Inflationary Pressures Rising

blueguyzee | August 20, 2012 | 5 Comments More

A composite indicator constructed from the trends in yields on the 10 year Treasury bond, gold and the CRB Index is suggesting that inflationary pressures are rising, and this, on average, is a headwind for equities. The indicator is shown in figure 1, a weekly chart of the SP500.

Figure 1 SP500/ weekly

The indicator is now just poking into the extreme danger zone for equities. As you know, yields on the 10 year Treasury spiked this week. The CRB Index remains strong thanks in part to strength in crude oil. Gold has been resilient and appears to be bottoming. Collectively, these three assets are in strong up trends, and this is a headwind for equities. How much of a headwind? Let’s run a study where we own the SP500 only during those times when the indicator is extreme (showing strong up trends in yields on the 10 year Treasury, gold, and CRB). That is, the indicator is at or above the upper band. Some of those buy and sell signals are shown on the price bars in figure 1. This study begins in 1972 and encompasses 86 trades. 50% of the trades were profitable, and the average trade lasted 5 weeks. The strategy equity curve is shown in the following graph.

Figure 2. Equity Curve

In essence, the strategy lost money. This was even during the 1981 to 2000 bull market; since 2000, the strategy has seriously underperformed.

The next figure is the maximum adverse excursion (MAE) graph. MAE shows every trade from this strategy, and it measures the angst factor. Look at the caret inside the blue box in figure 3. This represents one trade. The trade had an MAE or individual trade draw down of 5.36% (x axis) before being closed out for a winning trade of 0.35%. We know this was a winning trade because it is a green caret. So with this one trade you had to lose 5.36% (your angst factor) before your trade was closed out for a profit of 0.35%.

Figure 3. MAE Graph

Looking at the remainder of the trades on the graph, we note that 26 out of 86 had MAE’s greater than 5%. These are the trades (carets) to the right of the blue line. In other words, if you buy the SP500 when there are collectively strong trends in yields on the 10 year Treasury, gold and the CRB, you have a 30% chance (26/86) of seeing that position drop at least 5% over the following 5 weeks. Out of the 26 trades with MAE’s greater than 5% only 3 recovered to become winning trades.

Now let’s look at the maximum favorable excursion (MFE) graph. See figure 4 below. Like MAE, MFE looks at every trade from this strategy. In this case, MFE measures how high a trade runs up in your favor before being closed out for a win or a loss. Note the trade (or caret) inside the blue box in figure 4. This trade had a profit of 3.89% (x axis) before being closed out for a loss of 0.47% (y axis). We know this was a losing trade because the caret is red. Now look at the cluster of red carets to the left of the orange line. These are all those losing trades. From the start of the buy signal until the position was closed out, we can state that the majority of losing trades lost money from the start as the run up never exceeded 2%. 21% (18/86) of the trades were closed out for losses exceeding 4%. Now look to the right of the blue line. Here the majority of trades are winners, so if a trade runs up greater than 4% from its entry point, then it is likely to go to be a winning trade. However, it should be noted that only 8% (7/86) of the trades were closed out with gains greater than 4%.

Figure 4. MFE Graph

So what conclusions can we draw from this study where we bought the SP500 only during those times when the trends in yields on the 10 year Treasury, gold, and CRB Index were strong and rising? One, 30% of the time there was risk of a trade draw down that exceeded 5%. Two, losing trades generally occur with little run up in price. Three, this strategy was more than twice as likely to produce a loss greater than 4% as opposed to a gain greater than 4%. Four, if a trade ran up more than 4% it was likely to be a winning trade.

In the final analysis, it is my belief that strong and rising trends in yields on the 10 year Treasury, gold and the CRB Index represent a headwind for equities.