The Efficient Market Hypothesis (EMH) is not perfect, but it is useful. According to the EMH, market prices reflect all available information about the future. In other words, the stock price of Apple (AAPL) includes the best guesses of iPhone and iPad sales trends from millions of investors. Individually, any prediction is just as likely to be wrong as it is to be correct. Collectively, the predictions are often fairly accurate.
Available information can change suddenly, and that is why we often see large price changes when earnings are announced. If a company reports earnings that are better or worse than expected, the market needs to incorporate that information into the current price. As millions of traders make their best guess about what the new information means, we often see gaps on price charts showing their excitement or disappointment.
The EMH extends beyond stock markets and applies to commodities and financial futures as well. Changes in interest rates, for example, are seen when bond traders adapt their views to new information.
Bond prices move in the opposite direction of interest rates. This is because the interest payments investors receive on a bond are generally fixed. If a bond is paying $30 of interest per year on a $1,000 investment, that amount will remain constant over the life of the bond.
As interest rates change, for example if inflation rises and interest rates move up to compensate investors for that risk, the price of the bond will need to drop. The investor will still receive a payment of $30 a year, but if interest rates move higher the bond will need to trade with a lower price to entice investors to buy that bond instead of a newer bond that offers a higher payment.
If interest rates rise to 5%, an investor could receive $50 on a $1,000 investment in a newly issued bond, and the bond paying $30 would not be very attractive unless it was priced at $600 so that the $30 payment offered a similar 5% yield.
Interest rates have recently moved sharply higher and bond prices have fallen. Bond prices have now reached a point where they are attractive again according to my 26-week rate of change (ROC) trading system.
This system identifies the strongest ETFs to own at any time. It also includes some risk management rules to help us avoid bear markets. The system has been on the sidelines in the bond market as interest rates have moved up, thereby avoiding losses in bonds. Now the system says that the risks have declined and it's time to get back into the fixed-income market.
Falling interest rates are seen when the economy slows because there is less demand for financing in a slow economy. Traders buy bonds when they see a possible slowdown because they want to lock in higher interest rates while they are available. This buy signal indicates that the economy might not grow much for the rest of the year.
In particular, the 26-week ROC system says that iShares iBoxx High Yield Corporate Bond (HYG) is a buy. In signaling a buy, the system is putting us on the same side as the biggest bond traders who seem to believe that interest rates will be falling soon.
Bond traders have to report their positions to regulators every week, and the data is released in the Commitment of Traders (COT) report. To make the data easier to understand, I convert it to an index with 100 being bullish and 0 being bearish.
The chart below shows that commercials, the traders who know the market better than anyone (green line at the bottom of the chart), are bullish while small speculators, the traders who usually know the least about a market (red line), are bearish. In the past, this setup has produced profits for commercial traders, the ones who were long bonds.
The 26-week ROC system is saying that we should join commercials in the bond market. After HYG is added to the portfolio, it will hold four positions: