MLR - Gap up/gap down news driven markets soup du jour

Published : November 9 2011 at 14:24 ET

Gap up/gap down markets are the soup du jour, though actually have been behaving this way for much of 2011.

The Market Direction Model's cash position is the best course during such turbulence, much as it was after the May 2010 flash crash when the model scored big in a hurry on a sell signal, then opted to stay in cash for much of the post crash, with only two sell signals and one buy signal (two of these three signals were minorly profitable) from the May 25, 2010 buy signal to the August 11, 2010 sell signal.

The quick switches in signals in October are indicative of turbulence in the present market. Following the model's big gains on the heels of its August 31, 2011 sell signal, the model switched to a buy on October 5 which was profitable, followed by two signals which were both false signals.

One of the keys to making big money is being able to keep profits made during such periods. Extended turbulent periods are very good at creating deep drawdowns, as one who continually gets nickled and dimed will eventually get quartered. Thus the model opts to remain in cash for the timebeing. For now, it would take pronounced buying or selling pressure to push the model into a buy or sell signal.

Here are two possible scenarios:

Scenario 1: Buying pressure comes in from quantitative easing. RISK: Gap down news driven risk exists.

Scenario 2: Selling pressure comes in from negative news. RISK: The general markets move higher on support from quantitative easing.

In the meantime, precious metals seem to be the best course to take as they continue to have multiple tailwinds to help push them higher as gold completes its long term uptrend which began in 2001, more than a decade ago. We stand by our views that pyramiding various precious metals ETFs is a low risk way to approach the current market environment, with the added benefit of reaping potentially big gains should precious metals have a run to the upside that we saw earlier this year.


In terms of calculations that appear in, here are the basics:

We take the price of the NASDAQ Composite at the time the signal was issued such as the sell signal issued on August 31: 2561.68. We do the same for TYH, TNA, and TVIX.

If the signal came after the close or before the next day's open, we have always taken the closing price of the day's close. Due to unusually high levels of volatility and the news driven gap up/gap down nature of the current market environment, the last two signals that came back to back after the close/before the next day's open resulted in larger than normal positive biases to the model. That said, late 2008 resulted in larger than normal negative biases to the model. Over time, the positive and negative biases tend to wash out. That said, to smooth the biases, we have decided to start taking the next day's opening price if the model triggers shortly before the open. We will continue to take the prior day's closing price if the model triggers shortly after the close. Many of our members buy ETFs after the close if the model switches after the close since most brokerage firms allow for after market trading, especially in ETFs, most which are highly liquid.

Note, if we were to only take the next day's opening price, in some cases, there is the potential for strong negative bias if an after hours buy signal was followed the next day with a gap down, then a few days later, an after hours sell signal was followed the next day with a gap up. The trade could thus be quite profitable by buying at the open after both switches when in reality, it would be unprofitable in reference to the model's signal switches and potentially unprofitable if bought after hours that same day.

Members should be able to reproduce the returns we show in our tables assuming they acted at the time they received the report. The above discussion should smooth out short-term biases. Over many signals, any negative and positive biases should more or less wash out. Of course, subtract for any commissions, add for any money market gains when the model is in cash, and assume slippage is minimal because markets are made in ETF/ETN vehicles differently than they are made in stocks, so slippage is reduced to near zero.

Since we are taking prices each time the model switches signals, there is no additional degradation, decay, etc in the ETF. The price is the price at that point in time. Between the dates of the Market Direction Model's signals, if the market is in an uptrend or downtrend, leveraged ETFs should outperform their 1-times equivalents on a 2x or 3x adjusted basis. If the market is trendless, leveraged ETFs should underperform their 1-times equivalents on a 2x or 3x adjusted basis as we have discussed here:

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