The RED Spread: A Market-Breadth Barometer - Can It Predict Black Swans?

 |  Includes: BND, PHB, SPY, TIP, VTI, VWO
by: O. Young Kwon

A chance of having another financial turmoil like the one in 2007-08 is perhaps lower than one out of six-digit chances, but is still remotely possible because it is a part of our financial system which needs to adjust to a stream of distortions over time. The EU crisis, the "London Whale" episode, the Libor scandal, and the so-called U.S. fiscal cliff clearly contribute to an increase in the probability of another financial meltdown, even though it's still extremely low. The Rotation/Equity Diffusion (RED) Spread, or REDS, is designed to monitor the probable event with data points rather than just hunches or speculation.

In addition to mounting uncertainties, we are haunted by our deep-seated shocks, remembering our bad experiences during the 2007-2008 market failure. We don't want to see our capital shrink in half within a couple of weeks again. That is why we compile the REDS with two Diffusion Indexes: (1) a combination of 10 bond ETFs and 30 Stock ETFs in our TANER.Rotation Model (TRM) and (2) 40 equities in our TANER.Stock Model (TSM). The Diffusion Index is a statistical measure of the scope of expansions and contractions.

Our TANER System was born in August 2008 with two models: (NYSE:A) The TANER.ETF Model (TEM) with 40 ETFs and (NYSE:B)The TSM. The TEM is for our long-term core investments and the TSM is for our short-term trading accounts. Two models worked very nicely during the hairpin-shaped big swing so that our lost capital was recouped in a relatively short period, feeling like riding a helicopter rather than a donkey to climb to the top of Grand Canyon from Colorado River. Since December 2010, the list of the ins and outs of the TANER Momentum has been posted on StockTalks daily to share with other investors.

The original TANER System still functions smoothly, but recently two models were added to accommodate a much broader spectrum of ETFs and their more active trading pattern. One is The TRM and the other one is our TANER.Vanguard Model (TVM). The TRM remedied two shortfalls in The TEM: All 20 ETFs are stable but not too sensitive to daily fluctuation and bonds are over-weighed in detecting the sector rotation. The TVM helps long-term investors with the lowest-cost Mutual Funds and ETFs. As a result, The TANER System consists of four Models: The TEM, The TSM, The TRM, and The TVM.

A well-match between bulls and bears is needed for a normal market, where we can play a normal-distribution probability game. An odds at any moments depends upon market cycles, market trends on selected securities, and other last-minute fine tunings, by reviewing (1) overall macro news and related specific news for selected securities, (2) global-market leads, (3) the change in morning futures, (4) daily up/down streaks, (5) the previous day's top/bottom and closing in securities in our watch lists, etc.

The current stages of business cycles and macro news are the dominant factors to visualize the current market perspective - bullish or bearish -- given our time frames to invest. Indicators of the real sector such as GDP (real) and employment data, which are the main components in coincident composite indicators, are more important than financial indicators, which are the main components in leading composite indicators. The National Bureau of Economic Research (NBER) dates peaks and troughs of business cycles based on the composite indexes - coincident, leading, and (inverted) lagging. Two approaches - technical and fundamental - are heavily involved to improve our market outlook and security selection. The technical approach has an edge to generate market trends while the fundamental approach is better to select securities. We need other supplement or alternative approaches or our own systems such as our TANER System.

Our daily investing may work out as expected if we establish a reliable market outlook and an intelligent market strategy. It may sometime fail with light scratches. As long as market moves within 95% in our normal-distribution probability, our investments can generate profits. We can smoothly ride on steady trends (upward or downward) as we did from 2009 to 2010. Now we have been in somewhat trendless market for almost two years since the Japanese earthquake last year. How can we cope with this situation? Any system or strategy is not perfect. Some time it works and some time it doesn't. What can we do to achieve a consistent and reliable investment result? The answer is a Disciplined Flexibility [DF] which is a workable system based on plausible market perspectives and strategies.

The DF helps us keep away from lots of pitfalls and misguides that are caused by some rigidity and shaped by valuations or chart readings or historical parallelism. If you have a stubborn price targets for entry or exit, you should suspect a rigidity symptom. If you try to time accurately too hard, it is another example of the symptom. We struggle now under the current erratic market environment, trying new research methods and more innovated strategies.

The method is diffusion indexing. Diffusion index has been used at the NBER over three quarters of a century. Currently the Conference Board uses the DI for their Business Cycle Indicators. More mathematical version of DI, "Dynamic factor" has been heavily utilized in many macroeconomic models. The actual calculation of DI varies. A simple method is used in REDS to remove daily noises: (1) Averages of one month, two months, and four months, and (2) Average of those three averages. Two DIs - the Rotation DI (RD) and the Equity DI (EDI) - are computed, and the average of the two DIs, the RED, and the REDS are computed.

The novel features of the REDS are twofold. The first one is that the REDS analyzes two markets - Bond and Equity - simultaneously, not a single market (i.e. the Equity market) as most reliable market-breadth barometers based on market advance/decline and prices/volumes. The second one is a Diffusion-Index application and a spread between two DIs to avoid shortcomings from a single-variable analysis. Markets interact continuously and endlessly, domestically as well as globally. To capture the dynamic movements of markets, we have to analyze them together. There is, however, a tradeoff between sophistication and feasibility: The REDS is an output to emphasize more the latter than the former.

The REDS predicts not only Black Swans but Bulls and Bears, large or small. If the REDS succeeds to spot a symptom of a market crash in advance, It certainly will be a great accomplishment. If the REDS can just determine market turning points (big or small), it also definitely gives us a tremendous advantage over other investors. The following Table shows the possibility.

. . . THE Relationship Between REDS & Markets . . .
. . . . . . . . . . .
. . . RED . REDS . S&P 500 . 10Y TN .
DATE RD ED DI P/T DI P/T Price P/T Yield P/T
4/2/2012 . * * * * * 1,418.90 P 2.193% *
4/3/2012 53.8 56.1 55.0 * -2.3% * 1,413.31 * 2.280% P
4/4/2012 52.4 56.1 54.3 * -3.7% P 1,398.08 * 2.175% *
4/26/2012 53.0 53.0 53.0 * 0.0% B 1,399.98 * 1.960% *
5/25/2012 45.5 45.5 45.5 * 0.0% B 1,317.82 * 1.750% *
5/30/2012 45.0 45.0 45.0 * 0.0% B 1,313.32 * 1.620% *
6/1/2012 44.9 43.9 44.4 T 1.0% * 1,278.04 T 1.470% *
7/3/2012 55.8 56.0 55.9 P -0.2% * 1,374.02 * 1.630% *
7/25/2012 53.6 50.1 51.9 * 3.5% * 1,337.89 * 1.410% T
8/9/2012 55.0 50.7 52.9 * 4.3% T 1,402.80 * 1.690% *
8/10/2012 54.5 51.3 52.9 * 3.2% * 1,405.87 * 1.649% *
8/13/2012 53.8 49.5 51.7 * 4.3% T 1,404.11 * 1.650% *
8/14/2012 53.2 49.9 51.6 * 3.3% * 1,403.98 * 1.730% *
8/15/2012 53.0 49.5 51.3 * 3.5% * 1,405.53 * 1.800% *
8/16/2012 53.5 50.0 51.8 * 3.5% * 1,415.51 * 1.840% *
8/17/2012 54.0 49.7 51.9 * 4.3% T 1,418.16 * 1.820% *
. . . . . . . . . . .
. . NOTE: P=Peak T=Trough B=Breakeven RED=(a+b)/2 REDS=(a-b)% . .
Click to enlarge

The RED bottomed at 44.4 on June 1 and topped at 55.9 on July 3. It was a quick turnabout. The REDS reached an equity-market peak at -3.7% on April 4, after a peak of S&P 500 at 1,418.90 on April 2 and a peak of the yield (or a trough of the price in the opposite direction) of 10-year Treasury at 2.280% on April 3. It was a legitimate sell signal for equities. A significant correction during April and May was followed. During this period, the REDS showed three breakeven points on April 26, May 25, and May 30. On June 1 S&P 500 finally declined 9.9% from the previous peak on April 2, standing at 1,278.04.The yield of 10-year Treasury fell further toward 1.41% on July 25. It was a trough of the yield (or a peak of the price).

The REDS revealed an equity trough at 4.3% on August 9, August 13 again, and August 17 again. Is it a buy signal? If the bond premium in terms of a REDS reduces gradually, the equity market will boost by a spillover from the Treasury markets. Why is so optimistic? The U.S. economy is better than the EU and other emerging economies so that the U.S. equity market is a safe harbor to global investors. If the premium on the other hand will suddenly vanish to get a breakeven or a near breakeven with a significant fall of the RED, say, 40 or lower, it might be a warning signal for a Black Swan coming.

In other words, the necessary and sufficient condition for a market crash is that a sharp drop of the RED to 40 or lower and a near zero REDS. The reasoning for this hypothesis is that the primary safe haven for panicked investors is still the money market funds as cash even though some disputes surrounding them are going on now. Flights to cash depress both the equity and bond markets same time As a result, the REDS tends to approximate to zero with a heavy tank. It was what happened five years ago. The same thing must not happen again, but it is what we watch out for.

In general, your right strategies of investing and portfolio management depend largely upon your age, your tolerance level, and the size of your capital. No matter what strategy and investment time frame you choose, however, the signals from the REDS can lead you toward a more prudent road rather than a choppy one.

The next question is what kind of vehicles to consider. In our view, broad-based low-cost index funds and their ETFs are the right ones such as Vanguard Total Bond ETF (NYSEARCA:BND), Vanguard Total Stock Market ETF (NYSEARCA:VTI), SPDR S&P 500 ETF (NYSEARCA:SPY), i Shares Barclays TIPS Bond ETF (NYSEARCA:TIP), Vanguard Emerging Market ETF (NYSEARCA:VWO), Power Share High Yield Corporate Bond ETF (NYSEARCA:PHB).

You can adjust your allocation of bonds and equities in your portfolios, following the REDS. ETFs are convenient and efficient for you to diversify your portfolios easily if you select them properly. The TANER System is with you always, posting its TANER Momentum lists on StockTalks. You can find your favorites on these posts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.