Cabot Trend Lines and Cabot Tides...because the music is always changing
By Carlton G. Lutts, Founder of Cabot Market Letter
More than 30 years ago we had the pleasure of talking with Mr. Edward Johnson, the founder of Fidelity Investments of Boston. If you are not aware of it, we want you to know he was a great stock picker. His son, Ned Johnson, eventually took over the company and turned out to be a marketing genius, expanding the business tremendously.
The music is always changing
At the time we were both attending a Contrary Opinion Forum in Manchester, Vermont. Edward Johnson was one of the speakers and I'll never forget the title of his talk—it was, The Music Is Always Changing. And the gist of his talk was that just when you start feeling comfortable with the market direction or group of stocks in favor, something comes along to change everything. His point was that you should always be on the lookout for these changes that appear out of the blue. He likened this to a dance in which the music unexpectedly changes from a foxtrot to a waltz to a tango, etc. You have to keep changing your dance step to keep up.
Between some of the formal presentations we had a chance to talk to Mr. Johnson at length. He made an important observation about his business that has remained with us through the years. His point was in regard to market timing. He said that in spite of all the professional advice he was constantly receiving from his colleagues on the coming market direction, he would have been far better off simply following the "advice" of the 200-day moving average of a leading index such as the Dow Jones Industrial Average or the S&P 500 Index.
A moving average is used to smooth out the daily (or weekly or monthly) fluctuations in a stock or index. To get a 200-day moving average, you simply take the last 200 daily closes in a stock or index, add them up, and then divide by 200. Moving averages are widely followed by institutions, which often initiate or add to positions when a security falls down to its moving average.
The Cabot Trend Lines
Mr. Johnson’s statement impressed us so much that when we started writing The Cabot Market Letter in 1970, we made sure the 200-day moving averages of two important indexes were part of our timing system. Today we use the S&P 500 Index and the Merrill Lynch 100 Technology Index, and we’ve supplemented the 200-day moving average with a 100-day moving average. We call these averages the Cabot Trend Lines. Found on page 6 of every Cabot Market Letter, they are still one of our key indicators. They have stood the test of time!
Over the years, we have found that it pays to follow these Cabot Trend Line signals carefully, especially when a new signal flies in the face of "common wisdom." For example, we know that major bull markets begin in an environment of doubt, fear, apprehension and confusion. After a long bear market, when investors have been subjected to a deluge of bad news, the man on the street has no desire to buy common stocks. Yet that’s precisely when the Cabot Trend Lines give their best buy signals!
There’s no better example of this than our 2003 buy signal from the Cabot Trend Lines. Back in March of that year, America was preparing for war in Iraq. Unemployment was jumping and earnings reports were disappointing. And all of this was coming on the heels of a punishing three-year decline, further amplifying skittishness among investors. But on March 21, 2003, the Cabot Trend Lines turned bullish, right in the face of all that bad news. The rest is history: 2003 brought a super bull market, with the major indexes rising rapidly and the best growth stocks soaring into the stratosphere!
The Cabot Tides
As a complement to the Cabot Trend Lines, we use the Cabot Tides, a timing indicator that provides intermediate-term buy and sell signals that provide a faster response time.
The Cabot Tides are made up of five indexes that we continually monitor with their own 25-day and 50-day moving averages, rather than the longer moving averages associated with the Cabot Trend Lines. The five indexes are the Merrill Lynch 100 Index, the S&P 500, the NYSE Composite, the Nasdaq Composite and the S&P 600 Small Cap. For any one of these indexes to flash its own buy signal, the index has to climb above its advancing 25-day moving average. It is mandatory that the lower moving average be advancing for a valid buy signal to be given by that index. For a sell signal to be given, the individual index has to fall decisively through its lower (usually the 50-day, but sometimes the 25-day) moving average. These five indexes tend to move in unison, up or down, but with some variations. As you can appreciate, all of these indexes represent a very broad reading of the entire market. For the Cabot Tides as a whole to produce a sell or buy signal we must see at least three of the five indexes give a signal in that direction.
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 time lost in the first few weeks of identifying a new market advance. Also, 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 can quickly turn into a sell signal if the market turns weak enough to drop the indexes below their lower moving averages. When 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 the market.
In conclusion, we have found moving averages, when used correctly, to be a tremendous help in our market timing work. They help to turn us bullish early in bull markets, as they did in March of 2003, as they did in August and September of 2004, and as they did in August of 2006. They help to turn us bearish early in bear markets, (the Trend Lines were bearish from October 2000, right through October of 2001) before we’ve lost too much of our hard-earned profits. And so, today, our advice to you is simple, yet profound—pay more attention to moving averages! By getting out early in the next bear market, you’ll keep your investment portfolio safer. By buying early in the next major bull move, you’ll be buying smarter than the Johnny-come-latelies who re jumping into the market close to the top. By doing both, you’ll be investing better, and you’ll have better profits to show for it, too!
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