Trader’s Narrative

According to the difference between 10 year nominal treasury bonds and TIPS (Treasury Inflation-Protected Securities) we were headed for a major, even catastrophic deflationary scenario. Although the jury is still officially ruminating, looking at the market price of copper, it seems that the massive monetary and fiscal measures taken by the US and other major countries around the world have removed much of the risk.

As one of the most important industrial commodities, copper has a Ph.D. in economics. Since it is freely traded in a market, its price is decided upon by the wisdom of the “invisible hand”. Copper can even predict recessions! Right now, it is offering the first glimmer of hope within a very dark and gloomy economic outlook:

The lower window pane in the above chart shows momentum or more specifically, the annual rate of change. When it drops below zero, the economy tends to sputter. Right now, copper momentum is still mired in the negative. And to bring it back to zero, copper futures have to, at least, recover to $325. Which is a very tall order.

Obviously we aren’t there yet, but the rapid ascent which started late last year has already taken the industrial metal +50% from its low. So we if it continues in the same torrid pace, we’ll get there in no time. But no market is that simple, nor direct. Copper futures have jolted higher so within a shorter term time span, it will need to work that out before continuing.

But if we are truly in the first stages of a recovery, then copper is the commodity to watch. If the worst is actually over, then the price trend in copper will be the first to know. Way ahead of, and with much more accuracy than, any talking head on TV.

Continuing with the series, here is the fourth condition of a new bull market as outlined by Jim Stack of InvesTech:

I’ve hesitated to mention this technical indicator since I started writing this blog because it is almost too good. It is one of the few that have an uncanny ability to find the start of almost all major bull markets. So you can understand why I don’t want to run the risk of ruining it by popularizing it any more than it is. And it is not popular at all.

In fact, compared to say the RSI or MACD, the Coppock Guide is an esoteric and rarely mentioned technical indicator. It was created by Edwin S. Coppock some 50 years ago and although it is followed closely by a very small group of technical analysts, its calculation is not complicated at all.

You can keep track of it yourself. Here’s the recipe: you need historical monthly Dow Jones Industrial data. You add the 14 month ROC to an 11 month ROC, then you take a 10 month (simple linear) weighted moving average of the result. That’s it.

If you’re mathematically astute, you’ve already noticed that it is just another oscillator. Here is the chart of the Coppock Guide for the past few years, courtesy of InvesTech:

How is the Coppock Guide interpreted?
The most traditional interpretation is to recognize a buy signal when the Coppock Guide curls up while it is below the zero line.

It can also provide sell signals, although these are less frequent. If the Coppock curve makes a double top formation without first having come down to the zero line (or below it), the market is in for a seriously brutal bear market. You should be able to find one such occurrence in the chart.

So you can see why I think it is almost too good to share. In its history, only 4 false signals have occurred. That’s an 83% accuracy rate.

What is the Coppock Guide saying now?
The good news is that the Coppock Guide is in negative territory projected to fall into negative territory this month. So now any upturn can potentially give us a buy signal. The bad news is that this may happen next week, next month or next year.

The key factor is an upturn. But that can happen from an incredibly low level, like say in 1974 or 1932 (not shown) or it may happen just under the zero line, as in 1994.

Although no indicator can give a full iron clad guarantee, when the Coppock Guide turns up it would totally skew the probabilities towards a new bull market. As always I’m keeping a close watch and now that “the cat is out of the bag”, you can too.

According to the simple stock market timing method which relies on the 30 day rate of change of the 10 year treasury bonds, we are very oversold and should expect a rebound here.

This system is somewhat better at finding tops than bottoms, but it is a good general indicator to throw in the pot:

The rate of change (bottom panel) is really off the charts. The chart doesn’t go back that far but we haven’t had a reading this low since May 2003 when the S&P 500 was at 1000; lifting off a triple bottom and escaping from the clutches of the bear market.

There is an inter-market relationship between bonds and gold which may not be evident at first glance. The reason why the two disparate markets are connected is that they both rely on one factor: inflation. Or the expectation of future inflation.

For this reason, it is very rare for these two markets to go in different directions in the long run. Instead, they tend to dance around each other.

When the market expects future inflation to be higher, gold mining stocks rise and bond prices fall (yields rise). So in effect, by watching one market, we can attempt to gain insight into the other.

Jay Kaeppel developed a simple system to do just that. He looked at the 12 month rate of change (ROC) in the GMI (Barron’s Gold Mining Index) and compared it to the 12 month performance of bond prices going forward. We can substitute the Amex Gold BUGS Index (HUI) for GMI.

When the ROC for the gold index is positive and high, we would expect bond prices to decline going forward (next 12 months). Conversely, when the rate of change for HUI is negative or low, we’d expect it to be a great time to buy bonds. And this is generally what happens according to historical data.

Be sure to check out Kaeppel’s original article on this: Maximizing Bond Fund Profits. You can find it in the Reports & Articles section of my free trading resource “goodies box”.

So what is this simple intermarket relationship telling us now?

Well, as far as I can tell, the bond market and the gold market have decoupled. I can’t seem to find any meaningful relationship between them now. Kaeppel’s article was written in 1994 so it only included data until then. By looking at data from the late 1990’s to today, it seems that the two markets have gone their separate ways. Atleast for now.

For example, in the summer of 2002 when the 12 month ROC for the HUI index was astronomically high, bond prices actually were higher a year later. And in the summer of 2005 (see graph below), when the 12 month ROC was negative (-40%), bond prices actually peaked and were lower a year later.

Click to Enlarge Graph

Strange. As I’ve mentioned before, although the bond market is pricing in future expectations of inflation, other markets, like gold, silver, and the CRB commodities index are breaking down and not confirming this. What to make of this?

With the rising yields (falling prices) in the long end of the bond market, the yield curve is back to normal. Short term yields (90 day) are at around 4.80% and long term yields (30 year) pushing 5.25%.

The 10 year bond, what everyone seems to be watching these days, gapped up and closed very strong. This sort of move, although seemingly strong, is usually indicative of the last sprint before exhaustion. Which is why such gaps are called “exhaustion gaps” - but only in hindsight since its 20/20

So while the 10 year bond yields are rising, perhaps saying that the Fed won’t cut… the very short term bond market is staying stubbornly below the Fed funds rate. Only one of them will be proven right.

In any case, all this attention on the bond market got me thinking about simple mechanical trading systems that I mentioned before. I wondered if the bond market could be used to time the stock market in the intermediate term.

Tops are extremely difficult to identify. I haven’t really found many reliable indicators for the job. Put/call ratios and the myriad variations of that sort of data? Helpful. Sentiment surveys? At times. But what about bond yields?

I looked at the 10 year bond yields and did a very simple 30 day rate of change (ROC) calculation and compared it to the S&P 500 index. Surprisingly, it did a very good job of pointing out market tops. Take a look.

Click to Enlarge Graph

As you can see, when the ROC was approaching 9% things got a bit queasy for the bulls. The most recent case being just a few days ago.

The one glaring mistake it made was in October 2005 where it flagged the exact intermediate bottom as a top. But we can easily avoid that sort of thing by having a simple condition that the signal is only good if the market has been rising in the most immediate past.

And eventhough I wasn’t looking for it, the reverse (low ROC) is also a fairly good indicator of market bottoms. But of course, this is just too small a sample to be robust. At best it is a good starting point.