Tuesday, June 1, 2010

This Will Drive You Crazy

This article will no doubt drive crazy those investors who are always looking for that guarantee that everything in the markets is nice, neat and clear cut.

Over the past year, I went through the process of developing trading strategy. We used the 40 week moving average and combined this simple moving average with the indicator that assesses the trends in crude oil, gold, and yields on the 10 year Treasury bond. This strategy, which easily beat buy and hold with substantially less draw down, has given a sell signal as of last week's close.

Figure 1 is a weekly chart of the S&P500 with the indicator below. The buy and sell signals from this strategy are generated on the chart.

Figure 1. S&P500/ weekly

Why should this sell signal drive the seekers of the holy grail crazy? Because it is at odds with the extremes in bearish sentiment, which I believe is a "fat pitch".

So am I talking out of both sides of my mouth? The answer is no. With regards to bearish investor sentiment this is clearly a bull signal. Why? Because IF the market turns higher gains can be accelerated. Remember that is a big "IF" here. But from this perspective (where the only choice I have is when I put my money to work as opposed to controlling the direction of the market), I would rather put my money to work when no one "loves" the market.

On the other hand, the current sell signal from the strategy is just that a sell signal. Prices on the S&P500 have closed below the 40 week moving average for two consecutive weeks, and this is a sell signal. This is a fact. But in reality, this is a trend following strategy (with a filter applied), and we know that trend following strategies tend to generate buy and sell signals that lag the market. Why? Because they use moving averages. Furthermore, it is not unusual for investor sentiment to turn bearish (i.e., bull signal) when this strategy gives a sell signal.

For the record and what may be useful for some readers, the next buy signal from this strategy will be on a weekly close above the 40 week moving average. {Please note, I am not stating that this will happen; I would like it to happen, but it hasn't happened.}

So there you have it. I know for investors who are looking for that "certain thing" this does not help. On the other hand, if you have an understanding of how and why certain concepts or strategies work in the markets, this should make perfect sense.


ryanmburke19 said...


I admire your intellectual honesty and willingness to post all available facts--not just those in line with your views/positions. That might be too nuanced for some, but I for one appreciate it (and that is why I follow you). I am not looking for a cheerleader. I took a long SPY position yesterday based upon the notion that there is a distinct possibility that the markets could have a strong rally either to marginal (divergent) new highs ala the Oct 07 highs or to form a right shoulder. But I agree that there is also a very real risk that the veracity of recent selling indicates that there is something quite wrong with the market. But thats what tight stops are for.


Guy M. Lerner said...

Ryan: thank you!!

You just never now with the markets

All this stuff I present and others as well are just sign posts -- a way to function in a hostile environment