Daily State Of The Markets: Building An Unemotional Market Model

Includes: DIA, IWM, QQQ, SPY
by: David Moenning

Last time, we looked at the "Indicator Wall" a team of professional money managers I am involved with built for NAAIM - The National Association of Active Investment Managers. The idea was to provide NAAIM members with a complete rundown of key market indicators on a weekly basis.

As I mentioned, it is vital to understand that the "Indicator Wall" is neither a timing vehicle nor intended to be predictive in nature. No, this is a repository of key market indicators designed to provide updated readings on the state of the various factors that have historically driven stock prices and to provide a clear, unemotional take on the risk/reward environment.

The logical question that advisors and investors alike may have is, what do you do with the data? There can be no arguing that there is a LOT of information contained in the indicator wall, with many of the models appearing to be contradictory.

One approach is to try and glean a "message" from the indicators to draw a conclusion on the state of the current risk/reward environment. The idea here would be to try and utilize the right game plan for the current state of the market and/or to keep one's risk exposure in line with the overall big-picture environment.

The only problem with this method is the "message" from the indicators is open to interpretation. It should be easy to see that subjectivity, investor bias, and/or emotion enter into the mix when using such an approach. And while having key indicators available to use as a guide to exposure can be very helpful, allowing too much personal opinion into the game can cause investors to misinterpret the environment and/or fall victim to their own personal outlook.

Another Way To Play

Another way to utilize a big batch of market indicators is to incorporate them into a market model designed to unemotionally provide the current "state of the market."

To be sure, this can be a tricky business - especially for those new to the game. The good news is that I've spent the vast majority of my career around such models, so readers can avoid a lot of the mistakes we've made over the years.

The tricks to the trade include understanding the time-frame you are working in, being able to categorize indicators/models properly, understanding how indicators work with one another, and to recognize what the primary goal of the model is.

So, with the stock market still stuck in its tight trading range this morning (the chart below needs no additional explanation), let's explore how a "risk/reward environment model" might be constructed.

S&P 500 Index - Daily

A Simple Risk Exposure Model

Below is an EXAMPLE (and ONLY an example) of how to group market indicators in order to get a read on the "state" of the risk/reward environment.

The approach shown below is a "model of models" comprised of 11 independent indicators/models. Each indicator or model utilized gives independent buy and sell signals, which affects a percentage of the model's overall exposure to the market.

Here's the way this simple model works. The trend and momentum models each control 30% of the model's exposure for a total of 60%. These models are designed to give us the "state of the tape." Remember, price is the final arbiter of all market arguments and then the momentum models tell us if there is "oomph" behind the move. Next is what we call "the forest." The 4 Environment Models are intended to provide a take on the market's external factors and each control 7.5% of the portfolio's exposure to market risk. And finally, the Market Sentiment model controls 10% of the overall exposure. These indicators can help signal when the crowd may be at an extreme and one should be ready to "go the other way" for a while.

The model's "Exposure to Market Risk" reading (the literal bottom line of the Model) acts as an SAMPLE of a longer-term guide to exposure to market risk.

The model below is for illustrative and informational purposes only and does not in any way represent an investment recommendation. The model is merely an example of how indicators can be grouped to create a guide to market exposure based on the inputs from multiple indicators/models.

The bottom line is that the simple model's exposure reading is currently at 63%. This tells us a couple things. First, the overall reading being above 50% suggests that from a longer-term perspective, it is probably best to give the bulls the benefit of any doubt.

Second, we note that the current reading is below what would be expected during a healthy bull market (above 80%). Yes, this could be due to the recent sloppy action. As such, one would want to watch the model to see if the it can rebound in short order. Note that if the trend models were to improve (likely in response to a breakout above the current trading range), the model reading could easily return to a "healthy" level.

But again, the key takeaway is that things are not hunky dory at this time. Finally, it is important to note that risk being elevated doesn't mean a bear is just around the corner as this type of environment can a) remain in place for long periods of time in the past and b) can be reversed.

It is my sincere hope that this type of objective analysis is helpful in making heads or tails of what can best be described as a conflicted environment.

Publishing Note: I am traveling this week and will publish reports as time permits.

Thought For The Day:

Courage is what it takes to stand up and speak; courage is also what it takes to sit down and listen. - Winston Churchill

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 Economic Growth

2. The State of Fed/ECB/PBoC Policy

3. The State of the U.S. Economy

4. The State of the Earnings Season

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Neutral

(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Neutral

(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive

(Chart below is S&P 500 daily over past 2 years)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 2065
  • Key Near-Term Resistance Zone(s): 2135

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator (Short-Term): Neutral
  • Price Thrust Indicator: Negative
  • Volume Thrust Indicator: Negative
  • Breadth Thrust Indicator: Negative
  • Intermediate-Term Bull/Bear Volume Relationship: Neutral
  • Technical Health of 100+ Industry Groups: Moderately Positive

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:

    - Short-Term: Neutral

    - Intermediate-Term: Neutral

  • Market Sentiment: Our primary sentiment model is Neutral .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

  • Weekly Market Environment Model Reading: Neutral