What's The Message From The Market Math - Part II

In what wound up being a truly meandering missive Wednesday 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 of itself.

See also: What's The Message From The Market Math - Part 1

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?

See also: What do the Cycles Says About January 2014?

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.

See also: 13 Things Investors Learned in 2013

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.

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