Thursday, April 22, 2010

Why Popular Market Indicators May be Giving False Signals

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Market indicators based on percent of stocks above their 50-day moving average and the number of advancing versus declining stocks are flashing bullish buy signals. While these have supposedly worked well in the past, the underlying conditions that led to their success may not exist in today's market. If so, these indicators could be dangerously misleading.

Ned Davis from Ned Davis Research has recently declared the market is experiencing a 'breadth thrust'. This takes place when more than 90% of stocks are trading over their 50-day moving average. This indicates extreme bullishness in the market. This indicator could be a valuable buy signal to investors if it takes place after a significant market low. The indicator did indeed give a buy signal on May 4, 2009 and again on September 16, 2009. The returns have been considerable from these buys. Another buy signal was given on April 5, 2010. After more than a year of rallying and the Dow Jones Industrial Average up around 70% from low to high, this signal is now more likely to indicate a seriously overbought market with few investors left to buy. This indicator has only flashed 12 buy signals since 1967, three of which took place within the past year. The good returns from the two signals in 2009 have in all likelihood made the overall profit potential of following this indicator look a lot better than it was previously and this should be taken into account when examining claims as to this indicators past performance.

Dan Sullivan from The Chartist is also bullish. He bases his outlook on advances versus declines in the market being greater than two to one. His indicator gave three buy signals in 2009. There have only been 18 such buy signals in the last 60 years. The only other years with multiple buy signals were 1962, 1975 and 1982. The Dow was down 11% in 1962. As for 1975, it followed a major two-year bear market in 1973 and 1974 that almost cut the Dow in half. The Dow rose 32% in 1975 and closed at 852. Six years later in 1981, it ended the year at 875 or an additional 3% higher. In 1982, an 18-year secular bull market began, so this was a good call. However, what made it a good call was the market finally broke out after going sideways and down for 16 years. The most analogous situation to today's rally was 1975. The Dow should have rallied in 2009 from its deeply oversold condition and it has, but that rally can't be infinite.

Investors should not blindly follow market indicators, especially when media reports usually give information that is limited to only what is taking place right now. To accurately decide the value of a current buy or sell signal, it is necessary to know how and why it worked in the past. Close examination may indicate the indicator didn't work as well as claimed or that it works only under certain conditions like the Fed lowering interest rates or immediately after a major sell off. As is always the case, investors who want to make money in the markets need to think for themselves.

Disclosure: Not relevant.

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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