The Abnormal Market Filter: 'Barricade the Doors'

For the first time since the market meltdown last October, on Tuesday, the Abnormal Market Filter reading moved to 100%.

Over the last few months, I've talked a lot about my mechanism to determine when the market is acting “abnormally." It's called the Abnormal Market Filter. The idea behind the filter is to give my own programs a way to measure when the market has moved beyond normal ranges, because strategies based on historical norms might not be suited for that very abnormal moment.

The filter is included in the State of the Market report and both the YK and Scotty strategies, and in all three cases, as the market becomes more “abnormal”, position sizes are reduced (eventually to zero). The graph below shows the S&P 500 (blue) versus the filter reading for that day (red) from the beginning of this year.

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During both of this year’s market slides, the filter ratcheted up, hitting a high of 75% in January and 100%, yesterday.

These two very elevated months have given me an opportunity to look at how our programs react in real-time to this idea (and so far, I’m a very satisfied developer).

To illustrate, the graph below shows YK’s performance YTD both with (red) and without (green) the abnormal market filter. The red line represents the strategy as we issue it to investors, and the green line the old pre-filter version of the strategy.

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[linearly-scaled]

For most of the year, the Abnormal Market Filter has actually reduced portfolio returns, and generally speaking, I think this is going to be the case as there is significant money to be made when the market is making big volatile moves.

However, there is also significant pain to be inflicted when we’re wrong, and the filter has done a very good job this month defending against a series of what would have been very bad positions. Without the filter, YK returns would have been roughly -10.1%, month-to-date, and with the filter, would have been -0.9%. That’s a substantive difference.

I have no idea where the market goes from here (I leave market calls beyond 24 hours from now to the pundits). By design, as the market stabilizes, the Abnormal Market Filter returns to “normal” very quickly, so I foresee taking bigger positions again shortly. However, at this moment in time, I would be very hesitant to make large bets in this market.

Note: Readers looking to follow the abnormal market filter can find it every day in the second box of the State of the Market report (click to zoom).

Comments

[kelm:]

This is an interesting concept as many are still slavishly adhering to technical indicators that simply don't function correctly in abnormal situations. Your indicator also needs to include the long term historical divergences that we may be seeing. last century was the American century. It is far from certain that the next will be. Historical market analysis of the US markets will distort any emerging "new" picture for many years.

Feb 25 11:38 AM