Wednesday, February 18, 2009

About My Indicators

I receive a lot of email questions regarding my "smart money" and "dumb money" indicators. In addition, folks also seem to be interested in the "next big thing" indicator, which I use to identify the potential for secular trend changes.

I appreciate the questions about and interest in my work, but at this time, I am not willing to share all the details on how these indicators are derived. The indicators are proprietary, and I would like to keep them that way for now.

While some readers may not like that, I can tell you that there is nothing ultra special regarding the indicators. For example, take the "dumb money" indicator, which looks at investor sentiment. The purpose of the indicator is to identify when investors are extreme in their market outlook - as in, investors are either too bearish or too bullish. The importance of such an indicator is obvious as most investors are wrong about the direction of the market, so why not develop a tool that seeks to exploit that knowledge. Determine which way investors are leaning, and go against them.

Like most most indicators that I have explored, my tools are no holy grail. There have been times (2002 and 2008), when the S&P500 had significant draw downs (> 10%) even though the "dumb money" was extremely bearish. In these instances, the indicator failed spectacularly. Remember, I don't have the holy grail here.

But what I do do well and what I believe most people don't do is determine through the back testing process how all these indicators work. Many people don't like back testing because the past doesn't always predict the future, and this is true especially in the markets. But I will always counter with the following: if you don't know what worked in the past, you definitely won't know what works in the future. You need to do the work. It is a learning process.

You need to look at many different market environments (i.e., bull and bear markets), and many different markets. Unfortunately, most analysts and commentators only look to the left of the chart and typically they stop at the left hand edge of the computer screen. I am often reminded of one prominent blogger who "called" a sell signal in gold based upon a MACD cross on a monthly chart. But if you looked at the every other prior MACD cross in gold and in US equities (on a monthly chart), a MACD sell signal was more likely a better buy signal for both gold and US equities. So why even bother with such a tool if it doesn't work? But the only way, to know if it doesn't work is to do the work.

So while I won't share with you the actual formula for my indicators, I will always share with you how these indicators perform. I use the indicators to define a market environment and from this information, we can determine an expected return over a certain period of time. As an example, for the last 3 months I have stated on numerous occasions (every week) that higher prices are unlikely with the "dumb money" being neutral and prices below their 40 week moving. Historically, with this set of conditions, this was the high odds "call".

I really don't think I have done anything special with the "smart money" and "dumb money" indicators. Their premise for their continued use is sound. To beat the market, you cannot be the market. Therefore, a contrary approach, in my opinion is best.

The "next big thing" indicator is interesting if only because of some of the innovations and insights that I have made in constructing the indicator. The indicator is completely technical in nature; there is no fundamental data (i.e., interest rates) in there. Like most of my indicators, it is a composite of several observations, and it works across multiple markets. The "next big thing" indicator is no holy grail, but its usefulness is identifying the potential for a secular trend change in a particular asset. Once an asset has been identified that it might undergo a secular trend change, I then use more "traditional" technical analysis (i.e., moving average crossovers) to enter and exit a market.

What are some of the technical innovations that go into the "next big thing" indicator? For starters, I count (or rather I program the computer to count) the number of positive divergences between price and an oscillator across a certain time period. Typically, a certain number of divergences are seen at major market bottoms as the downward trajectory of prices slows. Another innovation is my use of pivot points. I can count (or rather I program the computer to count) the number of pivot points (high and low ones) from a prior market top. These findings can be quantified for many markets and are fairly consistent. During a bear market, an asset will typically thrust downward and pivot upward a certain number of times before bottoming. This would be akin to the waves that an Elliot Wave technician might discuss.

Once again, I am appreciative of the emails and comments - good and bad. Just remember, there is no holy grail, and while my word should not be end all or be all to your market analysis, I will always do my best to present my data objectively.

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