Market Timing Indicators
Cabot's Market Timing Indicators Here are detailed explanations of how we use our four primary market timing indicators which are discussed in every issue of the
Cabot Market Letter and the Cabot China-Timer which is used in the
Cabot China & Emerging Markets Report.Cabot Trend Lines The Cabot Trend Lines are our unique way of determining the long-term trend of the stock market. As long as both the S&P 500 Index and the Merrill Lynch 100 Technology Index fluctuate above their respective trend lines, we consider the market to be bullish. If both indexes are below their trend lines, we are in a bear market.
The Cabot Trend Line for each index is a composite of two moving averages, a 20-week and a 39-week moving average. We use only the lower reading of the two moving averages in any week. This lower average is always recorded as the Cabot Trend Line.
The technique of using two different time-length moving averages produces earlier buy signals safely when a new bull market is getting under way (the 20-week average) and it allows plenty of room for severe corrections in bull markets without false sell signals being given (the 39-week average). So using the trend principle, we can never be on the wrong side of the market for very long. And once the new trend forces us onto the correct side of the market, the probabilities favor a continuation of the current market trend.
Cabot TidesWe use five different market indexes to help us determine the overall intermediate-term direction of the stock market. They are: S&P 500, NYSE Composite, Nasdaq Composite, S&P 600 Small Cap and the Merrill Lynch Tech Index, an index that equally weights 100 of the leading technology stocks in the market.
The market is considered to be advancing on an intermediate-term basis if at least three of these five indexes are advancing. And contrarily, the market is deemed to be declining if at least three of these five are declining.
To derive intermediate-term signals, we compare each index to its own 25-day and 50-day moving averages. If the index is standing above the lower of these two moving averages, and that lower moving average is itself advancing, then this index is bullish. Otherwise, it's safe to assume the intermediate-term trend for this index is down.
Probably the most important advantage of using this moving average approach in timing the market is that you are guaranteed to catch every major market advance while avoiding every major market decline. This is the nature of a moving average. But there is a cost. It's the opportunity lost in the first few weeks of a new advance. And it's the small penalty you must pay for getting out of the market quickly when the market changes its mind soon after a new buy signal is given. For example, a new buy signal could quickly turn into a sell signal if the market turned weak enough to drop the index below its lower moving average. If that happens you should quickly turn defensive again and start thinking about the preservation of your capital instead of trying to make big gains in a falling market.
Two-Second IndicatorThe Two-Second Indicator is so named because that’s how long it takes to read: Just two seconds, every day. Specifically, this indicator measures the number of securities on the NYSE reaching new annual (52-week) price lows on any given day. This data is readily available in most major newspapers, though we use the data from The Wall Street Journal.
The Two-Second Indicator’s specialty is detecting market tops. When the number of daily new lows on the NYSE is greater than 40 while the major indexes are rising to new peaks, look out! It’s telling you that, internally, sellers are in control of most stocks, and the indexes are masking this weakness. We call this the Leaky Boat Syndrome, where, on the surface, things look fine, but in reality you’re taking on water! It’s the same story when new lows expand to more than 40 just as the indexes come down from their peaks—again, not a good sign.
However, if new lows expand to greater than 40 after the indexes are five days or longer off their peaks, then it’s not as big a deal; in this case, the Two-Second Indicator is simply telling you the market is entering a correction. This correction could be deep, and thus you should still practice caution. But the chances that the market is entering a real bear market at that point are unlikely.
Finally, when new lows are less than 40 day after day, that’s a sign of a healthy, robust market – the buyers are firmly in control of most stocks. Overall, it’s a simple indicator, but we’ve learned that the simplest indicators are often the best, and the Two-Second Indicator certainly fills that bill.
Master Sentiment GaugeOur Master Sentiment Gauge plays an important role in our investment thinking. Sentiment, as you may know, is a contrary indicator of stock prices—when most investors are bullish, that means most people have already bought stocks, and that means there aren’t many buyers left on the sideline, so prices are apt to slip. The opposite is also true, as high levels of fear usually occur near market bottoms.
Our Master Sentiment Gauge is a composite of a few different sentiment-related indicators, each of which is measured weekly. At the end of each week, each indicator is given a score from 0 (most pessimistic) to 10 (most optimistic). And then we tally the score from each indicator, resulting in our Master Sentiment reading, which itself can range from 0 to 100.
While the history of this indicator is limited, it’s proven to be of great value in recent years. Readings below 30 or 35 often occur near market lows—the bear market low of March 2003 saw its reading fall all the way to 12! Conversely, when readings rise above 80 or 85, the market is usually in for some rough sledding, though it should be noted that buy signals (readings below 30 or 35) are more accurate than “sell” signals (readings above 80 or 85).
Actually, because sentiment measures are an inexact science to say the least, we don’t use the Master Sentiment Gauge as a strict buy or sell tool. Instead, it helps us lean against the wind, possibly laying off new buying when readings are above 80 or 85, and maybe adding a stock or two when readings dip to the 30 region. In other words, it helps us keep our feet on the ground, pointing out those few times each year when the crowd is all pushing in one direction.
Cabot China-TimerThe Cabot China-Timer is a trailing market indicator that uses the performance of the Halter USX China Index to gauge the trend of emerging market stocks. The China-Timer is considered to be positive when the Halter Index—which is composed of over 90 Chinese stocks that trade on major U.S. exchanges as American Depositary Receipts or ADRs—is above the lower of either the 25-day or 50-day moving average. When the Index falls below both its 25- and 50-day moving averages, the China-Timer turns negative and the Cabot China & Emerging Markets Report adopts a defensive stance. The China-Timer will not be considered as having turned positive until the level of the Halter Index once again moves above either the 25- or 50-day moving average, and that average is itself trending upward.
While the Cabot China-Timer is based entirely on the movement of the Chinese ADR market, it is considered to be a proxy for the general level of risk tolerance in investors. If investors are leaving Chinese stocks, they will also be exiting Brazil, Russia, India and the other emerging markets.
More on Cabot Market Timing Indicators:We use five different market indexes to help us determine the overall intermediate-term direction of the stock market.
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The Cabot China-Timer is a trailing market indicator that uses the performance of the Halter USX China Index to gauge the trend of emerging market stocks.
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The Two-Second Indicator is so named because that’s how long it takes to read: Just two seconds, every day.