YOUR NEW DEATH CROSS?

While some may want to talk about the 50 day / 200 day moving average of prices and the two lines crossing each other (known as the death cross), I have a death cross of my own that I think has a bit more power behind it.

This is the chart of the E-mini S&P 500 Futures ($ES_F). It is a weekly chart that dates back to right around the times of the 2009 bottom, thus showing the latest bull cycle in the index. The top half of the chart and it's indicators are not as important as what is below.

The study below is one of my favorite studies. It is a multiple average true range (ATR) indicator which simply plots different periods of the ATR for the $ES_F. For anyone unfamiliar with what ATR is:

"The Average True Range study calculates the average of true price ranges over a time period. The True Price Range is defined as the greatest distance between today's high to today's low. The Average True Range is a moving average of the True Range over a specified period of time"

In this chart, since it is weekly, the blue line represents 13 weeks (or one quarter) of the average true range in the $ES_F while the purple line represents 52 weeks (on one year).

ATR is another way to measure realized volatility. What is to focus on is when the blue line crosses the purple line (the 13 week ATR crosses over the 52 week ATR = Death Cross) and when the blue line makes higher lows as represented by the drawn yellow trendline.

First, when the ATR Death Cross occurs, it means in the immediate near or very near term prices are going to experience more volatility than normal with normal being a period of one year. Over the past 4 years (longer than that, but for this example we will say), more volatility has equated to falling prices. As seen by the light purple boxes highlighting each death cross, the corresponding price action has been negative following each death cross.

In the 2011 instance, we saw the 13-week ATR bottom in early 2011 and continue to make higher highs and higher lows each week while price remained confined in a range. Soon after the Death Cross occurred, prices plunged and volatility rose sharply.

Now, in 2012/13, we saw the 13-week ATR make a bottom in early 2012 and since then has been trending higher. At the end of 2012, a Death Cross occurred (as highlighted), however unlike 2010 and 2011, this has not lead to lower prices in equities. So, what does this mean?

Well, for one, it could mean nothing and we could see the 13-week ATR cross back under the 52-week ATR. For me, this would be a bullish sign for the market as I believe prices would continue to rise. 

However, on the flip side of the coin, this could indicate a much larger drop than in 2011. Let me explain why.

First, each time the 52-week ATR line has reached a certain point on the scale, it has seemed to bottom there. That magic number has been between 36-37. In 2010, it was 37.16 and in 2011, it was 36.04. These were the lowest points that the 52-week ATR reached before it lifted higher in each one of those years. 

At present time, the lowest point we have reached was the week of 12/17 at an ATR of 38.06. However, when you adjust the ATR for current price, it reflects that this current 52-week ATR low is actually at a lower level than in 2011.

In 2011, when the lowest point of the 52-week ATR was reached, the $ES_F price was at 1341. If you simply divide the ATR by Price, you get 2.68%, meaning the average weekly range over the past 52 weeks was 2.68% of the current price (of 1341).

In 2012, when the lowest point of the 52-week ATR was reached, the $ES_F price was at 38.06, the $ES_F price was 1428. If you divide the 52-week ATR by Price, you get 2.66%, thus indicating we are at a lower level of volatility than we were in 2011. That may not be too surprising considering where the VIX is currently trading at. 

Also, in 2010, before the Death Cross occurred, the 13-week ATR stabilized before it rose sharply across the 52-week ATR. In 2011, as stated earlier, the 13-week ATR began trending higher as price traded within in a range. This occurred for roughly 5 months before the 13-week ATR lifted sharply as prices fell even faster. Now, in 2012/2013, the 13-week ATR has been trending higher since March 19, 2012 while prices have been rising. 

We are now going on nearly 10 months of a higher trending ATR with higher prices all while the 52-week ATR has been coming down, recently making the same low levels of 2011 AND a Death Cross recently occurring back in November 2012. 

It is no surprise that volatility is low. Implied volatility is at 5 year lows. Historical volatility (in its general measurement) is higher than implied volatility. However, using the ATR indicator and looking at multiple periods, we find that the movement in ATRs and the levels of the longer term, 52-week ATR, is very similar to that of previous times where major pullbacks occurred (in 2010 and 2011).

Options are cheap. As I stated in December, I believe that the best value out there is not in stocks or bonds or currencies or commodities or even real estate, but as an investor, right now I believe I can get the most "bang for my buck" by "owning" volatility, specifically volatility that is trading cheaper than the current S&P 500 volatility when beta weighed. That being said, I also believe I can get great(er) returns by being short beta. Those are my two primary strategies at the moment and will stick with them through 2013 until something radically changes my mind.

It's Sunday night and I'm open for business...