MDM - QE Perspective

Published : August 2 2013 at 10:12 ET

Only when quantitative easing ended as shown by the two white gaps in the chart below, did the markets have serious corrections which were the flash crash in May 2010 and the steep correction in Aug 2011 where the NASDAQ Composite lost -18.7% and -20.4%, respectively. Outside of those corrections, setbacks were minor but just enough to put everyone into cash.

The start of Operation Twist was in late September 2011, ended at the end of 2012, then the money printing baton was passed directly on to quantitative easing, or QE3 at the start of 2013. Over this period, the market had two corrections, -13% then -12% on the NASDAQ Composite, -10.9% then -8.9% on the S&P 500.

The Market Direction Model's 10/5/11 buy signal which was roughly at the start of Operation Twist resulted in a gain of 458% in XIV which moves roughly in the same direction as the general markets. Hindsight is always 20/20, and it would have been to our advantage for the MDM to stay on a buy signal since 10/5/11, and for investors to remain long any market ETF (QQQ, TNA, TECL, etc) or XIV which correlates with the general market. That said, most. including the trend following wizards, have found the 2011-present market period to be the most challenging period in their careers, based on their negative performance numbers. Trendless periods that grind out gains are from a price/volume perspective the most challenging indeed. And to know ahead of time that sitting on a buy signal would have been the best course of action is nearly impossible as the current period in market history has been unprecedented.

That said, we should take what QE history has shown us to heart. Today's unemployment report show that QE and Operation Twist have had negligible effect on improving the unemployment picture, since today's drop in unemployment is due to people dropping out of the work force. Studies have shown that psychological damage done after any recession lingers for years after the recession ends since unemployment can be devastating to individuals. It could be argued that the current situation is worse than past recessions, thus the repercussions will be deeper.

Nevertheless, central banks around the world will continue to print, so we should take advantage of this knowledge and ride the trend. The UVXY volatility model may therefore sit on its sell signal for longer periods than before which would mean sitting on a long position in XIV or a short position in 2x UVXY. MDM may also sit longer in its buy signal, though at pivotal points, it may switch to cash or a sell, such as on a high volume reversal on materially negative news.

Keep in mind that history shows money printing raises the price of hard assets including stocks. But there could be a black swan event that causes a market crash that we're not yet seeing, despite QE3 on full tilt. So nothing should ever be assumed. Examining price/volume action day by day is the best court of action as any serious crash has always been preceded by negative price/volume action all the way back to the 1920s.

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