and/or cautionary signals.
1. General Market Price
S & P 500 (SPX) made a recent all-time high of 2872 and a recent low of 2532. These are key levels right now, and a break above the recent high or a break below the recent low, while not predictive, could signal a further move in the direction of the price break. Markets have been known however to reverse right after crossing key levels, so while not predictive, I do look at price levels. Mathematically, markets can not go into a new up leg or a new down leg until they eclipse prior high or low levels. On a more narrow time frame, 2789 and 2647 are more recent high/low range and the same applies. Whichever breaks first, would indicate that side of the market is in control for the time being.
2. The 200 Day Moving Average of Prices
My core trend filter in markets in the 200 day simple moving average of prices. Prices trending above signals a primary uptrend for me and prices below signals a primary downtrend, or neutral at best. When the major Bear Markets of 1987, 2000 and 2008 started, they were all preceded by the S&P 500 having daily closes below the 200 day moving average as the attached three charts show. This does not mean that markets can not gap down significantly from above the 200 sma, because anything can always happen. The 200 sma however is my key trend filter, and as long as SPX price holds above it, I will defer to the long side in stocks. Prices can be very choppy in that range, as institutional money also watches that level, and a close below does not necessarily signify a further decline, but it is a cautionary sign for me when below.
3. Daily Trading Range
I use volatility extensively in my trading programs to manage risk and size positions. I use Average True Range, or ATR, which measures the range high to low that a market or stock trades in a single day. In October of 2017, SPX ATR traded at under $10, historically low as a percentage of price, and a sign of very quiet, lower volatility markets, which was discussed in one of our daily market videos, and caused me to keep position sizing lower at .20 to .25% for single stocks and .50% for ETFs. Markets most often revert to the mean, and ATR doubled by December 1 and traded to over 55 in February 2018. This sharp ATR expansion is accompanied by wide swings in market prices. One benefit is that it forces systematic traders to place less capital at risk in more volatile markets due to strict position sizing rules. SPX has also had more -1% days in 2018 than all of 2017. This volatility is more of a return to more normalized volatility. ATR has been edging up for awhile, but markets were trending straight up.
Heightened volatility often occurs at major market turns, but not every period of range expansion necessarily means a major market turn is underway. This ATR is something I am monitoring and as a result, position sizes are slightly smaller and I am carrying a higher than average cash weighting, currently at 20%. This does not mean that I am predicting a major change in trend, becasue I am not, I do not make market calls. It is simply a data point that I am monitoring.
4. Treasury Yields
My core belief, which I first learned from reading Stanley Druckenmiller, is that markets are liquidity driven more than anything else. QE is a prime example. Excess capital will find it’s way into risk markets and markets go higher, when that capital is removed from the system, markets pullback. Pure supply and demand. Interest rates, Treasury Yields and Central Bank policy decisions are key drivers of liquidity. I do not read into the fundamentals of Central Bank meetings, as I believe that all of the fundamentals get translated into the price chart. A recent rapid break out in 10 year Treasury Yields did coincide with the recent February SPX sell off. I am not saying that one caused the other, because we never really know, but they did coincide. Higher yielding stocks, such as Utilities and REITs have declined below their 200 day moving averages as yields have moved higher, as the rising so-called “risk free” rate of return in Treasuries causes other assets to get re-priced.
5. The Yield Curve
The Yield Curve that I monitor is the UST 2 years yields vs 10 year yields. A steep yield curve, where longer term yields are much higher than shorter term yields signals a strong economy and growth. When the curve contracts and shorter term yields narrow vs longer term yields this signals a tighter, or contracting economy. I do not trade off of the yield curve, but I do keep an eye on it for clues. Major bear markets in 2000 and 2008 were preceded by an inverted yield curve, as the attached chart shows, meaning that shorter term yields were higher than longer term yields. Once again, I do not see this as predictive, and do not trade off of it, I trade the chart for the market I am in, but an inverted yield curve can be cautionary. We are not there yet.
In summary, price is always first and I do not trade off an any secondary data, fundamental information, yield curves, etc. I trade the chart and the signals on the screen in front of me. I don’t make predictions or market calls and I do believe that all fundamental information gets translated into price, which is why I follow it. The non price data listed above however often gives clues to future market moves, and advanced preparation can always be beneficial.