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Why Tactical Strategies Aren't Working Very Well - Part II image

Yesterday, I began a series of posts that I have been meaning to write for quite some time. The topic at hand is why so many technical stock market indicators and, in turn, so many tactical investing strategies have struggled since the end of the credit crisis - and more specifically, over the last 5-7 years.

There can be little argument that tactical strategies, which are designed to capture the upside of the market when stocks are moving up and avoid - or even profit from - the downside during declines, have not fared particularly well since 2013. In addition to some very high profile "blow ups" in the tactical space, tactical managers of almost all shapes and sizes appear to have struggled during this time frame - at least from my point of view.

As Exhibit A in my argument, I detailed the historical returns (which, by the way, are generated by Ned Davis Research, one of the biggest institutional research firms in the country) of one of my longtime favorite "trend and momentum" indicators - the trend-and-breadth confirm model. I showed that from 1980 through 2007, this model would have been an excellent indicator of when to be long stocks and when to be on the sidelines.

However, as I detailed yesterday, if one viewed the historical testing of the indicator from March 2007 forward, the model appears to have been turned on its head. For 27 years, a positive reading from the trend-and-breadth confirmation model would have produced strong returns in the stock market and vice versa on negative readings. But since, well, not so much. In fact, the historical returns have been just the opposite of what had happened in the past.

This morning I'd like to offer Exhibits B, and C, and D in my argument that the character of the stock market changed rather dramatically in the years following the end of the credit crisis.

Exhibit B: The Price Thrust Indicator

This indicator measures what I call the "oomph" behind a move on the Value Line Composite. Historically, when an "upside thrust" signal was given (which is measured by the distance of 3-day moving average of the Value Line Composite from its 30-day mean), stocks tended to continue to move higher at a decent clip.

NDR reports that since early 1964 (which is when the data series first became available), when an "upside thrust" signal had been given, the Value Line Comp gained at a rate of nearly 18% a year, which is more than double the buy-and-hold annualized return of 7.6% per year for the index during the same period.

However, if one looks at the results since January 2010, the upside thrust signals would have produced annualized returns of just 4.3%, which is just under one-third of the buy-and-hold returns of 12.2% per year for the period. So again, what was a positive scenario for a very long time is no longer.

Exhibit C: The Breadth Thrust Indicator

A similar approach can be used to identify a "breadth thrust" in the stock market. This particular indicator uses the totals of 10-day advancing issues versus declining issues on the NASDAQ Composite. Again, historically, when an "upside thrust" has occurred, the historical test of this indicator showed that stocks moved significantly higher.

According to NDR, from August 1980 (when the data series began) through September 9, 2016, when an upside thrust signal was given, the NASDAQ gained ground at an annualized rate of +20.8% per year. And when a downside thrust occurred, the NASDAQ lost ground at a rate of -6.22% per year. As such, this indicator would appear to be a very valuable tool.

But as you might suspect by now, the story changes rather dramatically when the indicator is viewed from more recent times. Since the end of 2007, an upside thrust signal has produced annualized returns of -5.8% per year while the downside thrusts have seen annualized gains of +5.0% per year. Compared to the annualized buy-and-hold gain of 8.4% per year, I'm thinking that this indicator appears to have a problem.

Exhibit D: Sentiment Composite Indicator

So far, we've reviewed indicators that use price, price and breadth, and volume indicators. Often referred to as the "market's internals," variations of these indicators have traditionally been the bread and butter of tactical managers looking to time the trends of the stock market.

Now let's turn to something a bit more esoteric; a composite model of sentiment indicators. Long-time readers of my market missive know that sentiment is a tricky business to start with - and most investors (a) may not understand how such indicators work or (b) use them effectively (in my opinion, of course).

This particular NDR Model is a sentiment indicator designed to highlight short-term swings in investor psychology. It combines a number of individual indicators in order to represent the psychology of a broad array of investors to identify extremes in sentiment that may be used for "going the other way" when sentiment reaches an extreme.

From the beginning of 1995 (the date of the model inception) through September 8, 2016, NDR shows that when investor sentiment has been extremely pessimistic, the S&P 500 rose at an annualized rate of +32.7% per year. Impressive!

And when the readings of the sentiment model were at what was deemed extremely optimistic levels, the S&P fell at an annualized rate of -10.72%. So, once again, from my seat, this type of model would appear to be exceptionally valuable.

But when I shortened the time frame and started the game in December 2009 (due to my view that the character of the market changed somewhere in 2010/11), the results are once again, very different.

Telling NDR's computers to start the indicator in December 2009, I found that while an extreme pessimism scenario still produced strong annualized gains for the S&P (+33.9% per year to be exact), the extreme optimism readings, which over the preceding 20-year time frame would have been very useful, no longer signaled that stock market weakness was likely.

In fact, since the end of 2009, the overly optimistic readings (considered to be a "sell signal" for this model) would have produced annualized gains of +3.6% per year for the S&P (compare this to the -10.7% rate for "sell signals" for the entire data series). And with the buy-and-hold return of the S&P 500 sitting at +10.6% per year during this time frame, well, the sentiment "sell signals" don't appear to be all that effective.

That's all the time I have on this fine Friday morning where our beloved Denver Broncos surprisingly find themselves 1-0 on the new season. Next week, I'll explore about why I believe the character of the market has changed - and why these historically tried and true indicators have stopped being effective. And then we'll explore what I see as the answers to the dilemma.

Have a great weekend!

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of Global Central Bank Policies
      2. The State of U.S. Economic Growth
      3. The State of the U.S. Dollar
      4. The State of the Global Bond Market

Thought For The Day:

Courage is knowing what not to fear. -Plato

 

Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

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Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

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