4 Factor Trend Reversal Indicator Sees a Bear

Technical vs Marco and Fundamentals:

Macro analysis is helpful, but not able to determine turning points in markets. There are so many things an investor might consider that it is beyond human capacity to know which are most important and how they interact.

Fundamentals and valuation are better, but stocks can remain undervalued or overvalued for long periods of time.

To get closer to the actual event of a major market trend reversal, you need to use the calculator that rolls everything and everybody’s opinion into single factor.  That factor is the market itself.  The price and volume action of the stock market is the end-point resolution of all the facts, all the investors, and all of their money.

Sometimes the market acts so suddenly and dramatically that there is no warning (e.g. a flash crash), but most of the time there is a discernible build-up of evidence one way or the other that gives investors time to make adjustments if that is what they are inclined to do.

Unfortunately, what works shifts over time, so continued retesting of indicators is essential, but measurement of price and volume action is “where it’s at”.

Fundamentals are great for security selection, but not for gauging market trends.  Fundamentals and technical (chart) analysis are two separate but important parts of portfolio management.

Find a Method and Stick To It, But Adapt Method Over Time:

One key to using chart (“technical”) indicators is to find ones that work pretty well most of the time (none work all of the time), and to find ones that are not redundant to confirm one another.

Here is a method we are using at this time — noting that it didn’t work all that well in the 1980 through 1995 period as it has in the 1995 through 2014 period.  For 2015, we think a continuation of the utility of the 1995 through 2014 pattern of behavior is more likely than the 1980 through 1995 period.

The indicator we use is a combination of 4 factors:

  1. the price position above or below the 12-month moving average
  2. the up or down direction of the most recent month moving average versus the previous month
  3. the 3-month moving average of the 12-month money flow index above or below 50 (on its 0-100 scale)
  4. the price position above or below the slow parabolic stop & reverse indicator.

The first two factors (price position relative to moving average and moving average leading edge direction) are necessary conditions for confirmation  of a trend reversal.  The second two factors (money flow index and stop & reverse index are used to provide confirmation or non-confirmation of the first two indicators triggering an alert).

Importantly, money flow and stop & reverse are essentially non-overlapping among themselves, and non-overlapping with the first two indicators. That is critical to make multiple factors useful.

Money flow index provides a volume dimension to the data. Parabolic stop & reverse provides a time element to the data.

Back Testing:

When all 4 are negative a major top occurred in 2000 and in at the rough boundary of 2007-2008.

In 1981 and 1987, the indicator resulted in a late exit.  We can write-off 1987 to a flash crash type of event, but in 1981 it just did not work.

In a number of other periods, the absence of all four would have kept you in the market when a nervous belly might have resulted in exiting, and subsequently experiencing a whipsaw that left money on the table.

Our Own Failing:

We must admit that in the 2011 European debt crisis, we feared a repeat of 2008 and allowed our judgment about the macro scene attempt to front-run the indicators.  That turned out to be a mistake.  There was no Bear market, and we had opportunity loss (read that underperformance) by the time we re-entered.

Conditions Today:

Today we find ourselves in a Correction that may become a Bear.

Our 4 factor indicator is at 25 (0-100 scale) based on 3 of 4 factors negative.  Only money flow index is positive and it is weakening.

Breadth indicators are negative, but they yield curve is positive, and we think there is a triple top and head & shoulders pattern leaning toward the last leg probably falling into place for a Bear.

Our 4 factor indicator can show values of 0, 25, 50, 75 and 100.  It could be used as a purely binary 100 or 0 long/short, or enter/exit tool — or it could be used for some sort or staged entry or exit.

We have been guided by this (supported by breadth and some other factors) to partially phase out of stocks over recent periods.  As a result, we have not experienced the full impact of this correction on our stocks allocation, which is partially in cash.

Close-Up Of Past Periods:

Figure 1 plots the leading S&P 500 ETF (SPY) from 1980 through 1985, along with the data for our 4 factors.

It has a pink dot over each of the factors when they are negative, and a green dot over the factors when there are positive, when at least 2 of 4 are either flashing agreement as negative or positive. Our thinking is that when only 1 or 2 are either positive or negative, there is no consensus, but when 3 agree we must take strong note, and when 4 agree a trend reversal is confirmed.

FIGURE 1:

spy tech 1a

It didn’t work that time. The exit was late, due to a precipitous price drop and the re-entry was late due to a more gradual recovery. The exit was around $7.50 and the re-entry was around$ 8.75.  Opportunity was lost, but there was an unquantifiable avoidance of a potential major loss.

If only the price position versus the average and the direction of the last month of the average were used re-entry would have been around $7.75

In 1984 there were 2 factors that went negative, but it didn’t go further — no trend change.

Figure 2 plots 1987 through 1992.

During the October 1987 one-day crash, all 4 factors were triggered, but there was no build-up time.  If an investor did follow the method then, they would have exited (or shorted) at $16+.  If they used the indicator for re-entry, they would have stayed out of the market for about 1.5 years and re-entered around $20+, leaving a lot on the table.

If they had used only the price position versus the moving average and the direction of the leading edge of the moving average, they would have been out 9-10 months and re-entered at around $17+.

In 1990, there was a market decline that triggered only 3 of 4 factors, which if followed, prevented an exit and avoided a whipsaw.

FIGURE 2:

spy tech 2a

Figure 3 plots the period 1993 through 1998.  Because there were no instances of the moving average leading edge turning down, there were no trend direction change alerts.

FIGURE 3:

spy tech 3a

Figure 4 plots the period 1999 through 2005.  Here the method did very well.  It alerted for an exit in late 2000 around $100, and alerted for re-entry in 2003 at around $76 — with more than 2 years of freedom from the stresses other experienced watching the broad indexes decline.

FIGURE 4:

spy tech 4a

Figure 5 plots the period 2007 through 2010.  The method alerted for an exit at the end of 2007 at around $115.  It “prevented” participation (by virtue of no signal) in the head fake rally in early 2008.  It alerted for re-entry in late 2009 at around $99.

Clearly, some brave souls, with guts, luck or a good short-term system may have re-entered earlier in 2009, and made a pot-full more money, but they also risked a further catastrophic loss.  To each his own.

We prefer longer-term indicators when it comes to trends, because we think in terms of long-term trends, and don’t prefer to in and out a lot.

FIGURE 5:

spy tech 5a

Figure 6 plots from 2010 through August 2015.  We are in a 3 of 4 alert as of the end of August. The money flow index is the missing factor, which is declining, but not yet below 50.

As you will see in Figure 8 below, the weekly indicator for money flow is now alerting to the downside, so we expect when we do the September monthly indicator, there will be a 4 of 4 exit alert.

We impatiently try to look ahead between monthly data, by tracking weekly data too.  That data is noisy however, and much more prone to whipsaw.

We have been phasing out based on a combination of monthly and weekly data.  While some of our clients for different reasons chose not to tactically allocate between stocks and cash, those who chose to do so are between 50% and 100% in cash within their normal stock allocating amount.  I am personally at the 75% level.

FIGURE 6:

spy tech 6b

Figure 7 shows how we use binary alerts about each factor and the combined factors to avoid the tedium and visual judgements required to analyze the charts the way we did above for illustrative purposes.

Our signals actually look like this, where the 4 factors are binary zero or one; and the combined factors are rated zero to 100 in increments of 25; where 100 is a major trend reversal to UP alert, and 0 is major trend reversal to DOWN alert.

This monthly calculation shows the combined factors at 25 (almost a confirmed major trend reversal), with only the money flow index failing to confirm.

FIGURE 7:

SPYmoFactors

Like you might expect, when the monthly data gets close to a full confirmation (a 75 or a 25), we really want to try to look ahead, so we peak at the weekly data.

We are only 3 market days from the next monthly plot which we believe will be a confirmed major trend reversal to DOWN, based on the weekly data for the same factors shown in Figure 8.

FIGURE 8:

SPYwkFactors

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