SentimenTrader ---- TradingEdge Weekly for Aug 23 - V-bottoms, breadth thrusts, September seasonality

 Key points:

• Stocks carved out an impressive v-shaped bottom
• Investors are back in risk-on mode
• We can see that in options data, with reversals in put/call ratios
• It's hard to blame them with breadth thrusts firing
• A September strategy for stocks
• Financials and tech are among the sectors with thrusts
• The copper/gold ratio is also giving bullish signals for financials (but not bonds)
• An impressive price momentum system for tech, with a major caveat
• Sentiment on gold was higher than other major markets

A v-shaped bottom

Well, this has been quite a ride, huh? From pure panic to the euphoria of all-time highs with just one more decent day, all in a couple of weeks. It's been a while since investors were this wishy-washy.

The last two times investors panicked to the downside and then upside, like this one, with the S&P hitting a 50-day low during the panic, it marked important bottoms.

For lack of a better term, we'll call these v-shaped bottoms, though some may not necessarily look that way on a chart. February 1939 and February 2018 were the only times when these happened while the S&P 500 was either above its 200-day moving average or was within 10% of its prior multi-year high. Only 2 out of 33 signals were triggered during ongoing bull markets, so it's safe to say we're seeing an unusual situation now. 

One wrinkle with our current rally is that the 10-day gain has exceeded the 10-day loss immediately preceding the 50-day low. That was the case in only a third of the precedents, and after these, the S&P tended to sport very short-term weakness (except for the last two signals) but consistent gains over the next two months, with only one loss, which was quickly reversed.

Taking a modestly different tack, the S&P 500 also cycled from a 50-day low to within 15% of its 50-day high in two weeks or less.

After these cycles, the S&P did quite well over the next 3-6 months, with only two losses that were subsequently reversed in the months afterward. Its returns were nothing special, but only three of the twelve signals witnessed more than a -4% drawdown at any point within the next six months.

Back to risk-on

Thanks to the rapid rebound, Dean noted that the Risk On/Off indicator surged higher relative to its recent range. Similar precedents displayed excellent returns, win rates, and significance relative to random returns.

A swing trading system that uses the proprietary Sentimentrader Risk On/Off indicator, a composite encompassing 21 diverse sentiment and breadth-based measures, triggered a new buy signal when it recovered from the lower end of its 84-day range. The previous alert led to a 7% gain for the S&P 500 over the subsequent two months.

Whenever the 84-day range rank for the Risk On/Off indicator cycled from below 5% to above 68.5%, with the S&P 500 above its 200-day average, the world's most benchmarked index displayed outstanding returns and consistency across all time frames. Furthermore, returns demonstrated significance relative to random returns across most time horizons.

Generally, bull market environments favor sectors with offensive qualities rather than defensive ones. Aside from Technology, which is experiencing an AI-driven innovation phase, sectors with positive relative trend scores lean more defensive. This composition likely reflects the easing in interest rates. 

Considering the defensive sector tone, investors would likely benefit from analyzing trends in specific stocks.

Put/call reversal

Consistent with the idea of a move to risk-on behavior, Dean noted that the CBOE total put/call ratio reversed relative to its recent range, triggering a buy signal. 

Following heightened pessimism, the CBOE total put/call ratio reversed this week. The previous alert occurred in April, leading to a 7% gain in the S&P 500 over two months.

The put/call ratio trading model applies an 84-day range rank to the 10-day moving average of the CBOE total put/call ratio. A pessimistic reset condition is confirmed when the range rank indicator exceeds the 99th percentile. Once the reset is achieved, a new buy signal occurs when the range rank falls below the 56th percentile. Within five sessions of the range rank falling below the buy threshold, the 5-day rate of change for the S&P 500 ETF (SPY) must be > 0%. i.e., market momentum is positive.

When the range rank for the total put/call ratio reversed relative to its recent range, with the S&P 500 above its 200-day average, the world's most benchmarked index displayed excellent returns and consistency over medium and long-term horizons. Over the next three months, the signal experienced a maximum loss of over -5% in 13 out of 51 instances and a maximum loss of -10% in 5 out of 51 occurrences, highlighting that no trading signal is without risk. 

With technology stocks bearing the brunt of the recent sell-off, the aggregated put/call ratio for the Nasdaq 100, which compiles option data for the index's members, spiked to an elevated level relative to its recent range. The Nasdaq 100 ETF (QQQ) displayed solid returns and consistency over medium and long-term horizons following similar range rank reversals. 

A thrusty move

The rebound has seen good participation. Jay showed that the Breath Thrust Indicator continues to signal ongoing strength.

The NYSE Zweig Breadth Thrust indicator is computed by calculating the number of advancing issues on an exchange, divided by the total number of issues (advancing + declining), and generating a 10-day exponential moving average of this percentage.

A true "Zweig Breadth Thrust" occurs when it moves from below 40% to above 61.5% within any 10-day period. However, the indicator provides valuable weight of the evidence even if we apply less stringent parameters. The chart below displays every date the Breadth Thrust indicator crossed above 60%, including all overlapping signals. 

The critical thing to note is that these signals tend to occur within the context of a rising market. Ideally, there is a signal early in a bull market, and regrettably, there are occasionally signals that occur late in a bull market. However, the point here is not that this signal will be used as a trading system but as a measure of the likelihood that a given market advance will continue.

Jay also noted that the Short-Term Risk Level hit an extremely high level. Typically, these signals have only been able to trigger during the beginning or middle of strong bull moves. From 2-12 months later, the S&P 500 showed a positive return after all six signals.

A September strategy

September is the only month that has shown a loss on average for stocks. Jay showed that trading days around a market holiday tend to be better than average for stocks, and a "September Strategy" can be summed up pretty simply as follows: Enjoy the holiday. Then take the rest of the month off.

Here are the trading rules:

• Hold the S&P 500 Index from January through August and October through December
• Also hold the SPX for the first three trading days during September.  During all other trading days in September, hold cash

The chart below displays the growth of $1,000 invested in the S&P 500 index ONLY during the 1^st 3 trading days of September starting 1919-12-31 (black line) and ONLY during ALL OTHER trading days of September (blue line).

The first 3 trading days of September were sort of OK sometimes (cumulative +23%) while all other September trading days were not so good (cumulative -79%).

The chart displays the cumulative growth of $1 invested using the "System" rules spelled out above versus the cumulative growth of $1 using buy-and-hold since 1919-12-31.

For the record, $1 invested using the "System" grew +278,621% while $1 invested using buy-and-hold grew +59,099%. Over 104 years, the "System" has outperformed buy-and-hold by 4.7-to-1.

Sector thrusts

Not only was there a breadth thrust in the broader market, but Dean showed that the S&P 500 Financials sector and the Nasdaq 100 also triggered breadth thrust signals.

Over the past ten days, no sector has seen a more pronounced skew toward advancing issues than financials. The sector's 10-day A/D ratio stands at 3.23, the third highest since our website data began in 1998. The 10-day A/D ratio is calculated by summing the advancing and declining issues over ten days and then measuring the ratio between the two totals.

Whenever the 10-day A/D ratio for the S&P 500 Financials increased above 2.5 as the index simultaneously closed at a 2-year high, the positive momentum in the sector tended to persist from two weeks to twelve months later. However, as is typically the case following a thrust, don't be surprised if financials suffer over the next week to digest the gains.

Maximum losses beyond -5% or -10% over the following three months were rare, with only four and one precedents, respectively.

The Nasdaq 100, a popular benchmark followed by investors, saw its 10-day A/D ratio increase above 2.0, with the index above its 200-day average. Following similar thrusts, the Nasdaq 100 displayed solid returns and consistency, especially a year later, rising 88% of the time.  

A metal ratio to forecast stocks and bonds

The Copper/Gold Ratio compares the price of the leading industrial metal to the price of the leading precious metal. Jay noted that this ratio is presently at a very low level historically and readings at this level have tended to be bearish for long-term bonds but bullish for financial stocks.

The chart below highlights all dates when the Copper/Gold Ratio was below 0.17 versus the iShares 20+ Year Treasury Bond ETF (ticker TLT). Previous instances have occurred in 2008-2009, 2016, 2019, 2020, and now again in 2024.

Interestingly, long-term treasuries are simply a proxy for (the inverse of) interest rates. While we have not analyzed it closely, this suggests that low Copper/Gold Ratio readings tend to foreshadow higher interest rates. 

Intuitively, one might presume that what is good for bonds is also good for the overall financial stock sector and vice versa. But the chart below highlights all dates when the Copper/Gold Ratio was below 0.17 versus the Financial Select Sector SPDR Fund (ticker XLF).

The message here is that the Copper/Gold Ratio is presently a favorable factor for financial stocks, one of many that can affect the financial sector. It's a piece of evidence suggesting we give the bullish case for financial stocks the benefit of the doubt.

A winning system for tech, but...

Jay suggested that there is a natural urge to try to turn a single indicator into a standalone trading system. He discussed an example with a "100% Win Rate" AND a potentially fatal flaw.

For our test:

1. We will use the FAMA French Technology Index from 1950 to 1991 and then the S&P 500 Technology sector index after that
2. Our entry trigger will be a six-day percentage gain for the index of +8.75% or more
3. After any entry trigger signal, we will hold a position in the technology index for 252 trading days
4. If a new entry trigger signal occurs while a previous signal is still active, we will extend the holding period for another 252 trading days

A new entry signal occurred on 2024-08-15. Historically, 100% of holding periods showed a gain for the technology index. 

A closer look reveals that this strategy is a good example of one that contains a potential flaw (i.e., no risk management). The chart below displays the hypothetical growth of $1 invested in the technology index only during the periods using a log scale. During 2002, the tech sector kept experiencing the occasional entry trigger in the midst of the devastating decline following the bursting of the tech bubble in 2000.

The table below displays the results of these signals. The first three columns show the start and end dates of all favorable periods and the net percentage return. The last two show the maximum drawdown from entry price and from any peak achieved during the entire holding period.

On four occasions, an investor who bought on the signal date would have had to ride out a decline of -20% or more before realizing the ultimate gain. 

Investors like gold more than other markets

Gold's breakout to the end last week excited many investors.

It's getting harder to ignore the yellow metal, and it's clear that more investors are starting to pay attention. On the Dashboard, we see that sentiment toward gold is higher than in three other major markets - stocks, bonds, and crude oil. April 2020 is the only time in the past decade when this was the case.

The table below shows gold's returns after investors had a more optimistic outlook on it than they did on stocks, bonds, or oil. Short-term returns were mixed, but over the following year, it sported a double-digit average gain, well above any random time, with an excellent risk/reward profile.

It's notable that almost all the signals were triggered during protracted bull markets; this type of sentiment mix is not typically what we see at or near blow-off peaks in the metal.

After the signals above, gold mining stocks consistently underperformed the metal over most time frames. Over the next 6-12 months, they did better, but it was close to being a crap shoot with an unappetizing skew of risk versus reward.

The other three asset classes also mostly provided disappointing returns. The S&P 500 suffered a negative mean return up to three months later, and its average return and probability of a positive return weren't much better than bonds or oil.

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.