October 25th, 2011

A Bull Market Signal?

Mark Hulbert, in today’s Wall Street Journal’s Marketwatch blog asked the provocative question: “Did Monday’s strong market action satisfy one of the official definitions of a bull market?” His answer was “Believe it or not, the answer is yes — at least for some market indexes and some definitions. Which is remarkable, given that just three weeks ago another market index satisfied another of the official definitions of a bear market.”

The signal to which he referred was the Index crossing above the 200-dma. He writes further that “crossing the 200-day moving average is not the only definition that analysts use to determine a shift in the market’s major trend. Still, this trend-following indicator has a respectable record at anticipating shifts in the market’s major trend.”

In my market timing studies I’ve found that:

  1. market timing is a too imprecise practice to be binary (all-cash or all-in, bear or bull, yes or no) and
  2. a combination of indicators is more effective for market timing than any single indicator alone.

For example, in developing my Market Security Meter based on nearly 50 years of market data, I found that (as quoted from my upcoming book, Run with the Herd):

“….a neutral, unmanaged buy-and-hold strategy delivered $17,022, or a compounded average annual return of 6.20% over the test period between March 12, 1963 and December 31, 2009. Applying the 200-dma market timing rule to that same hypothetical portfolio over the 46-year period improved the results marginally and delivered an ending portfolio of $21,938, or 6.62% compounded average return before considering taxes, interest and transaction costs.

Selling when the Index crosses below the 200-dma is a simple rule that marginally improves total long-term results but it has disadvantages. For one thing, it works best in secular, or long-term, bull markets as contrasted with markets that have shorter-term (2-3 year) fluctuations like the period between 2000 and 2010. Over the 45 years in the database, the indicator suggested all-cash positions 33.4% of the all trading days….

The strategy produces a marginal improvement but not one that would have made you rich. You would have avoided some losses and wound up with a $4,748 higher ending balance. “

The problem with the indicator is that it over-prescribes an “all-cash” positions, periods when investors who follow the rule are out of the market when they should actually have been fully invested.

The problem can be remedied by combining the 200-dma rule with another common indicator and moving into an all-cash position only when both selling rules simultaneously proscribe an all-cash, risk-off posture. Only when the signal of one of the rules confirms the other should you actually assume the worst.

I combine the different configurations of these two indicators (plus some minor tweaking for instances that fall between them) into what I call a Market Security Meter:

The Index crossing above the 200-dma did actually change the color of the signal from Red but it surely didn’t cause the light to turn Green.

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