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Chart Advisor: Preparing for High Volatility

Posted October 4, 2023 at 7:45 am

By Todd Stankiewicz CMT, CFP, ChFC

1/ The 5% Canary

2/ The Power of Utilities

3/ Leverage for the Long Run

Investopedia is partnering with CMT Association on this newsletter.  The contents of this newsletter are for informational and educational purposes only, however, and do not constitute investing advice. The guest authors, which may sell research to investors, and may trade or hold positions in securities mentioned herein do not represent the views of CMT Association or Investopedia. Please consult a financial advisor for investment recommendations and services.

1/ The 5% Canary

Today we examine indicators derived from some of the CMT Associations Charles H Dow Award winning research papers. Looking at these indicators can provide further context on where the risk and opportunity may exist in the markets.

The first indictor is from the 2023 Award winning “The 5% Canary” by Andrew Thrasher. The 5% Canary is defined as a 5% decline in a major market index inside a 15-day period. The paper suggests that these types of declines can act as early warnings. While the paper goes onto further elaborate on differentiating “Confirmed 5% Canary” signals, we will focus on the standard signal for brevity.

The markets recently peaked on July 31, 2023. The above chart highlights the performance of several indices over the next 15 trading days from this peak, spanning July 31 through August 18. While the S&P 500 Index (SP500) and the Dow Jones Industrial Average (DJI) have avoided the 5% drawdown, the Nasdaq Composite (IXIC) and MSCI USA Small Cap index have clearly dropped below these thresholds. Based on this research paper, this could serve as a warning sign of more volatility to come.

2/ The Power of Utilities

The 2014 Charles Dow Award Winner, “An Intermarket Approach to Beta Rotation, The Strategy Signal and Power of Utilities,” by Charles Bilello and Michael Gayed address the potential signal that the utilities sector can provide. The paper suggests that when the price ratio of the Utilities sector to the broad market is positive over a 4-week period, rotate into low beta or utilities for the following week.

This ratio chart of the S&P500 Utilities Sector ETF (XLU) vs the Vanguard Total Stock Market ETF (VTI). The top chart is the 4-week rate of change of this ratio. The paper suggests that when this Rate of change (ROC) is positive, investors may want to consider rotating into utilities. During 2022 this ROC was persistently hovering around positive. As such the utilities sector outperformed the broader market. This supports the indicator.

Currently, this ratio is negative, which suggests a rotation into broad market equities, but despite the traditional implications of this signal, it may be worth considering that a reversion to risk off in the market may potentially be taking place. This is especially worth consideration since the daily RSI of XLU dipped down to 17.57 on October 2, 2023. The weekly RSI of the ratio itself is displaying a bullish divergence as the decent dip lower in the ratio is accompanied by a higher low in the RSI.

This suggests that while the traditional indicator may be signaling a risk on stance, it may be prudent to consider that there is the potential for a reversion to risk off based on how overextended the indictor has become.

3/ Leverage for the Long Run

The 2016 Charles Dow Award winner “Leverage for the Long Run,” by Charles Bilello and Michael Gayed created a simple rule to own the S&P500 index when it is above the 200 day simple moving average and sell the index and rotate into T-Bills when it is below the index.

This paper suggests that the risk-reward of the S&P500 index is favorable when it is above the index, but it is unfavorable when the index is trading below the 200-day simple moving average. This strategy is often talked about with investors, but rarely at the level of detail that Bilello and Gayed achieved in this paper.

Currently we are only 33 points away from the moving average. Observe carefully to see if the index finds support at the 200-day SMA. A bounce may indicate opportunity, but a break in the moving average may indicate the need to take steps to manage risk.

Originally posted 4th October 2023

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