S&P 500 Market Overview and Margin Signal New Update

After two weeks of red candles, we finally managed to align a few consecutive positive days. The question now that we all have is, is that over, or is it just a dead cat bounce? The first thrust we had from the low was followed by a huge reversal that signaled that it was not over. Since this reversal, we are now seeing a more constant and uniform push.

There are a few things that tell me that it's over. All the different VIX indicators are now very sparse and cooled down considerably. The SKEW reading on Monday came in around 130, which was more than 23 points down since the beginning of this drop. This was 4 points more than the average, and only 5 points less than during the COVID crash. We are also seeing a huge spike in the SKEW today, which is usually a sign that the drop is over. This spike should cool down in the next few days as people rebalance their options. One last thing that is more subjective but signals to me that this leg down could be over is how the market reacted early this week following the relatively hawkish speech given by Powell last Friday. A market that moves up on good news is always a sign of an exhausted sell-off. There is also other thing, like DXY that reverse course and bond rate that finally reverse course.

Inside the strategy, there are two metrics that are very close to their buy thresholds. One is a price action metric related to the BWR Ribbon of SPY that monitors the distance between the blue and the red ribbons' centroid, their order as well as their width.

All conditions on this one are close to being met. Even closer to the threshold for a buyback signal is one statistic related to the current standard deviation in the “at the money option” in all the S&P 500 companies' related options. Unless we have a strong reversal tomorrow, this one should send a signal for sure.

The ideal scenario for a buyback signal would be on a red candle. Indeed, if you look at the strategy history, since the strategy needs to see some green before re-entering the market, it usually happens very close to the second Elliott wave that provides some cooldown of the initial rally. This is one of the two reasons I always said that although the timing in applying the hedge signal is incredibly important on the way down, it is not as crucial on the way up (the other reason being the velocity of the trend that is always slower on the way up). There are probably a couple of days before and after the signal that the intraday price action could provide a better entry price.

We will naturally play our signal on the day it triggers, but I may be more opportunistic in my own account. I need to recall that the WU strategy has been designed for our capital protection against drawdown rather than for bottom fishing. I actually don’t think that it is currently feasible to program a strategy that would consistently hit the bottom of a drawdown. This would involve making a call on the oversold condition of a market, which becomes more in the realm of a prediction, rather than a reaction like we do. There is one or two lines in the WU strategy that would buy blindly once-in-a-lifetime metrics that are so extreme that this must be a bottom. One of these lines came ridiculously close to triggering a Buy on the IOFund Nasdaq strategy on December 28th, 2022. This would have been a direct home run if the threshold would have been set just 0.5% lower. But it did not happen, so in all other instances, we need to see what is usually associated with a resuming trend to avoid going into a dead cat bounce. And looking at the history of our signal, avoiding dead cat bounces is one area where our signal has rarely failed in past bull markets. This high level of conviction, even if this mean seeing more green candle before buying back, allows us to have a more aggressive market posture that will easily recover what we missed while we were market neutral.

This combined with the fact that our margin indicator is also now back in the blue color (see the other part of this post for information about the new update of our margin signal), should have us follow our next signal with a lot of conviction by putting 100% of our capital in UPRO. This would give us a beta roughly equivalent to 3X. I also anticipate that if this rally holds, our margin signal should also fire an alert a few days after. We may take this opportunity to take 33% extra leverage by using our margin (at a whopping 6.28% interest rate!).

Last legs

By going super green on a not-so-good job report yesterday, it’s like if the market told us that it knows and accepts that we are heading into a recession, but that it wants to celebrate one last leg that could be fueled by a Fed pause. This is aligned with my personal view of the market.

Will this leg hold for months and extend into 2024, or will the party be done by Christmas? I don’t know, and probably nobody does. I will try to capture as much as I can, knowing that my maximum downside should be around 5% on SPY. However, there are two specific things that I will monitor for this next run. The first one is the DJI to GOLD ratio. I will be careful when this ratio touches the upper green line that as serve as a point of reversal many time. I have been monitoring this metric since a very long time and I always wonder what would happen when we would touch this line around the end of the triangle.

The other data that I will continue to monitor is again the SKEW. As it becomes more clear that we are going to have a recession, I anticipate that people will protect their gains like we have never seen before. The 2022 pain is still too fresh in people's minds to be ignored and I’am sure that people are more sensitive to loss that they were in 2021. This should create an all-time high peak on the SKEW, which is a measurement of the imbalance in the out-of-the-money options that I always see as the potential energy accumulate in a system for a drop. The current all-time high was at 170 in June 2021. I will start to be cautious when we peak over 160.

Update of the Margin signal

On Friday, June 16th, we had a buy signal from the Bear market indicator (although we were already in the market) at the same time as a sell signal. In the indicator version of our margin signal, these two conflicting orders created a visual glitch where the line indicating risk stayed on the screen although it was supposed to not display when we are off-margin. This didn't affect any of the trades, only the visual display. I was aware of that glitch, but it was relatively low on the coding priority list since I kind of liked being able to monitor the risk indicator even though we were not on margin. Actually, my intention was to solve this bug but also make it always visible at the same time. However, I had forgotten why I couldn’t do it in the first place. The issue is that in a drop, some of the underlying indicators used to compute the overall margin risk signal go off the chart or lose their meaning. Therefore, I need to force some of the components to have a zero value which would result in an apparent low risk, when the reality is different. Anyway, I guess this part is hard to understand if you didnt see the code, but I did spend hours trying to improve this. This led me to rethink some parts of the indicator, which resulted in an updated and improved version of the Margin Indicator.

In this new updated version, the strategy will tend to re-enter the market more quickly after exiting preemptively on some “hedge signal” as long as the margin signal carries a low level of risk. The previous version had one condition that was overly restrictive. This results in about 33% more trades than before. These new trades now include a losing trade, but this one is only -1.3%. The reason I accepted a loss was because not only was it very small, but the new strategy allowed me to lower the maximum drawdown from 7.2% to 6.6% while improving the overall return. I think that when on margin, experiencing a drawdown is one of the most painful things an investor can go through, so lowering this number could probably help me keep my sanity while on margin. The extra return is not to be neglected since this is the primary reason we go on margin anyway. Here is a table that recaps the statistics of the old version versus the new version.

Finally, in this new version, the visual line will stay on even if we are not on margin as long as the signal means something (i.e. that none of the underlying indicators are off the chart or disabled). This means that there are still some periods where the Margin signal will not display, like for most of the 2022 bear market, but there are periods in a bull market where you will be able to monitor it even if we are not on margin, like at this moment. I hope you will love this change as this signal is some sort of fear and greed index. The margin signal is the one we have the least live history for. Don't be surprised if I don't lean on it with incredible leverage just yet. Like it took me some time with the hedging strategy to be comfortable playing it with 100% of my capital, I should slowly learn to trust the margin signal as time goes on. Maybe this will come with some regrets along the road, like with the margin signal I didn't take in May that would have given a significant boost to our fund. But in time, you will see me play more and more aggressively with this signal. I'am actually impress so far at how it has performed. This drawdown started exactly when the signal turned red. But It's just that I never forgot the story of Icarus...

Along with our margin signal, we also did a very minor update to our hedging strategy to avoid suffering from the same bug of two conflicting signals happening at the same time and keeping all our strategy on the same code basis. Now it's simple, in all case we give priority to the sell signal if a sell and a buy signal happen simultaneously. I don't really see this happening outside of a bear market, but I wanted to make both signals follow the same logic and getting uniform. Some of the changes we made to our Margin signal had a negligible impact on the strategy, but not enough to change the stats.

These updates means that those who currently have the old versions loaded on their TradingView may have to suppress the indicators before re-adding them. Sometimes this doesn't work and you need to restart TradingView. The version you should now see on your screen are Margin Risk Indicator[1.3] and Hedging Signal [1.6].