In this article I will be reviewing my 3 favorite barometers for gauging investor sentiment in order to predict market outlook.
The chosen tickers are:
- (NYSEARCA:SPY): This ETF will be used as a proxy for U.S. markets, since it moves almost identically.
- (NYSEARCA:GLD): this ETF will be used as a proxy for commodities.
- (NYSEARCA:TLT): this ETF will be used as a proxy for U.S. bonds.
When these 3 markets make big moves, it´s time to pay attention to what they´re saying.
It´s very important to take notice of:
- Which of these 3 market gets hit first during a financial crisis.
- The duration of the sell-off of risky asset classes, such as SPY and GLD.
- The time it takes for U.S. bonds to rise drastically and then return to normal levels after a great flight to safety of bonds takes place.
This simple observation can give you an edge to be better positioned for the rest of this year. This is also a history lesson from the financial crisis of 2008. We will first dissect how these 3 markets reacted during the financial crisis of 2008-2009 and then compare it to current market conditions.
Who got hit first?
It´s a common myth that gold is a "safe-haven" because of its limited quantity and other qualities that gold bugs would love to tell you all about.
But GLD has proven quite the contrary, being the first market to be hit by the 2008 financial crisis. When the perceived risks are high, commodities get sold first.
The sell-off of started in late July 2008, and was the first sign that something was not right.
As seen on this chart (courtesy of stockcharts.com), GLD bottomed on November 2008 (4 months before equities did), and started a multi-year bull market that took to more than double its 2008 low.
SPY was the next market to react:
SPY´s first big weekly decline happened during the first weeks of September 2008, 2 months after GLD started its decline.
If you would have exited long SPY positions in late July 2008 when GLD was being sold-off, you would have spared yourself a -47% impact to your portfolio.
How did bonds react?
U.S. bonds were not useful for timing the beginning of the GLD and SPY declines, but were very useful for timing the end of the equities and commodities sell-off.
The bond market was the last of these markets to react. Participants were scared of falling prices in risky assets such as Gold and U.S. equities , so they sold these risky assets and then rushed to buy bonds.
Since bonds yields move opposite to their price, this flight-to-safety caused bonds prices to get to all-time highs on December 19, 2008, which caused TLT to print 107.47 at the close.
TLT made a 30% move to the upside from mid-November to mid-December. A month is all it takes for panic to get prices to ridiculous and unsustainable levels.
TLT gave the Buy Signal
After reaching record-highs, bond prices kept falling from mid-December 2008 to March 2009; returning to levels seen before the flight-to-safety sent bond prices soaring. The timing was perfect. This decline in TLT prices by itself gave a big buy-signal, money was moving from bonds back to risky assets such as SPY and GLD, which started a multi-year rally for these 2 ETF´s. The risk trade was on.
What are these 3 markets saying now?
I will start with GLD again, to check if we get any warning signs of an impending decline like the ones we got in 2008:
A 15% decline in GLD that started in mid-February is the first warning sign that a sell-off in and equities is starting again; especially now that GLD broke its 50 week moving average (WMA) (blue line).
This had not happened since (care to guess?): August 2008.
Is it SPY´s turn to fall?
As you can see in the graph, 2 months after GLD started declining, it was SPY´s turn to start declining, also note that piercing below the 50WMA is a bad sign, just like what happened in 2008.
The big decline I am expecting in has not come yet, but is so close you can smell the fear about Europe´s final resolution regarding the "Grexit", if Spain is going to need to be bailed out by the ECB and friends, among many other economical, political and war-related problems Mr. Market does not like.
The bonds: Waking up and smelling the coffee
As it happened during the last recession, it is now time for the U.S. bonds to react to the fear, as investors take money out of risky assets such as commodities and equities and go to the "safest" investment: bonds.
I do think we still have at least a month of flight-to-safety from investors, providing more room to rally for TLT.
How to trade this market
My take on this summer sell-off is simple enough: History will repeat itself, although with a smaller percent movement.
GLD once again signaled the start of the decline in risky assets, and it will be followed by SPY. After risky assets fall, TLT will be making a quick and huge move up to all-time highs.
The most obvious trade right now would be: shorting SPY, going long GLD and shorting TLT.
The timing is trickier though, as this sell-off is young and will need another 2-6 months to play out completely.
The safest bet right now is to exit long equity and commodities positions until TLT goes over 135, and then short or buy (NYSEARCA:TBT), which is an inverse ETF for TLT; this trade should last about 2-3 months.
When TLT returns to around 110, exit this short trade and go long SPY, which should be around 110-120.
Remember that bear markets give you opportunities to get on the long side with risk/reward so attractive that you will not get the same opportunity again for years.
Do not hesitate to pull the trigger on the buy button on equities once these conditions are met:
- A strong sell-off in SPY. Target zone: 110-120.
- GLD makes a sustained rally for at least 1 month.
- Bond prices return to levels seen before the panic started this year. TLT Target level: 110-115.
I do expect this sell-off to be of less magnitude than the one in 2008, as many of Europe´s woes are already known and various scenarios appear to be somewhat baked-in. Who would have guessed kicking the can down the road worked?
That is why my targets are not lower than 100, I would not mind if SPY declined even more, the sale will only get better for us all.
This is the time to be watching these 3 markets closely.
Good luck everyone, I will be posting trades on this forum as the target prices come into play.
Disclosure: I am short SPY. I will initiate short positions in TLT and/or long in SPY/GLD at any time when my targets are met.