Trend Indicators

I use two market indices and two time frames to determine overall direction and strength of the U.S. stock market. The Russell 3000 index is cap-weighted index that represents the largest 3000 companies in the U.S. It tracks very closely to the S&P500 index. The Value Line Arithmetic Index is an equal weighted index of approximately 1,650 stocks. The VLA provides an estimate of how an equal-dollar weighted portfolio of stocks will perform. Using a combination of both indices, I can get a pretty good idea of the trend the U.S. equity market.

I use a 200 day moving average as a benchmark to measure the long term direction of the market. Although my model was designed to indicate intermediate term risk, I’ve learned it’s a good idea to use a longer periods to provide macro context and weight to shorter term indicators. The 75 day moving average is a reasonable measure of the intermediate term direction of the market. It serves as the early warning that a trend change may be in the making.

The score of each trend indicator is determined by the daily close of the index and the five day moving average compared to its benchmark moving average. The five day smoothing minimizes whipsaws that can produce jarring changes model scores.

Each trend indicator can produce one or three possible scores: +1, -1, or zero. Below is an example of how I score each trend indicator.

+1 = close and 5 dma > 200 dma
0 = close > 200 dma, 5 dma < 200 dma
0 = close < 200 dma, 5 dma > 200 dma
-1 = close and 5 dma < 200 dma

My Timing Model

My timing model is composed of 8 indicators; 4 trend indicators and 4 sentiment indicators. The concept behind the model is quite simple – the trend indicators quantify the direction of the U.S. equity market and the sentiment indicators provide a counter-balance when markets reach extremes and begin to reverse. I designed my model intentionally to generate yin/yang messages – using two opposing but complementary factors - trend and sentiment.

The eight indicators are:

1. Russell 3000 Index vs. its 200 day moving average
2. Value Line Arithmetic Index vs. its 200 day moving average
3. Russell 3000 Index vs. the 75 day moving average
4. Value Line Arithmetic Index vs. its 75 day moving average
5. Buy/Sell Confidence Model (via Sentimentrader.com)
6. Advisor and Investor Sentiment Model (via Sentimentrader.com)
7. Composite Model (via Sentimentrader.com)
8. Intermediate Term Indicator Score (via Sentimentrader.com)

Each indicator can log a maximum (bullish) score of +1, or a minimum (bearish) score of -1. Theoretically, the model can oscillate between +8 to -8, although +5.5 and -4.5 are the best and worst readings I have ever seen.

Here is how I translate model scores into percent long equity allocations.

2.5 = 100%
2.0 = 90%
1.5= 80%
1.0 = 70%
0.5 = 60%
0.0 = 50%
-0.5 = 40%
-1.0 = 30%
-1.5 = 20%
-2.0 = 10%
-2.5 = 0%

My Introduction to Timing Models

I was first introduced to the concept of market timing models in the mid-1980’s after a co-worker regularly brought me Martin Zweig newsletters to read. Eventually I picked up Zweig’s book Winning on Wall Street in which he introduced his readers to a simple model that included both monetary and tape indicators. I was immediately hooked by his scientific approach and saw models as a logical way to gauge market prospects. Most newsletters of the time were full of hype, speculation and subjectivity.

Eventually I went on to read classics like Norman Fosback’s Stock Market Logic and kept clippings on anything concerning market indicators. Keep in mind this was an era before most folks had home PCs, let alone internet access – Barron’s and newsprint was as good as it got.

I soon understood market indicators fell into one of four categories:
Tape – trend, breadth, and momentum (velocity) indicators
Monetary – interest rates, liquidity, and economic factors that influence liquidity
Sentiment – surveys, asset flows, P/C ratios, volatility measures, etc.
Valuation – P/E ratio, Bond/S&P dividend ratio, etc. (Ned Davis would say valuation measures are basically the same as sentiment)

I also spent many years investigating technical analysis tools and techniques, but came to the conclusion that most practitioners where either fooling themselves or others. This isn’t to say I didn’t see value in using technical indicators, but saw TA primarily as a way to reduce drawdowns, not as a means to achieve outsized profits. The folks I read about that really excelled at “TA” are traders like Linda Bradford Raschke – who have essentially developed a keen awareness of subtle anomalies that can arbitraged. They aren’t chart readers or people who developed complex timing systems.

I was also a big fan of Gerald Appel, the author of the old Systems and Forecasts newsletter and inventor of MACD. After reading one of his books (I believe it was called Stock Market Trading Systems) I thought he was a genius. As the years went by I began to realize the methods outlined in his book were more of an exercise in data-mining and curve fitting than a system that could hold up over a long haul.

Back to indicator categories: Although I believe monetary and valuation indicators provide great value in ascertaining market risk, they provide more value to investors who have an orientation to typical bull/bear cycles of 3-4 years. The most recent occurrence of the inverted yield curve is a great example. How many months has the market produced excellent returns when this proven indicator signaled caution? Most investors lose faith in indicators that take many months before they fulfill on their message.

My orientation is intermediate term (typically 6-8 month cycles). Using this timeframe, tape and sentiment indicators provide the most value. In my next post I’ll try to outline the components of my timing model and the underlying rationale.

Buy/Sell Confidence Model

The chart above is a screen grab of Jason Goefert's Buy/Sell Confidence Model (aka Smart/Dumb Money Confidence Model) 2001-2006. This is one of the few models that Goefert doesn't disclose his data sources, but my guess is he is using Rydex/Proshares Fund Asset Flows of index funds and/or CBOE Commitment of Traders data for stock index futures.

I added the red and green bands in Photoshop to more easily visualize the model's behavior in relation to the S&P 500. The dark green bands indicate periods where the model was oversold, the dark red bands indicate periods of over-optimism. The lighter bands indicate periods one month after the model reversed course from an extreme level.

This chart is highly instructive of how most sentiment indicators behave.

1. Market indexes can continue to rise/fall after models reach extreme levels
2. Model reversals are a more reliable indicator of a market reversal
3. Sentiment models do not always reach extreme levels at market tops/bottoms. They aren't closed buy/sell timing models in and of themselves.

I use sentiment models/indicators to counter simple trend indicators. If you've ever experimented with technical indicators such as moving averages you'll know trend indicators are always wrong at both peaks and troughs. By balancing trend indicators with sentiment indicators you can create a timing model that is "less wrong" at key turning points. For example, instead of being 100% in cash at a market bottom, your combo model might suggest you only be 70% to 80% in cash.

I'm not looking for perfection here. You can see that although this model is a great tool, it isn't perfect...and it certainly cannot predict market prices. The purpose of a timing model imho is to reduce portfolio volatility, not to deliver outsized gains. If it ends up doing the later, great...consider it icing on the cake.

Week of 11-25-2007

Timing Model = -1.0
30% long, 70% cash


Global Allocation of long positions

MSCI EAFE Index 30%
MCCI Emerging Markets Index 30%
Russell 3000 Index - U.S. 40%


Top U.S. Sectors

U.S. Health Care 4.5
Precious Metals 3.5
U.S. Technology 3.5
U.S. Oil & Gas 3.5
U.S. Semiconductor 3.0
U.S. Utilities 2.5
U.S. Consumer Goods 2.5
U.S. Biotechnology 2.5
U.S. Basic Materials 2.5
Composite Internet 2.5


Top Intl ETFs

S&P Latin America 40 Index Fund 3
MSCI Brazil Index Fund 3
FTSE/Xinhua China 25 Index Fund 3
MSCI Emerging Markets Index Fund 3
MSCI Pacific ex-Japan Index Fund 3
MSCI Hong Kong Index Fund 3
MSCI Australia Index Fund 3
MSCI Spain Index Fund 3


Strategy 3

EAFE 16.7%
Emerging Markets 16.7%
Money Market 16.7%
Industrial Materials 16.7%
Agriculture 16.7%
Precious Metals 16.7%
U.S. Large Cap 0.0%
U.S. Small Cap 0.0%
U.S. Long Bonds 0.0%
U.S. REITs 0.0%

Purpose of this blog

Roger Nusbaum who blogs at Random Roger's Big Picture had graciously allowed me to post my tactically asset allocation strategy weekly status on his blog for over a year. Roger is an professional investment advisor and as such needs to tread cautiously - apparently his compliance group has advised him to remove any comments on his blog that reference position percentages. As a result, I will post them here for any readers who are interested. If you expect anything more than a weekly post you will be sorely disappointed.

DISCLAIMER: I am not a professional investment advisor and nothing on this blog should ever be interpreted as a recommendation or advice.