#57 S2N: Markets don’t crash from overbought conditions, they crash from oversold conditions!

S2N Spotlight

I came across a Bank of America research piece today that caught my eye with its title. “Markets don’t crash from overbought conditions, they crash from oversold conditions!” It sounded like blasphemy to common wisdom, so I wanted to check it out and do my own research.

I really don’t know much about the Williams %R indicator; in fact, just this week I stumbled across it, so I guess that made me more attuned to wanting to know more. I started doing

The Williams %R, also known as Williams Percent Range, is a type of momentum indicator that is used to identify overbought and oversold levels in the price of an asset. It was developed by Larry Williams, a prominent trader and author. The Williams %R is similar to the stochastic oscillator but is plotted on an inverted scale.

Ok so here is the deal I quickly prototyped it by coding it in Amibroker, as Friday is always a rush for me with the Sabbath. I prefer presenting it in the newsletter and on the site by coding it in Python, but I ran out of time.

Backtest Report

I used monthly S&P 500 data going back to 1930. The parameter setting for the Williams %R indicator was a lookback window of 28 months, not the default 14.

In a nutshell, the strategy has been profitable for nearly 100 years and outperforms on the buy and hold of the SP500 on a risk-adjusted basis. It has traded 63 times over this period and was in the market for 53% of the time. The SP500 is currently valued in its top decile, making its valuation in the 90th percentile when looking at a PE ratio of 21.4. I think this indicator can be enhanced by bringing in some valuation component, which I will try to do early next week.

S2N Observations

I mentioned that the SP500 is overbought and over valued above. I think there are better opportunities investing in other markets. I mentioned the Hang Seng some time ago and think this is a market with better opportunities. I will post some more on this idea next week.

Japan Curves

I was looking today at the yen’s forward curve going out 10 years and couldn’t believe that the market is pricing the yen over 10 years with a 155 handle. If you look at how the yen has behaved in the last week, it touched 160 and then 152 in the space of a few days. How do you price a curve for 10 years at 155?

At least when I look at the Japanese yield curve, there is a little bit more variability in the pricing. I suspect there is some good money to be made trading the yen over the longer term. This means the yen should weaken.

While on the subject of the yields, I think this is a pretty cool visualisation. What I have done is take all the components of the yield curve and plotted them together. So 1M means this is the shortest part of the curve at 1 month and the 30YR the longest at 30 years. What you can see is that there has been a very strong secular trend since the 1980’s of interest rates trending down. With that secular trend, you can see there were plenty of cyclical cycles. Its these shorter cycles of the interest rate cycle that have made the Fed FOMC policy meetings into a circus, and its Chairman the ringmaster.

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