How Time Stretches Can Provide An Edge

While it seems the S&P has hardly pulled back at all since the March lows, one market that has made it the entire time without a single close below the 10-day moving average is Singapore. EWS has now closed above its 10-day moving average for 25 days in a row. When a stock or ETF spends an extended amount of time on one side of a moving average it creates what I refer to as a “time stretch”. I’ve discussed time stretches on the blog before but not for quite a while.

When a time stretch gets large, such as the current 25-day 10ma time stretch for EWS, you can often expect a move back to the other side of the moving average in the near future. I have found time stretches to be useful in system building.

To demonstrate, looking at the current EWS situation I set up the following criteria among my list of about 115 liquid ETF’s. (This list excludes all inverse and leveraged ETF’s.)

1) ETF must have closed above its 10-day ma for at least 25 days.
2) Today it closes at the highest level of the upswing.

Selling short under those conditions and then covering on a close below the 10-ma provided the following results over the last 10 years across my list of ETF’s:

Trades: 211
Wins: 167
Losses: 43
% Wins: 79%
Avg Win: 1.8%
Avg Loss: -2.1%
Avg Trade: 1.0%

As you can see, although the concept is simple, the results can be quite powerful. Traders may want to consider including time stretches in their bag of tricks. I use them for a few systems tracked in the Gold members section of the website and in Quantifiable Edges Subscriber Letter.

A Selloff Reminiscent of the 60’s and 70’s

Anyone who traded through the bear market of the 2000-2003 knows that it was marked with sharp selloffs and sharper reversals. Moves lower were short and violent and moves back up were much the same. Since early May the market has sold off in a way that has rarely been seen since Reagan entered the White House.

The S&P 500 and Dow have both closed below their 10-day moving averages for 19 days in a row. Unless the S&P rises over 2.7% tomorrow and closes above 1295.57, then it will mark 20 days for that one. I looked back to 1960 to see all other times the S&P closed below its 10-day moving average for at least 20 days in a row. Below is the list.

1/29/62
4/17/62
5/22/62
6/14/65
3/15/66
11/8/67
2/13/68
1/10/69
6/16/69
12/11/69
2/6/70
5/1/70
5/27/71
8/9/71
2/9/73
11/27/73
4/15/74
1/31/77
3/14/80
2/9/84
2/12/03

What we seem to be experiencing is a selloff similar to those that occurred in the 60’s and 70’s, but not since.

The selloff in financials has been more than twice as long. KBE and RKH, two bank ETF’s, have now closed below their 10-day moving averages for 40 days in a row. The last day they closed above it was May 6th. Since that time RKH has lost 29.9% and KBE 33.5%. I am unable to find any other ETF that has ever traded below its 10-day moving average for 40 days. EWW (Mexico) came close when it went 39 days in 1998. While the history for many ETF’s is limited, the persistency of this selloff is quite incredible.

The Edges Are Dulling

There’s a fair amount of studies outstanding and the market has been putting in a decent bounce, so let’s see where we are at:

First off I found it interesting that the Nasdaq 100 /Russell 2000 Relationship remains disjointed. We are now at 8 days of at least a 1% differential in returns.

Time Stretch Study
This was the first study of the currently active bunch to be posted. The exit on this study was based on a close above the 10-day moving average. The S&P 500 accomplished that today, closing the study. The entry was officially at the close on Friday the 18th. Since I didn’t post it until Sunday the 20th, anyone who may have taken a trade based on this should have gotten a significantly better entry price due to the massive gap down on the 22nd. Even assuming the lousy Friday the 18th entry this study would have been good for about a 2.2% gain.

Capitulative Breadth Indicator
On January 22nd the CBI jumped from 5 to 13. I discussed in detail how moves as high as ten or more have led to strong market bounces in the past. (Click on the “CBI” label at the bottom of this post to see all posts related to this topic.) The standard exit I discussed was exiting when the CBI fell back to 3 or lower. On Thursday I discussed the “profitable 8” exit strategy. This entailed selling on drop in the CBI to 3 or lower or the first profitable close of 8 or lower. This strategy, while consistently profitable, would have shaved about 0.6% per trade off affected trades.

With the drop in the CBI to 5 today I decided to look at a similar exit - selling the first profitable close of 5 or lower or selling when the CBI hit 3. A “profitable 5” exit would have affected only 4 instances. Two of them it hurt the return. The other two it helped the return. The net effect using a “profitable 5” strategy was slightly positive. An exit at today’s close would have netted about 3.3% from the 1/22 entry trigger. If the alternate entry on 1/23 was taken it would be a 1.1% gain. I will continue to update the CBI until it triggers the standard exit reading of 3 or less.

Reversal Bars Studies
The Large Reversal Bar Study which was originally published on the 9th, triggered again on the 23rd. After pulling back below the close of the reversal bar (1/23/08) it has now closed back above it. On the 15th I posted a trade management follow up to the January 9th study. Based on the trade management outlined then, a stop should now be placed below today’s low (1/28).

The Large Bars Down and Up Study is on track so far. That study showed a pullback was likely within the first 5 days following the reversal up (1/23). After that the market was likely to rally – probably after retesting the lows. It’s too soon to draw any real conclusions here, yet.

Summary Thoughts
Oversold conditions are being worked off in most of the outstanding studies. Even with less than ideal entries, profits should be available. Profit taking seems prudent. While certain studies like Reversal Bars and Nasdaq/Russell indicate more upside is likely to come, they also indicate extremely high volatility is likely. Wednesday will almost certainly see volatility with the Fed decision due. There is nothing wrong with letting some profits ride, but I’d suggest traders consider taking at least a portion of their holdings off the table now to protect gains. Preserve capital and wait for a better edge.

Rob Hanna

Time & CBI Indicate A Bounce Could Be Near

In Friday’s blog I mentioned it looked like the market was beginning to capitulate, but I didn’t feel it was quite there yet. The study I showed indicated that strong, high-volume, extremely weak breadth declines like we’re seeing are difficult to time. Frequently there was more downside when looking at those conditions. Friday in fact brought about some more downside. While price and volume are still not telling me to dip my toe in, breadth and time are.

My favorite breadth indicator when the market is experiencing strong sellofs is my Capitualtive Breadth Indicator (CBI). On Friday morning I noted the CBI had only hit 3 so far and I would feel better about being aggressive if it was 7 or higher. It poked up to “5” at the close. This is normally the first level where I begin to consider it somewhat significant. Based on the position of stocks in the qualifying list it could easily spike up to 7 or higher on Tuesday and possibly even reach the “10” level by Wednesday. The CBI is not a perfect timing device, as it can be early, but the higher it gets, the stronger the subsequent bounce is likely to be. In an upcoming post I’ll show some worst-case scenarios using the CBI.

Time is beginning to favor the “bounce” argument as well. The move down has been extremely persistent and the major indices have all failed to put in a decent bounce. The closest thing we got was the minor rebound following the large reversal day. While that ultimately failed, it did put in an effort just barely good enough to allow traders to exit with a small win or small loss. Still, the major averages all failed to even poke above their 10day moving average on that bounce.

I took a look at a fairly simple mean-reversion strategy based on the current setup and the results were quite positive. I ran the test back 30 years. Below is the setup:

Condition1 – S&P 500 has failed to post a HIGH above its 10-day simple moving average for at least 12 straight days.

Condition2 – S&P 500 posts its lowest close in at least 12 days.

Buy the S&P 500 on the close. Exit the trade when it closes above its 10-day moving average.

There have been 12 such setups over the last 30 years. Every one of them has been a winner. The average gain was 1.9%. The worst drawdown was about 4% on a closing basis. The average trade lasted a week. The trades are listed below:



I also ran the same trades with a time exit. Rather than selling on a cross of the 10ma, I simply sold “X” days later. This will help to illustrate the typical type of action:


As you can see, most of the bounces lost steam after about a week. In fact, once you get 3-4 weeks out, losers outnumbered winners and losses were larger than gains. So while this kind of “time stretch” trade has been good for a bounce – that’s normally about it. Outstaying you’re welcome could be hazardous.

Mean reversion trades can be especially difficult in markets like this where price is in a freefall and there is no support nearby and no reasonable place to set a stop. Limiting exposure to control risk is therefore extremely important. And since exact timing is difficult and the market may still have a good amount left to fall, it is imperative that traders have additional capital they can put to work should the setup improve.

To sum up, the time stretch is indicating a bounce is likely coming soon and the rising CBI is indicating the bounce could be sharp. These two factors are providing a quantifiable edge. Aggressive traders could consider adding a small amount of long exposure in anticipation of this bounce.

Rob

P.S. Traders interested in seeing another similar example of a "time stretch" may see the October 11th post from my old blog.