Traditional Trend Indicators Do Not Work Anymore

A colleague and I have a running discussion that I believe warrants mention this morning. To set the stage for this discussion, you first need to understand that I am not a true-blue, died in the wool, chart technician. Nor am I strictly a fundamental or value guy. And no, I am also not a “pure” quant. In short, I consider myself a “market environmentalist.”

Before you lump me with all the “going green” fanatics out there, I am not referring to the environment, I’m talking about the market environment. My goal is to (a) keep an open mind in order to try and stay as objective as possible and (b) use whatever means or measures are at my disposal in order to try and stay in tune with the overall environment of the stock market.

With that said, the primary point I’d like to make this morning is that the markets have changed over the past year or so and that many traditional indicators of the market’s internal strength are no longer as valuable as they once were. Take for example, the idea of a “90% up (or down) day.” Historically, when either breadth or volume was “one sided” – to the tune of 90% or so – it was an indication that the move had some “oomph” behind it and was likely to continue. But since the market now moves in either a “risk on” or “risk off” mode, it seems that most days are 90% days. As such, I now put very little emphasis on the idea of breadth or up/down volume – at least on a daily basis.

The same can be said for very simple trend indicators. It is said that price is a “pure” indicator due to the fact that nothing can cause price to diverge from itself. Thus, the idea is that if you can stay on the right side of the prevailing trend, you should be in good shape. This idea has led to the widespread use of moving- average indicators over the years, where the price trend of the index or security in question is smoothed out by averaging the prices of the last X-number of days. Then when the security you are trading crosses above or below the moving average, you buy or sell accordingly.

As to the question of which moving averages are best, we could spend the rest of the month arguing over whether it is best to look at very short-term ma’s such as a 5-day versus longer-term moving averages. But if you spend any time at all watching financial T.V., you will undoubtedly agree that the financial press is fixated on longer-term moving averages such as the 50- or 200-day.

Traders, on the other hand, are much shorter-term in nature and tend to focus on ma’s such as something in the vicinity of 20 days. But here’s the big point… Due to the fact that HFT now dominates our world, the use of a 20-day moving average crossing as your trigger point for a trade has become next-to worthless.

Ian Naismith, who is a fine analyst, a past President of NAAIM, and the head of Sarasota Capital, did some research on the subject that he presented to a group of active managers this week. His conclusion: Using moving average crossovers as buy and sell points is a complete waste of time and a terrible signal. Ian illustrated his point by showing the results of trading the SPY using a simple 20-day ma since the inception of the SPY. Total return of the system over the period: +15%. The problem is the buy-and-hold approach returned +165% during the same period – oh, and less than 30% of the trades were successful. Yikes!

I won’t bore you with the rest of the stats, but the results, while better when you went with a longer ma, did not beat holding the SPY since its inception.

So, as I’ve been saying recently, we’ve got a new market environment on our hands. This can be said for the period that began in 2000 as well as the post-flash crash era. Therefore, as market analysts, we’ve got to do more than just relying on age-old trend indicators because many of those indicators just don’t work anymore. And it is for this reason that we must continue to work hard to stay in tune with the market’s environment.

Turning to this morning… Markets have improved a bit on the passage of new measures in Italy and the fact that Italian bond yields are now trading lower.

On the Economic Front… We will get an update on the UofM sentiment index at 9:55 am.

David Moenning
Editor:  The Daily Decision