Daily State of the Markets

What’s The Message From The Market Math – Part II

Math Calculations - chalkboard

In what wound up being a truly meandering missive yesterday morning, we explored one of Wall Street's oldest clichés, "Don't fight the Fed." Today, we'll try to tighten the message up a bit and focus on another famous Wall Street-ism: "Don't fight the tape."

It is unclear whether it was Ned Davis or his friend, the late Marty Zweig that actually invented this dynamic duo of investing phrases. However, these two ideas, when used together, can help keep investors running with the bulls during good times and standing safely on the sidelines when the bears come to call at the corner of Broad and Wall.

The Plan: Get The Big Moves Right

As has been mentioned a time or twenty in this space, our investment decisions are guided neither by intellect or gut hunches. Instead we rely on models, indicators, and rules in our constant attempt to stay on the right side of the market's really important moves. Remember, if you can get the big moves right, the rest will likely take care of itself.

What we are attempting to do in this series is to present the current "state" of some of our favorite indicators. So, without any further meandering, let's begin.

The Tools: Trend Identification

One of the simplest ways to stay in tune with the big-picture cycles of the market is a little something called trend-following. Before you start booing and hissing about the idea of your valuable time being wasted with a discussion of something so simplistic as a moving average, let's agree on one thing: An indicator doesn't necessarily have to be fancy to work in this game. And if used properly, even something as simple as a moving average can help investors make hay while the sun shines.

In case the topic hasn't been covered lately, one of the keys to success in this business is to utilize a "weight of the evidence" approach. In simple terms, this means that instead of relying on any single signal or indicator, investors should put together a stable of their favorite indicators. You see, when the majority of the indicators are all singing the same song, there is a decent chance that you won't get fooled to any large degree.

So, while something as simple as the "golden cross" isn't necessarily the greatest timing vehicle invented (it can be downright late at times), staying long stocks when the 50-day moving average of the S&P 500 is above its 200-day moving average has been a pretty good idea. For example, since 1930, the S&P has gained at a rate of 9.10 percent per year when the 50-day has been above the 200-day. And the index has lost -1.1 percent when the 50-day has been below the 200-day.

In addition, this represents a very nice, long-term indication of the "state of the trend." Thus, if nothing else, one might want to check in on this indicator every once in a while to confirm which team is in control of the game. Currently this indicator is soundly bullish.

The Tools: Trend and Breadth Confirm

Now let's turn to something with a little spice to it. The next indicator we're going to check on is definitely shorter-term oriented and has a heck of a record. Since late 1980, the market has gained at a rate of more than 33 percent per year when the "trend and breadth confirm" indicator is positive and has lost ground at a rate of -24 percent when negative. So, is your attention piqued?

Here's how it works. Take a look each day at a 25-day simple moving average of the stock market. This is the "trend" part of the indicator. And then at the same time, look at a 5-day ma of a stock-only advance/decline line (the "breadth" part). Believe it or not, that's it.

When both the trend and the breadth indicators confirm a positive reading (i.e. both are above their respective ma's), the market has tended to roar higher. And when both "confirm" negatively (both are below their ma's), things tend to get ugly, sometimes very ugly.

Truth be told, this is one of our favorite indicators. It isn't great at "timing" entry and exit points, but it is a great indication of the state of the market's trend and momentum from a short-term perspective.

Currently, the "T&BC" indicator has flipped back to positive.

The Tools: The Industry Diffusion Index

Although trend-following and the use of moving averages may be scoffed at as being unsophisticated, there are some pretty cool uses of these indicators.

While neither standard deviations, Z-scores, nor risk-parity systems are not employed in this next indicator, it does seem to work pretty well. But fair warning, there is some work involved.

The concept is simple. The goal is to stay in tune with the "weight" of the trend evidence from each of the 104 industries that make up the S&P 500. And how do one do that? Moving averages, of course.

We start by plotting each sub-industry against a simple 50-day moving average. We then add up the number of sub-industries that are above their respective ma's. If that total is above 56.5, the environment is considered bullish and one should remain invested in stocks. And if the total number of sub-industries that are technically healthy is below 45.5, it indicates that the bears are large and in charge at the time.

This approach is technically referred to as a diffusion index, which certainly sounds fancy, right? However, as you will likely agree, the idea is pretty simple. And the returns of the approach are nothing to thumb your nose at as such a system would have gained 18.3 percent per year since 1980.

Currently, the industry diffusion index is positive, but the momentum has waned.

The Tools: Build a "Tape" Model

Finally, if you have access to a boatload of data and some pretty good-sized computers, you can build a combination of indicators that work well together – i.e. a model to provide the "weight of the evidence" for you.

The good folks at Ned Davis Research have done just that. By combining all kinds of trend and momentum indicators (including all the fancy stuff you'd expect from a quant shop), their Tape model can help investors stay in line with the state of the tape.

Over the past 32 years, the S&P 500 has gained ground at a rate of 19.7 percent per year (which is about double the buy-and-hold return) when the model was positive. And when the model has been negative, the S&P has lost ground at a rate of -16.4 percent per year.

So, while most investors probably don't have access to this type of high-powered modeling, it should be fairly clear that "fighting the tape" is probably a bad idea. Oh, and regular readers of this column know that we do have access to these types of models and we do tend to let everyone know when our favorite indicators flash a signal.

Currently, the Tape model is, wait for it… neutral. Interesting!

What's Next?

Next up, we will look at our models for the economy, sentiment, inflation, and valuation. It is our sincere hope that this type of analysis is useful to readers in their trading/investing.

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The Outlook for Economic Growth
      2. The State of Fed Policy
      3. The State of the Earnings Season

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Neutral
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Positive
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive
(Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Near-Term Support Zone(s) for S&P 500: 1820-1810
  • Near-Term Resistance Zone(s): 1850

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend – I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"…

  • Trend and Breadth Confirmation Indicator: Positive
  • Price Thrust Indicator: Positive
  • Volume Thrust Indicator: Positive
  • Breadth Thrust Indicator: Positive
  • Bull/Bear Volume Relationship: Moderately Positive
  • Technical Health of 100 Industry Groups: Neutral

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • Overbought/Oversold Condition: The S&P 500 is Moderately Overbought from a short-term perspective and is Overbought from an intermediate-term point of view.
  • Market Sentiment: Our primary sentiment model remains Negative .

 

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading: Moderately Positive

If you are looking for a disciplined, rules-based system to help guide your market exposure, check out The Daily Decision System.

Turning To This Morning…

The Fed minutes didn't really provide any impetus for market movement overnight but perhaps the start of earnings season will as AA kicks things off after the close today. Before that, we'll get weekly jobless claims to digest. So far, European bourses and U.S. futures are higher.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell…

Major Foreign Markets:
– Japan: -1.50%
– Hong Kong: -0.91%
– Shanghai: -0.80%
– London: +0.20%
– Germany: +0.29%
– France: +0.05%
– Italy: +1.37%
– Spain: +1.10%

Crude Oil Futures: +$0.51 to $92.84

Gold: +$3.00 to $1228.60

Dollar: lower against the yen, euro and pound

10-Year Bond Yield: Currently trading at 2.998%

Stock Futures Ahead of Open in U.S. (relative to fair value):
– S&P 500: +5.56
– Dow Jones Industrial Average: +61
– NASDAQ Composite: +11.61

Thought For The Day…

There's none so deaf as those who will not hear. -English Proverb

 

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
StateoftheMarkets.com

Positions in stocks mentioned: none

Forget the fast money and the latest, greatest option trade. What investors need is a strategy to keep them in the stock market during bull markets and on the sidelines (or short) during bear markets. The Daily Decision System Can Help

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

 


 

The opinions and forecasts expressed are those of David Moenning, founder of StateoftheMarkets.com and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of TopStockPortfolios and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided “as is” without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

The information contained in our websites and publications is provided by Ridge Publishing Co. Inc. (Ridge). One of the principals of Ridge, Mr. David Moenning, is also President and majority shareholder of Heritage Capital Management, Inc. (HCM) a Chicago-based money management firm. HCM is registered as an investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Ridge is a publisher and has not registered as an investment adviser. Neither HCM nor Ridge is registered as a broker-dealer.

Employees and affiliates of HCM and Ridge may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

About the Author

David Moenning is a the Chief Investment Officer at Heritage Capital Management. Dave is also the proprietor of StateoftheMarkets.com, which provides free and subscription-based portfolio services. Dave began his investment career in 1980 and has been an independent money manager since 1987. Thus, Dave has been live on the firing line and investing for a living for more than 25 years.