Things That Do Work These Days

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Publishing Note: I am Traveling Monday-Thursday this week. Daily State of the Markets reports will be published as my schedule permits.

Good morning. In Monday's report, we concluded that due to things like the move to decimalization, the elimination of the uptick rule, program-trading, sophisticated hedging strategies using futures, the evolution and proliferation of ETF's, and HFT (high frequency trading), the market simply does not "trend" as well as it once did on a daily basis. However, I did promise to present a couple ideas that actually do work in helping investors actively manage the risks of the stock market and that are also easy enough for the average investor to use on their own. So, let's get to it.

Given that the daily volatility in the market has clearly increased over the past few years, it has become more difficult to easily quantify the current trend of the overall market. As such, the key is to find a way to step back from the intraday "noise" in order to identify the overriding trend of the stock market.

One VERY simple way to do this is to "eyeball it" using a chart of the S&P 500. While you will likely laugh at the idea, stand up and step away from your computer screen. Now squint your eyes and try to blur the daily bars on the chart. Funny yes, but it is effective. Next, you can switch from bars or candles on your charts to closing prices only. Another is to remove price from your chart altogether and look at the direction of various moving averages (I like to do this with the 5-, 10-, 18-, 25-, and 50-day weighted moving averages that have been moved forward two periods). Still another is to stop looking at daily charts and focus on the action of weekly and/or monthly charts.

In my work, I have three screens dedicated to charts of the stock market at all times. I look at a one-minute chart over a one day period to help me identify when program trades kick in. Next is a 30-minute chart using a modified SAR system that helps me identify key trends and levels over a two week period. Then there is the traditional daily chart with the ma's and other indicators. And finally there are my weekly and monthly charts, which I've been using more and more over the past couple of years. The bottom line is if you want to know what the real trend of the market is, look at a weekly or monthly chart.

Let's get back to the task at hand - identifying things that do work these days to help manage the risk of the stock market. The first idea I'd like to present is simple but effective in keeping investors in tune with the primary (i.e. long-term) trend of the market. We start with a simple 200-day moving average on the SPY. But instead of looking at price crossing above or below the ma, we simply note the direction of the moving average itself. When the ma is moving up, you stay long. But when it begins to move down (by any amount), you sell to cash. Easy enough, right?

According to Sarasota Capital's Ian Naismith, the results aren't too bad. From the inception of the SPY (in mid-1993) through 9/30, implementing such an approach would have produced a return of +226%, which has easily outpaced the buy-and-hold gain of +157%. The system would have kept you in the market during the big runs and would have allowed you to miss some of the nastiness seen during severe declines.

Next up is a media darling that, unlike the much ballyhooed crossings of the 200-day moving average, actually works: The Golden Cross. Mr. Naismith reports that buying and selling when the 50-day simple moving average of the SPY itself crosses the 200-day ma produces decent results. Ian says that using the approach on the SPY since inception would have produced cumulative gains of +302%, which is nearly double the buy-and-hope approach. Not bad, eh? The beauty here is that both ma's are readily available and free.

Before we get to what today's market looks like let's examine one more simplistic active risk management idea this morning. The beauty of this next system is that you only have to look at a chart once a month. While my monthly system is a little tougher to implement than the previous two ideas, it is also more effective. We start with a monthly chart of the S&P 500. We then add a smoothing to the chart which will act as our trade trigger. Specifically, we add in a 15-month weighted moving average that is moved forward two periods.

Since 1995, the S&P 500 index (price only - no dividends reinvested) is up +175.19% through Friday's close. Our semi-active system for managing risk involves buying the S&P 500 when the index is above our 15-month smoothing and then shorting the S&P 500 index when the index is below the smoothing. The bottom line is the system would have produced a return (before commissions, fees, slippage, etc) of +410%.

But (and this is a pretty important but), this system has been whipsawed a bit lately and has not outperformed the market since 2008 (in which the system gained +35.6% while the S&P lost -38.49%). Currently this system is on a sell signal from 9/1.

To be sure, none of these long-term trading systems presented is perfect. And frankly, following any of them can be difficult at times. However, all three systems WILL help you identify the really big trends in the market, which at this point in time looks to be neutral.

Turning to this morning... All eyes remain on Europe this morning as rates continue to be a problem in Italy and Spain. In addition, rates have hit all-time Euro-era highs in France this morning. Finally, the ECB is reportedly "buying heavily" in the bonds of Italy and Spain. But the futures in the U.S. are pointing to a lower open.

On the Economic Front... The Consumer Price Index for October fell by -0.10%, which below the consensus estimates for an unchanged reading. When you strip out food and energy, the so-called Core CPI came in with a gain of +0.1%, which in line with expectations for +0.2% but above September’s +0.1%.

Thought for the day... Remember that there is more to life than increasing its pace...

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

• Major Foreign Markets:
  • Australia: -0.87%
    
  • Shanghai: -2.49%
    
  • Hong Kong: -2.00%
    
  • Japan: -0.92%
    
  • France: +0.08%
    
  • Germany: -0.74%
    
  • Italy: -0.12%
    
  • Spain: +0.68%
    
  • London: -0.62%
  
  
• Crude