Learn To STOP Curve Fitting!
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By John F. Carlucci of Advisor Perspectives
As we all know, the key to successful investing is very simple:
“Buy low, sell high.”
However, you enter a chaotic, fun-house world of uncertainty once you ponder the logical follow-up question:
Investors desperate to solve this riddle have come up with solutions as varied as Fibonacci Analysis or the length of women’s hemlines. At some point, most exasperated investors have even considered the strategy articulated by Seinfeld character George Costanza: “If every instinct you have is wrong, then the opposite would have to be right.” (see video clip)
Luckily, there is a technical indicator that answers the “When?” question with a high degree of specificity and predictive value: the percentage of S&P 100 stocks above their 200 day moving average. This article will discuss that indicator, its historical track record and fine points of its practical application for trade timing.
Figure 1 below illustrates the indicator, referred to on the StockCharts.com graphic as $OEXA200R, on a monthly time scale from 2007 to present. For my personal use, this is the primary chart I refer to every day and against which I cross-reference the other charts examined in this article. I will first discuss the $OEXA200R in particular and then present it and the S&P 500 charts in a side by side comparison for various historical time frames.
I have found that the 65% point (illustrated by the blue line) is the main predictive value to watch. If the chart drops below the 65% blue line I take that as my sell signal for all long positions in anticipation of a possible severe correction. It’s also the key signal for re-entering long positions after a correction, either brief or prolonged.
Referring to Figure 1, the $OEXA200R dropped below the 65% line on July 25, 2007. It briefly rose above 65% on September 18, 2007, only to fall in fits and starts from October 16, 2007 to a generational bottom on March 1, 2009, when virtually 0% of S&P 100 stocks were above their 200 day MA. In retrospect, any conservative investor who liquidated all securities positions to cash according to this model would have avoided the financial cataclysm that millions of others suffered.
Next, I’d like to draw your attention to the red and green line directly below the 65% blue line. This is set at 50% of S&P 100 stocks above their 200 day MA. If the $OEXA200R drops below 50%, illustrated by the green to red line change, I interpret that as the sure indicator of a cyclical bear correction. In practical terms, it is the drop-dead “STOP ALL TRADING!!” signal. Trading is possible within the 50% to 65% zone but it must be done cautiously and with tight stops, as will be explained later in this article.
To determine when to resume long trading after a cyclical bear correction I wait until:
a) $OEXA200R rises above 65%
And two of the following three also occur:
b) RSI rises over 50
c) MACD cross (black line rises above red line)
d) Slow Stochastic (black line) rises over 50
As one can see, the $OEXA200R chart was very accurate in forecasting conservative entry and exit trading points during the past several years. Any investor who had simply followed this as an overall framework within which to execute a specific trading strategy would have profited handsomely.
How accurate has the $OEXA200R been from a historical perspective? Figures 2 and 3 illustrate the $OEXA200R and S&P 500 in a side by side comparison during the six months prior to publication of this article.
The $OEXA200R briefly touched 65% on July 18, 2011, and then dropped below 65% on July 26, signaling the point at which to sell all long positions and “watch and wait”. It subsequently dropped below the 50% mark on August 1 and remains below the 65% line.
Examining the S&P chart, one can see that a final exit from long positions on July 26 would have been at close to the peak of the market. This preceded the S&P dropping below its 200 day MA on August 1 and the “Death Cross” sign (50 day MA dropping below 200 day MA) on August 10.
For a longer perspective, Figures 4 and 5 illustrate the $OEXA200R and S&P 500 in a side by side comparison during the past decade as far back as historical data is available.
The predictive accuracy of the $OEXA200R is apparent. There are several additional observations I would like to make with respect to Figures 4 and 5. When the MACD for both $OEXA200R and S&P 500 are dropping it indicates a bear non-tradable market, as occurred from July 2007 to early 2009, as well as from July 26, 2011 to present. When the MACD for both are trending positive it indicates a bull market. When the MACDs don’t synchronize, as happened from 2003 to 2007, but the $OEXA200R is within 50% to 65% it indicates a market that is tradable, with caution. When the MACDs don’t synchronize and the $OEXA200R is below the 50% to 65% zone as it was during mid-2010, it indicates a non-tradable market. Again, I cross reference Figures 3 to 5 against Figure 1 as my primary chart.
In conclusion, the $OEXA200R can be thought of as a valuable early yellow light flashing “bears ahead” or a confirmatory green light that we’re really back in a bull market after a bear. The individual investor can then execute his particular securities screening and trade procedures within those accurately defined “go and no-go” periods. While women’s hemlines are certainly the object of enjoyable study, the wise investor could profit much more richly with the technical indicator $OEXA200R.
–By John F. Carlucci
John is a formerly retired first wave boomer with a Ph.D. in English from Duke and a lifelong interest in economics and finance. In 2011 his website was acquired by Advisor Perspectives, where he serves as the Vice President of Research. Read more at John’s website.
Contributing authors are active participants in the financial markets and fully engrossed in technical or quantitative analysis. They desire to share their stories, insights and discovers on System Trader Success and hope to make you a better system trader. Contact us if you would like to be a contributing author and share your message with the world.
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