SentimenTrader ---- Weekly for Sep 27 - Good breadth conditions, gold cross currents, the dollar and commodities

 

TradingEdge Weekly for Sep 27 - Good breadth conditions, gold cross currents, the dollar and commodities

Key points:

• A breadth signal with a perfect record
• Small-cap stocks have enjoyed a rare streak of positive momentum
• More cyclical industries are reaching new highs
• Demand for liquidity is waning
• Looking at the VIX during presidential election years
• Does it matter which sectors have been reaching new highs along with the S&P 500?
• Gold is facing some compelling short-term headwinds
• However, there are some good signs for longer-term gold bugs
• A simple system using the dollar to trade commodities

A recovery with a perfect record

The NYSE McClellan Summation Index cycled from below 100 to above 1000. Dean showed that similar improvements in market breadth resulted in a 96% win rate over the following year. Signals within 2% of a high have never experienced a loss over the next two, six, and twelve months.

When the Summation Index resides above zero, it suggests a positive breadth trend. An even more compelling signal is observed when the Summation Index transitions from below 100 to above 1000.

Whenever the NYSE McClellan Summation Index shifted from below 100 to above 1000, the S&P 500 exhibited exceptional returns and consistency across all time frames, but especially a year later, when it rose 96% of the time. Over the following year, the S&P 500 recorded just one maximum loss greater than -10 %, an event not witnessed since 1976. 

Precedents that occurred with 2% of a 5-year high in the S&P 500 rose 100% of the time over the subsequent two, six, and twelve months. 

Applying the signals to sectors suggests most could experience some turbulence over the next few weeks. From a medium to long-term perspective, seven groups outpaced the S&P 500 over the following year, providing plenty of opportunity.

Small-cap streak

At the start of December 2023, the small-cap Russell 2000 finally closed above its 200-day moving average. As long as investors stuck it out through the short-term wiggles, it's worked out because, since that date, the Russell hasn't closed below.

That means the Russell just celebrated its 200th consecutive session above its 200-day average. It's a relatively rare achievement for this particular index, as it's only the 16th such streak in the past 45 years.

Some equity indexes aren't as prone to trend-following as others. The Russell is one of those indexes. 

Below, we can see the index's future returns once it reaches the milestone of 200 days above its 200-day average. Returs were below random across almost every time frame, and the risk-reward was about even. That changed for the worse over the 6-12 month time frames. 

These bouts of protracted levitation above the 200-day average were not great signals of a relative resurgence. Over the next 2-3 months, the Russell outperformed the S&P only 27% of the time. And almost all of those bouts of outperformance lost their luster in subsequent months.

A decile analysis of Russell 2000 returns based on its distance from its 200-day moving average shows the Russell's annualized returns based on the percentage the index is from its average. We can see three clear regimes - below -3.6% (oversold), above +4.3% (positive momentum), and in-between (the mushy middle). 

The positive numbers, even when the Russell is far above its 200-day, are thanks to a few bursts of rapid gains, usually when it's emerging from a protracted bear market.

These returns suggest that the dangerous part for investors will be when the 200-day average catches up to the index, it starts to flatten out, and the positive momentum evaporates. That's when this index tends to enter a long period of chop, at best.

Cyclical new highs

More than 35% of cyclical sub-industry groups closed at a 52-week, with the S&P 500 recording a new high. Dean noted that similar breakouts from cyclical groups preceded an 86% win rate for the S&P 500 over the next six months.

With investors celebrating the first Federal Reserve rate cut following a tightening cycle since 2019, stocks exploded to the upside, producing the highest percentage of 52-week highs from cyclical sub-industry groups in more than five months.

Whenever more than 35% of cyclical industries closed at a 52-week high, and the S&P 500 closed at a 5-year high, the world's most benchmarked index was likely to continue trending higher, rising 86% of the time over the subsequent six months. 

The potential for a short-term pause becomes more apparent when looking at the maximum gain and loss table, where risk overshadowed reward in the following month.

Growth-oriented sectors like Consumer Discretionary, Healthcare, and Technology outperformed the S&P 500 and value groups over most medium to long-term horizons.

When the Federal Reserve lowered its target rate three or fewer times, and the percentage of cyclical groups recording a 52-week high exceeded 35% with all the other previously discussed conditions in place, the S&P 500 exhibited excellent returns and win rates over medium and long-term horizons.

Ebbing liquidity premium

The S&P 500 Liquidity Premium indicator cycled from the upper end of its recent range to the lower half, behavior which Dean noted has produced excellent returns for the S&P 500.

The S&P 500 Liquidity Premium indicator compares the volume of the S&P 500 ETF (SPY) to the volume of the underlying stocks comprising the S&P 500. When volume in the ETF increases relative to stocks, the indicator rises, indicating that investors are uncertain about the outlook for the market, a scenario typically associated with corrective phases.

The system generates a buy signal whenever the 84-day range rank for the SPY Liquidity Premium indicator cycles from above 99% to under 42% and index momentum is positive. 

Whenever the SPY Liquidity Premium's 84-day range rank cycled from above 99% to less than 42%, with the index above its 200-day average and exhibiting positive momentum, the S&P 500 ETF (SPY) displayed excellent returns and consistency across all time frames. Furthermore, the signal exhibited significance relative to random returns in 6 out of 7 intervals.

Following liquidity premium risk-off signals, the S&P 500 showed a fairly strong tendency to decline in the near term, falling 67% of the time over two weeks. At some point in the next month, the world's most benchmarked index displayed a loss in 28 out of 39 cases. Something to watch for in the weeks ahead.

October surprise?

October has a reputation as being a volatile month, even though it has been a favorable month for stocks. Still, Jay suggested that presidential election year history suggests being prepared for a spike in volatility.

The standard interpretation of VIX movements is that the VIX will rise when fear or uncertainty does since there will be a greater demand for put options.

So, how does volatility behave during the month of October? Well, it's volatile. But, let's consider presidential election years versus all others. The chart below shows the hypothetical fluctuations of the VIX Index (using $1.00 as a baseline starting point) during the month of October since 1986, excluding presidential election years (.i.e., 1988, 1992, 1996, etc., are excluded). Pretty steady downtrend, especially during the past 25 years.

Now, the chart below shows the hypothetical fluctuations of the VIX Index (using $1.00 as a baseline starting point) during the month of October since 1986, only during presidential election years (i.e., only 1988, 1992, 1996, etc. are considered).

During these Octobers, the VIX rose 100% of the time, for a median +21%. The minimum gain was just over +8% while the max was over +50%.

Sector drawdown comparisons

Now that the S&P 500 has scored a fresh high, it may be instructive to look at the sectors and how far each is from its own high. Then, we can go back over nearly 100 years and look for the highest-correlated sector drawdowns on a day the S&P hit a record high for the first time in months.

Let's look at other times the S&P 500 closed at a record high for the first time in at least a couple of months. Then, we'll look at where each sector is trading relative to its own record high and pinpoint the instances with the closest sector drawdowns to what we're seeing now.

The chart above shows us that utilities are about 1.4% below their all-time high, while on average, the fifteen highest-correlated instances saw utilities about 0.5% below their high. Technology was around 3% from its high during those instances, while now it's a little more than 5% below. You get the drift.

The point of the exercise is to look at forward performance. We want to see how the S&P 500 performed after other times it reached a record high, and the sector drawdowns were the most closely aligned with what we see now. It wasn't great news for short-term traders, but returns got progressively more encouraging. During the next 6-12 months, there was only a single loss of any magnitude, and over the following year, the average reward was three times the average risk. 

Among factors, value stocks stood out. Over the following year, they averaged more than a +25% return, outpacing any other factor.

Gold crosscurrents

The bad news for gold bulls, according to Jay, is that several indicators are flashing very unfavorable signals for gold stocks in the short-term.

The chart below displays the annual seasonal trend for The Gold Bugs Index (ticker HUI). It's on the cusp of what has been an unpleasant window for the group.

We see a period of seasonal weakness that extends from Trading Day of Year (TDY) #182 through #211. For 2024, this period extends from the close on 2024-09-20 through 2024-10-31.

The chart below displays the hypothetical growth of $1 invested in ticker HUI only from TDY #182 through #211 every year since 1958. The net result is a cumulative hypothetical loss of -88%.

During 45% of the years, HUI showed a gain during this period and five times, HUI showed a gain of +10% or more, so it wasn't a slam dunk for bears.

Our GDX % in Bear Market indicator shows the percentage of the GDX ETF components that are trading more than 20% below their 52-week highs. Gold stocks have a somewhat sketchy history of being highly volatile and very prone to reacting sharply to overbought or oversold situations.

The chart below highlights those rare occasions when the 100-day moving average of GDX % in Bear Market crossed below 17%.

Our GDX % in Correction indicator shows the percentage of the GDX ETF components trading above that are trading more than 10% below their 52-week highs. That also recently gave a signal that has preceded consistently negative returns.

Our GDX Breath (%>200-day) indicator shows the percentage of the GDX ETF components trading above their 200-day moving averages. That recently reached 94%, which (you guessed it), preceded negative returns for GDX.

Some long-term potential

While those (mostly) shorter-term indicators suggest caution, Jay also highlighted the continued longer-term upside potential for gold futures.

The chart below displays the annual seasonal trend for gold futures. There are a couple of periods of potential weakness in the months ahead; however, overall, the seasonal trend remains positive between now and late February 2025.

The Copper/Gold Relative Ratio Rank indicator shows where the ratio is relative to its range over the past four months. When the ratio drops to a low level, they exhibit risk-off behavior. This tends to be favorable for gold as more investors move aggressively into more speculative areas such as precious metals.

The chart below highlights those dates when the 50-day average of the Copper/Gold Relative Ratio Rank crossed below 5 for the first time in three months.

The Hedge Fund Exposure - Gold indicator compares indices of hedge fund exposure against returns in gold futures to see how much exposure hedge funds appear to have to the gold market. When under-exposed, gold may see buying pressure come in as funds add exposure. At the moment, hedge fund exposure is at a significantly low level which has preceded gains in gold over the next year 92% of the time.

Using the dollar to trade commodities

It is well-established that commodity prices in general tend to trend opposite to the U.S. Dollar. Jay outlined a way to use one to trade the other.

For testing, we will use the Bloomberg Commodity Spot Price Index (BCOMSP) and the U.S. Dollar Index (USD). Our test starts on December 31^st, 1970, so encompasses almost 54 years of history.

For the system, when the 26-week exponential moving average (EMA) for the dollar is above the 30-week EMA, we will consider that unfavorable for commodities, and vice-versa.

The chart below displays Variable C (i.e., the difference between Variables A and B). Remember, negative values are purportedly favorable for commodities and vice versa.

The chart below displays the hypothetical growth of $1 invested in the Bloomberg Commodity Spot Price Index only during those weeks when Variable C detailed above ended the previous week in negative territory.

The JK Commodity/Dollar Oscillator has been negative since 2024-08-16. Since that time, BCOMSP has advanced +4.5%.

Jay showed that results were also consistently positive when using the Invesco DB Commodity Index Tracking Fund ETF (ticker DBC) since its inception.

About TradingEdge Weekly...

The goal of TradingEdge Weekly is to summarize some of the research published to SentimenTrader over the past week. Sometimes there is a lot to digest, and this summary highlights the highest conviction or most compelling ideas we discussed. This is NOT the published research; rather, it pulls out some of the most relevant parts. It includes links to the published research for convenience, and if you don't subscribe to those products, it will present the options for access.