Trader’s Narrative

Going back to the end of November 2007, the bond market was giving a great signal that a rally in the equity markets was about to unfold. From the time I wrote about it to its top in December 2007, the S&P 500 Index gained 100 points (1410 to 1510). That may not seem like much in today’s topsy turvy market. But you have to remember that back then the VIX was at ~20.

The idea is that the rate of change in the bond market has a bearing on the equity market. I first read about this in Mark Boucher’s book, The Hedge Fund Edge where he outlines dozens of similar ideas.

Put simply you buy when the rate of change in the 30 year bond yield is less than or equal to 9% and sell when it is above that level. The performance for this simply system is impressive. Equally impressive is that doing the opposite isn’t profitable. This is a sign that we aren’t data mining but dealing with an inherent relationship in the financial markets.

I use a variation of this system, however, the most recent signal didn’t work and I suspect it had to do with the craziness that we’ve seen in all financial markets:

Ho-hum. You know, another day. Another all time high.

But wait, what’s that creeping higher and higher. It’s the bond yield. Both the 10 year and the benchmark 30 year bond yields are getting up there. There is a lot of chatter now about how this is a bad omen for the equities. The logical explanation is that bonds compete with equities for money. When they are cheap enough (yields high enough) people will prefer to buy them instead of equities.

This reminds me of one of the first trading books I read: Mark Boucher’s “The Hedge Fund Edge”. I recommend it highly. Boucher introduced me to the concept of technical analysis and for that I’m eternally grateful. He only gives it a cursory treatment but it was enough to whet my appetite. I went on to read countless technical analysis books. Another important concept Boucher taught me was the liquidity theory or the liquidity cycle from an Austrian school of economics point of view.

To show how real it is, he produces some trading systems that rely on the bond market for signals. I’ll share two with you (you really should pick up a copy).

The first looks at the 12 month rate of change of the 30 year bond yield. If it is equal to or less than 9% you buy the S&P 500. You exit when the yield is greater than 9%. Since his book was published in the late 1990’s it covers January 1943 to the end of 1997.

The result of the system is an annual return of 14.8%. The worst position was in 1974 (-11.93%). Interestingly enough, this system is only invested 64% of the time. So you could have even higher returns if you plopped your money in a money market fund the rest of the time.

The inverse system (buying the market when the ROC is more than 9% and selling when it is equal to or less) provided a -0.9% return. So atleast according to this system, there is real world evidence of the efficacy of liquidity theory.

The second bond system Boucher mentions is based on the yield curve. The rules are to buy the S&P 500 when the ratio of the 30 year bond yield to the 3 month bond yield is greater than 1.15. And to sell when it is equal to or less.

The system covers the same time as the first one and similarly, is only invested 63% of the time. Yet it produces an astonishing 19% annual rate of return. And even more astounding, the worst trade is only a loss of 3.81%.

I know what you’re thinking, where are we according to these systems right now?

The 12 months rate of change of the 30 year bond yields is at 8.70%. And the 30 year yield to the 3 month yield is at 1.058 right now.

Here’s a graph of the most current 30 year bond yield rate of change (12 month) and the S&P 500:

I’ll write some more on the bond market and its implications for the equities market over the weekend. Until then.