Bond Market Correction Ahead

09/09/11 09:20:09 AM

by Alan R. Northam

Long-term statistical analysis shows that the bond market will continue higher, but shorter-term analysis shows a correction straight ahead.

Security: TLT
Position: N/A

Now that we have established that the iShares 20+ Year Treasury ETF (TLT) has entered into a long-term bull market trend (see my article "Bond Bull Market Begins," published 8/19/11), it is time to manage the trend. The first thing that we must keep in mind is that the long-term bull market will continue until proven otherwise. Thus, any downward selloffs are to be considered corrective.

Figure 1 shows the daily price bars plotted in the lower panel along with the 200-day linear regression trendline, the upper and lower one sigma channel lines, the upper and lower two sigma channel lines, and the upper three sigma channel line. The lower three sigma channel line is not plotted. Note that as price started to approach the upper two sigma channel line, it backed off to the upper one sigma channel line. On a second rally, price touched the two sigma channel lines before backing off once again to the upper one sigma channel line. Finally on a third rally, price broke above the upper two sigma channel line but immediately fell back below it.

These three failed attempts to rally above the upper two sigma channel line are good illustrations showing that the upper two sigma channel line acts as resistance while the upper one sigma channel line acts as support.

FIGURE 1: TLT, DAILY. This chart shows the daily price chart of the iShares 20+ Year Treasury ETF (TLT) in the lower panel along with its 200-day linear regression trendline and its upper and lower channel lines. The top panel shows the linear regression slope indicator followed by the R-squared indicator.

Graphic provided by: MetaStock.

Looking at the linear regression slope indicator in the top panel of Figure 1, note that it continues to point upward. This is an indication of price acceleration in the upward direction informing us that the long-term upward rally will continue.

Looking at the R-squared indicator, note that this indicator continues to move upward and is now approaching 0.5. This indicator measures the strength of the trend. Normally, this indicator moves above 0.7 before warning that the long-term uptrend is entering into its topping phase. Thus, this indicator suggests that the long-term uptrend still has room to rally higher.

As a result of the long-term statistical analysis, we should expect TLT to continue higher. However, we should also not be so naive as to realize that price has moved significantly away from its linear regression trendline and that price will eventually regress to the trendline.

To get an idea as to when we should expect TLT to regress toward the 200-day linear regression trendline, we look at the next shorter time frame. Figure 2 shows the daily price bars of TLT along with its 50-day linear regression line and associated upper and lower one sigma channel lines. As long as price continues to rally up within these channel lines, TLT will continue to move upward. Note that the 50-day linear regression slope indicator in the top panel continues to point higher. This is an indication of price acceleration.

As long as this indicator continues to point upward, we can expect price to continue higher. However, when this indicator turns lower, it will signal that an intermediate-term price correction is at hand that could see price fall back down to the 200-day linear regression trendline (see Figure 1) or even the 200-day linear regression lower one sigma channel line.

FIGURE 2: TLT, DAILY. This chart shows the daily price chart of the iShares 20+ Year Treasury ETF (TLT) in the lower panel along with its 50-day linear regression trendline and its upper and lower one sigma channel lines. The top panel shows the linear regression slope indicator followed by the R-squared indicator.

Graphic provided by: MetaStock.

Looking at the R-squared indicator in Figure 2, note that it is now above 0.7. This is an indication of an exceptionally strong intermediate-term upward rally.

The problem with strong rallies is that they don't last very long. Why? Because all traders who want to be in this rally are already in the rally, and there is no new money to continue to fuel this market higher over this time frame. The result is that once the R-squared indicator moves above 0.7, the rally becomes vulnerable for a correction. Thus, we should now be on guard for the R-squared indicator and the slope indicator to start to turn downward. This will be our first warning that price is ready to move back down toward the 200-day linear regression trendline.

In conclusion, the long-term trend still has considerable room to continue to rally higher. However, over the shorter-term time frame, the rally in TLT has become exceptionally strong and vulnerable for a correction back toward the 200-day linear regression trendline. Once this correction is completed, the long-term upward rally will continue.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

	Garland, Tx
Website:	www.tradersclassroom.com
E-mail address:	inquiry@tradersclassroom.com

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Bond Market Correction Ahead

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