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FRED GOODMAN'S KEY INDICATORS FOR
INVESTMENT SUCCESS
For the last three or four months, I have been studying the volatility of the S&P 500, using different calculations. One method is calculating the spread between the daily high and low, and dividing it by the low. Then I take both 10-day and 12-month moving averages and plot the difference between them as a percent of the 12-month moving average. The chart below is the result. It seems to inversely track the S&P 500 well, reaching highs when the S&P reached lows and vice versa.
One of the other methods is simpler to calculate and seems to track the market better. I have plotted it against the Dow in the next chart. I call this the MiniMax Indicator, because it is calculated from the maximum high over the last 10 days and the minimum low over the same period. You subtract the minimum low from the maximum high and divide the result by today's close. A buy signal, signified by a green arrow, occurs when the indicator drops by 10% of any high it reaches above 11. A sell signal (red arrow) occurs when the indicator climbs by 10% of any low it reaches below 3.1. So for example, if the indicator reaches 15, it will give a buy signal when it drops below 13.5. Notice that there was a buy signal just after the July 24 bottom in 2002, but no sell signal followed. There were several additional buy signals, but the indicator never dropped below 3.1 until yesterday. When it advances above 3.41, there will be a sell signal. As you know, I never rely on just one indicator. I require that a majority of those I follow agree with each other. I have not yet incorporated a volatility indicator into the Summary Index, and this one has several hurdles to get over before it will be added.
In the chart above I have used the Dow, but any index may be substituted. I have experimented with buy and sell signals based on a 10% reversal after the volatility reaches an extreme high or an extreme low, but there remains additional study to refine the buy and sell points. Here is the same chart drawn for the S&P 500. There may be differences of a day or two in either direction, but basically the two indices plot similarly. In the next chart I have plotted the MiniMax Indicator since 1990.
It is important to note that the absolute level of the MiniMax volatility has varied over the 13-1/2 years. The 12-month moving average (maroon line) reflects this. It is quite clear that volatility decreased sharply in the second half of 1991 as the market began to rally. It remained low until 1996, and then started to increase until it reached a maximum this year. The variability must be accounted for in developing an indicator that will be robust enough to provide buy and sell signals over extended periods of time. One could of course, simply ignore the indicator when the volatility is low, but there is a better way. In the next chart I have plotted the S&P against the percent that the volatility is above or below the 12-month moving average.
Notice that here the volatility is much more regular than in the chart above. The peaks that occurred during the period of low volatility have been magnified, as they should be, by measuring them relative to the average for the 12 months of which they are a part, rather than picking some arbitrary level for the entire period. The next step is to develop parameters that can be used to signify buy and sell signals. Then, I will test the parameters against previous 13 year periods to see if the selected parameters will work in different time periods. I'll report further in the next week or two.
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. 
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