Gold has been falling for 18 months now and shows no signs of reaching a bottom. Stock market volatility fell to extraordinary lows by one measure. Look for more of the same in both markets – downside moves in gold and a trading range in stocks.
Volatility Signals a Small Trading Range Ahead
Stocks entered last week oversold and continued to sell off on Monday and Tuesday morning. After rallying 2.2% from Tuesday's low, SPDR S&P 500 (SPY) ended the week with a gain of 0.14%, reversing a loss of the exact same amount the week before. SPY has now closed at exactly $152.11 in two of the last three weeks. With small moves of 0.14% for two straight weeks, February ended as one of the least volatile months in stock market history.
The CBOE Volatility Index (VIX) is widely used to measure volatility and VIX is significantly below its long-term average values. The chart below, compressed to show the entire trading history of SPY, uses a different volatility indicator, the monthly average true range (ATR). ATR measures the distance from high to low (accounting for gaps) in a time period. The chart shows the value of the ATR divided by the closing price, expressing the trading range as a percent of the current price. This calculation makes indicator values comparable over time. Last month, this indicator fell to 3%.
This the 10th time this indicator has fallen to 3% since SPY began trading 240 months ago. In the past, these signals have been followed by a directionless market. One month after previous signals, SPY was higher five times and lower four times. The average market move in the month after the signal has been 0.3%, less than half the average move of 0.61% seen in all months.
We may be in for an extended period of low volatility using the history of the monthly ATR as a guide. Six months after these signals, SPY has been up 100% of the time one year after the signal. The average 12-month gain has been 3.51% after the signal compared with an average one-year gain of 6.89% seen in the SPY over the past 20 years.
Based on the ATR, look for SPY to churn near current levels for the next few months. Stocks seem unlikely to make a big move unless unexpected news causes panic selling. Traders should look at individual stocks for the best opportunities. Even in a low volatility market, there will always be some stocks with high volatility capable of delivering strong gains.
Traders also should consider more volatile indexes for significant moves. With volatile indexes, selectivity is important. PowerShares QQQ (QQQ), an ETF that tracks the 100 largest Nasdaq stocks, gained 0.35% last week. First Trust NASDAQ-100 Equal Weight Index (QQEW), isn't weighted down by Apple (AAPL) and was up significantly more, adding 1.04%. Until AAPL stops falling, QQEW is the better choice.
Recommended Trade Setup:
-- Stopped out of SPY at $149.50
-- Buy SPY on a breakout above $155
-- Sell SPY short on a break below $145
Gold Has Been Falling for 18 Months
Investors finally seem to be giving up on gold. Last week, the price of SPDR Gold Trust (GLD) fell 0.35% while assets in the ETF fell another 1.74%. There is now $63.8 billion invested in GLD, the lowest amount since last July, and anyone who bought GLD since then is most likely showing a loss.
Gold, at this point, is in a bear market. No precise definition of a bear market exists, but it is widely believed to be a decline of 20% or more. Although the price of gold is only 18% below its all-time high, gold prices have been falling for 18 months.
The typical definition of a bear market ignores time, which should be a consideration. For the stock market, Ned Davis Research has defined a bear market in terms of price and time: "A bear market requires a 30% drop in the Dow Jones Industrial Average after 50 calendar days or 13% decline after 145 calendar days."
This definition recognizes that a slow downtrend is just as devastating to wealth as a sharp decline, but the grinding decline can be harder to see. GLD fits the second category of bear market, one where a significant decline over an extended period of time has occurred.
GLD is now below its 10-month moving average and momentum indicators continue to point to additional declines. There is no reason that I can see on the charts to buy gold now.
In the precious metals market, it seems that a short position is still the best trade. PowerShares DB Gold Short ETN (DGZ), an inverse fund that goes up when gold prices fall, gained 0.16% last week and remains a hold.
Recommended Trade Setup:
-- Buy DGZ on dips below $12.25
-- Maintain stop-loss at $11.75
-- Maintain price target at $14
This Week's News
Earnings season is winding down. There are still a few reports scheduled for the first full week of March, but we have enough data to say that the trend was positive with about 61% of companies beating analysts' estimates, a number that is about average.
If companies can continue beating estimates at this pace, stocks are not overvalued and could continue moving higher. The current price-to-earnings (P/E) ratio on the S&P 500 is 13.6 based on estimated earnings for 2013, slightly below the long-term average of 15.
Without earnings to focus on, traders will be closely watching the unemployment report on Friday. Expect a volatile day no matter what the numbers are.