EZV Algorithms: We're Probably Setting Up A Breakout To The High Side

Summary

• In Wednesday's blog I pointed out that the VIX metrics had suddenly appeared cautious after a bullish trend since late August.
• Yesterday, that cautious move did not accelerate, and now it looks like if the next few days play out well,  we could be setting up for an extended rally.
• I'll explain the reason I use two slopes and the implications for current market expectations.

In Wednesday's blog I noted that the Primary Slope had unexpectedly turned negative, but remained above the trigger level; the Confirming Slope was positive but not enough to be bullish. That condition set up a probable pivot point: if the SHAPE deteriorated further in coming days we could be looking at a near-term sell signal; if it held up we'd stay on the bullish course.  I said it this way: 

"It could be that given the market's undecided behavior today, VIX traders are simply injecting a small dose of caution in the bullish mix, or possibly the change represents the start of a psychology reversal. Either way, the metrics will tell a story in coming days."

With Thursday's action the SHAPE held up and we're one day closer to confirming a bullish run.  

The context is worth noting.  Markets are very close to all-time peaks and that always results in some caution.  But if they do break out, they'll often run for a while.  It's starting to look like EZV Algorithms metrics are setting up for just that.  Here is the dashboard.

EZV Algorithms Dashboard

Source: Michael Gettings        Data Sources: Fidelity, VIXCentral.com, CBOE

While the Primary Slope is decidedly negative, it remains better than the trigger level and it's a transient metric that can easily change in a matter of days.   The SHAPE remains in a safe zone, and with the S&P futures up this morning, it's likely to stay there, at least for a couple of days.  Then, if you look at the Confirming Slope you'll see that, while it's worse than the threshold, it is positive and likely to become more so in coming days as the high early data points fall off the chart. 

So, as I see it developing, the most likely scenario is that we'll see the Confirming Slope turn bullish (above threshold) while the Primary Slope recycles to more solid bullish indication.  Once the Confirming Slope is bullish, it will take some time and SHAPE deterioration before a sell signal could develop.  In other words, I suspect we'll break out to the upside soon and sustain it, but there could always be surprises.  If so, we'll see those as they emerge and respond.

Obviously, all of this is driven by the conviction that the structure and calibrations of the algorithm are meaningful.  I'll point out two factors in that regard. 

First, when I developed the algorithm I began with the SHAPE and Primary Slope only, and I got pretty good results.  But on inspection I found that the short look-back was cycling rapidly and producing too many false sell signals.  So I decided to test a second slope to confirm the trend over a longer look-back period, i.e., Confirming Slope.  That eliminated many of the false signals.  

The second point is one I've mentioned so often that it might bore you.  The slopes and triggers are not back fitted.  They are only applied to future periods after being calibrated on historical data that ends prior to their application.  Every time the differential between the algorithm's performance and the buy-and-hold strategy falls below a threshold, the algorithm looks at historical data to that date, recalibrates, and applies the new parameters to decisions from that point forward - never backward.   So the algorithm that calibrates the slopes and triggers is not benefiting from over fitting and therefore has every likelihood of working in the future as it worked in the past.

So to close, I expect we'll be reaping profits for a while, but if something changes, we'll see the bearish risk emerge before it turns into a rout.  And routs are great as long as you avoid them to buy cheaply later.