  |
 |
FRED GOODMAN'S KEY INDICATORS
FOR INVESTMENT SUCCESS
INTRODUCTION Technical analysis is a great way to use objective indicators to bring scientific methods and disciplines to trading and investing. But there has always been a nagging problem -- how does the technical analyst integrate diverse indicators into a coherent decision about the market?
My answer has been to develop a comprehensive Technical Trading Model. It consists of three modules:
It all began in 1979 when -- having already been active in the stock market for 19 years -- I had the idea that a group of indicators acting together, would have much more significance than any of the components. To test out this theory, I started looking at a summation of 8 broad market barometers including the Dow, Dow volume, S&P 500, NYSE, Value-Line and the futures contracts traded on the last three. To remember these components, I am now looking at a program I wrote in BASIC at that time, 23 years ago. I found merit in the concept. But I didn't really bring it to fruition until I started the Summary Index (or SI) in December, 1998, as a means of generating my most important intermediate-term buy signals and intermediate-term sell signals. Then last week I created the Quick Summary Index (or QSI), as a way of integrating significant short-term changes in the market's technical condition. Taken together, the Summary Index and the Quick Summary Index have a most impressive track record -- as you will see in a moment. HOW DOES IT WORK? Today the SI and the QSI include 29 indicators -- all the ones I write about every day in my report, and more. Every day I count the number of indicators that are bullish, bearish and neutral. For the Summary Index, I smooth the counts with a simple smoothing algorithm, and scale them to fit a consistent range of output values. The smoothed, scaled net difference between each day's positive and negative indicators is each day's Summary Index value. For the Quick Summary Index, I simply count each day's negative and total positive indicators, and look at the raw value of both counts -- I neither smooth, scale nor look at the net difference. Therefore, the QSI is much more sensitive to short-term changes in the indicators. The chart below, a version of which has appeared daily in our reports for years, shows the Summary Index in dark blue and the S&P 500 in maroon, with all of the buy signals and sell signals produced during the last 5 years as red and green triangles. The Quick Summary Index, appears as a series of red and green spikes that pop up from time to time above the 17 level on the scale of the Summary Index. The QSI buy and sell signals appear as red and green triangles with black borders around them.
HOW ARE BUY AND SELL SIGNALS GENERATED? Buy signals are generated when there is an extreme of negative indicators, and sell signals are generated when there is an extreme of positive indicators. It may seem paradoxical that we would get a sell signal when there is a preponderance of bullish indicators -- and a buy signal when there is a preponderance of bearish ones. But it makes sense if you think of each indicator as giving a valid buy or sell signal at a point in time -- but then as time goes on, the effectiveness of the signal attenuates even before it officially reverses. Consider, for example, a simple new high/new low indicator. When the number of new highs suddenly picks up and the number of new lows starts to decline, we are alerted that there has been a bullish change in the market. This constitutes the indicator's buy signal. This is followed by an acceleration in the number of new highs and a sharp drop in the number of new lows that shows that we were right when we first noticed the improvement and got the signal. However, that is not the buy signal, just its confirmation. After that there is a period during which the rate of change decreases, and that may or may not turn into a sell signal -- it may just be a temporary pause. It is not until the number of new highs starts declining and the number of new lows starts rising that a sell signal is given. The same is true for many indicators. We look for a change in direction from an extreme level as the buy or sell signal. Such a change reflects the exhaustion of a move in one direction and the birth of a sustainable move in the other. The period in between signals is simply confirmation. WHAT ARE THE SPECIFIC RULES FOR BUY AND SELL SIGNALS? A Summary Index buy signal is generated when the SI falls below 4.5 and then rises back above 4.5. Conversely, a Summary Index sell signal is generated when the SI rises above 17.0 and then drops back below 17.0. A Quick Summary Index buy signal is generated when the total number of negative indicators reaches 19, and then drops to 16 or below -- or when the total number of positive indicators falls to 3, and then rises to 7 or above. A Quick Summary Index sell signal is generated when the total number of positive indicators reaches 19, and then drops to 16 or below -- or, when the total number of negative indicators falls to 3, and then rises to 7 or above. HOW DO THE TWO INDICES WORK TOGETHER? In my Technical Trading Model, Summary Index buy and sell signals require no confirmation from the Quick Summary Index. But not vice versa. For a QSI buy signal to be acted upon, there must already be an SI sell signal in effect (otherwise the QSI buy signal would be meaningless) -- and the SI must not be below the buy trigger level of 4.50 (which means it's not on the verge of giving its own buy signal). For a QSI sell signal to be acted upon, there must already be an SI buy signal in effect -- and the SI must not be above the sell trigger level of 17.00. There are also rules for ending a QSI buy or sell signal. When a QSI signal ends, the SI signal then in force takes precedence. A QSI buy signal ends if there is an SI sell signal; if the number of positive indicators reaches 19, and then falls to 16 or below (unless at the same time the SI is above 17); if the number of negative indicators goes back above 17; or if the S&P 500 closes below a trailing stop-loss set at 4% below the highest closing level achieved following the QSI buy signal. A QSI sell signal ends the same ways -- but the opposite. TRADING ON THE BUY AND SELL SIGNALS To turn the signals from the Summary Index and the Quick Summary Index into actual trading decisions, I rely on the Trend Indicator. The TI gives me the long-term technical condition of the market, and determines how much risk I am willing to take on a given signal from the SI or the QSI. The Trend Indicator is derived from the S&P 500 and its 200-day moving average, scaled to fit the 4.5 and 17 trigger levels of the Summary Index. Based on the position of the Trend Indicator, I can determine whether the market is in a long-term uptrend, a downtrend, or one of two neutral positions.
Here are the four possible states of the Trend Indicator: 1. Uptrend (green sections in the chart above): When the Trend Indicator crosses above the mid-line at 10.75, the market is in an uptrend. 2. Neutral-Up (blue sections): When the Trend Indicator makes a high above 17 and turns down, the trend is considered to be neutral following an uptrend, or neutral-up. 3. Downtrend (red sections): When the Trend Indicator drops below the mid-line the trend is down. 4. Neutral-down (orange sections): Once the Trend Indicator makes a low below 4.5 and turns up the trend is considered neutral following a downtrend, or neutral-down. Research has shown that Summary Index and Quick Summary Index buy and sell signals behave very differently depending on which Trend Indicator state is in force at the time the signals are given.
Therefore, our Technical Trading Model calls for putting more money at risk on buy and sell signals that are in harmony with the current state of the Trend Indicator -- and less money at risk, or none at all, when the signals are in conflict. The table below shows the percentages of portfolio value that we will allocate to equities -- either on the long side or the short side -- in our two Technical Trading Model portfolios, depending on the how the state of the Trend Indicator interacts with SI and QSI buy and sell signals.
Special Rules for Trading Low Volatility Markets THE TRACK RECORD Our Technical Trading Model -- using the buy and sell signals of the Summary Index and the Quick Summary Index based on the state of the Trend Indicator -- shows excellent performance in backtesting. The actual levels of the Summary Index were produced in real time during the periods indicated. The application of the SI's history to this particular trading strategy has been optimized by backtesting. Remember, neither past performance nor backtested performance are a guarantee of future returns. Combining the SI, the QSI and the TI into a single Technical Trading Model from December 31, 1998 -- buying the S&P 500 at each buy signal and shorting it at each sell signal -- has produced the excellent compound annual returns shown in the chart below. Trading the NASDAQ 100 instead has produced even better returns. See the paragraph below the chart for important methodological disclosures. The table below shows a detailed breakdown of the track record of the Technical Trading Model: This table is updated daily.
Here are the results of the Summary Index and Quick Summary Index buy and sell signals, assuming buying at every buy signal and shorting at every sell signal, constructed from historical data based on the rules given above. The following returns assume that the S&P 500 Index was traded at its closing price the day of each signal. In practice, one would have to wait until the following day to trade. No commissions or other trading costs are considered. At the same time, there is no interest income assumed on cash balances during sell signals. This chart is updated daily. As you know, I'm a skeptic. So first, remember -- once again, past performance is no guarantee of future returns. And remember that your utilization of this and any other investment tool should depend upon your understanding of the risks and upon your own financial situation and experience. Fred Goodman, CFP, is a fee-only Certified Financial Planner based in Los Angeles. You can send him your questions and comments via email at Fred@MarketMonograph.com. The charts and commentary represent what Fred is thinking about the market and thinking of doing for his own account and for accounts he manages. There is no guarantee that you will profit from trading as discussed herein. You may lose money and Fred assumes no responsibility for what you do or do not do with this information. 
|
