Is This The Best Stock Market Indicator Ever?

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:

“When?”

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.

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  • vimal says:

    Hi. Is this something you can backtest over say 15years using SPY to see how it would have performed? Have you done this exercise as it would be great to see the results

    • Hello,

      It sure would be interesting. After reading the article myself I wanted to do the same thing you suggested. However, it looks like the breadth indicator that I would need only goes back a few years in TradeStation. If I get more time on this I would like to investigate it more.

  • Dave says:

    Hi
    The three indicator filters for going long – are they signalled on the monthly or the daily chart, both timeframes are drawn showing the indicators and there don’t seem to be any examples given to clarify it.

    Thanks

    • I agree it’s not all that clear. My understanding of the author’s intent is the $OEXA200R can be applied to a daily chart. However, the other indicators should be used on a weekly or monthly.

      Personally I like to simplify things so, I’ve been watching all the indicators on one weekly chart.

  • BtTdrWd says:

    752031 316812Excellent read, I just passed this onto a colleague who was doing a little research on that. And he actually bought me lunch because I found it for him smile So let me rephrase that: Thanks for lunch! 493865

  • Michael Young says:

    How would one program this to show in tradestation?

    • If I remember correctly, TradeStation did not have a lot of historical data on the $OEXA200R indicator. However, that was a while a go. I’ll add this to the list of future article and see if anything changed. If it did, I’ll create an article on the topic. Thanks!

  • Eric Severance says:

    Hi Jeff,
    Re-read this today… And wondered if you (or others) had done more with this (BackTesting, clarifying, TradeStation work, etc. Please let me know.
    Thanks, Eric

  • Wei says:

    Gents,

    In regards to the query on daily versus weekly for the indicator, I believe the answer is the $OEXA200R is on a daily chart, and the rest are weekly. Here is a quote from Advisor Perspectives:

    Following a major market correction, the conditions for safe re-entry are when:

    a)Daily $OEXA200R rises above 65%.
    And two of the following three also occur:
    b)Weekly RSI rises over 50
    c)Weekly MACD black line rises above red line
    d)Weekly Slow STO black line rises above red line

    You can find the whole article here: http://www.advisorperspectives.com/dshort/commentaries/Carlucci-Indicator-Update.php

    Please note that it is not written by the original author.

    I have been doing some work on the $OEXA200R as a market filter/timer and while I don’t use it the way Mr Carlucci does, it has shown more promise than alot of other market breadth indicators I have experimented with. I test with Amibroker not Tradestation and have data going back to 1990 for the $OEXA200R. It actually looks ok back all that way. The thing we all need to realize though is that there are only 2 real occasions since then that you really needed the ‘insurance’ that this kind of market filter would provide, the dot com crash and the GFC. Otherwise you were probably better off with a buy and hold strategy (outside of these 2 events). So realistically even with 25 years of backtesting, there are 2 major events that make all the difference. Even a simple moving average crossover or Golden Cross would have protected you during those times.

    I’ve spent weeks testing and researching all kinds of market filters (from price action, volatility, market breadth and even looked at fundamental data) and in my opinion, there is no magic bullet or holy grail. Everything is a balance of risk/reward, if you want to get out early when the market turns down, you will miss out on profits and invariably be see-sawed in and out of the market.

    Most systems I have seen have been tested since 2000, since this is when the bulk of better data appears. Most of these market timers/filters will show a drawdown of 20% during the GFC. The problem is that with market timers/filters, people generally use them for investment portfolios. While a 20% drawdown is difficult but tolerable on a income type mean reversion system, watching 20% of your savings/retirement evaporate in a market downturn is very difficult. Normally you compound this type of system as well, so at time of taking the 20% drawdown, the actual $ amount will be high (as your equity should be the highest). Now that’s only 20%. Most market filters when applied to a quasi backtest to the S&P 500 index (not SPY – SPY history not long enough), back to the Great Depression shows roughly a 50% drawdown. Which is much better than a buy and hold which lost a whopping 86%.

    This is why my latest area of focus has been staged market gates/filters. It involves using several market filters to scale in and out. It reduces profits but also reduces drawdowns by scaling you out of the market. I try to use gates that do not show significant correlation. When all gates open, you’re fully invested. When all shut, you’re in cash. In between, you are less than 100% invested. On paper these systems actually have their rate of return reduced quite a bit and are about as unsexy as you can get. But when it is my savings invested in a system, getting compounded each year, unsexy sounds just fine to me.

    To put it another way, in the last 100 years we have had a crash that wiped 50% off the stock market and one that wiped 86% off it. I am 35 and if I expect to live to an average old age, I will probably see at least another 50% one, and maybe even an 86% one. If I see the latter, it doesn’t really matter how much money I made before that. By my back of the envelope calculations if one made 10%pa for 20 years and compounded it every year, then hit a Great Depression year and lost 86%, they would be back to square one. Maybe I am overly cautious, but it just seems like downside protection is very important. One market filter can probably reduce that drawdown to about 50%, but I can’t see reducing below that without staged gates/filters. And that is still all assumption because there is no way for me to test different gates back as far as 1929, because there is not enough data going back that far.

    Hopefully I haven’t doom and gloomed everyone too much.

    Happy Trading,

    Wei.

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