Experienced investors and stock market technicians would argue with the old adage that says, “You can’t time the market.” By watching key stock market technical indicators and historical market data, you can get a better-than-average idea of where the stock market may be headed.
Music is Always Changing
Over 40 years ago, Cabot founder Carlton Lutts had the pleasure of talking with Edward Johnson, the founder of Fidelity Investments of Boston. Johnson 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.
Carlton and Edward Johnson were both attending a Contrary Opinion Forum in Manchester, Vermont. Edward Johnson was one of the speakers, and none of us at Cabot will ever forget the title of his talk. He called it, “The Music is Always Changing.” This gist of it was that, just when you start feeling comfortable with the market direction, or the group of stocks that are in favor, something comes along to change everything. His point was that you should always be on the lookout for these changes that seem to come out of the blue. He likened it to a dance in which the music unexpectedly changes from a foxtrot to a waltz to a tango. You have to keep changing your dance steeps to keep up.
Keeping in Step
In between the formal presentations at the Forum, Carlton had a chance to talk with Johnson at length. Johnson made an important observation about market timing that we at Cabot have never forgotten. He said that, despite all of the professional advice he constantly received about the coming market direction, he would have been far better off to simply follow the “advice” of the 200-day moving average of a leading index like the Dow Jones Industrial Average or the S&P 500 Index.
A moving average serves to smooth out the daily (or weekly or monthly) fluctuations in the price of a stock or an index. To calculate the 200-day moving average, simply take the closing price for each of the past 200 days, add them up, and then divide by 200. Moving averages are commonly followed by institutions, which may initiate trading or add to positions when a security falls down to its moving average.
Still Working After 40 Years
Johnson’s statement impressed Carlton so much that when we started writing the Cabot Market Letter in 1970, he made sure that we included 200-day moving averages as part of our timing system. Today we use the 200-day moving averages of the S&P 500 Index and the Nasdaq Composite. And we now include a 100-day moving average as well. We call these averages the Cabot Trend Lines and they are still one of our key indicators. They have stood the test of time.
So what do these indicators tell us? We watch them carefully, especially when they are giving a signal that flies in the face of so-called conventional wisdom. For example, we know from experience that bull markets always begin in an environment of fear, doubt and confusion. After a long bear market, when investors have been deluged with bad news, the average investor has no desire to buy stocks. Yet that’s precisely when the Cabot Trend Lines give their best buy signals!
The Music is Changing Faster than Ever
As you know, the stock market is always changing and it pays to remain alert to these changes. At the turn of the millennium, we noticed that the market was slowly becoming more volatile, and bullish and bearish cycles were becoming shorter in duration. In response, we developed the Cabot Tides, a timing indicator that provides intermediate-term buy and sell signals with a faster response time. These signals complement the longer-term Cabot Trend Lines.
The Cabot Tides are made up of five indexes—the S&P 500, the NYSE Composite, the Nasdaq Composite, The S&P 400 MidCap and the S&P 600 Small Cap. The Cabot Tides monitors the 25- and 50-day moving averages.
When an index climbs above its advancing 25-day moving average, it’s a buy signal. (The lower moving average has to be advancing.) When an index falls decisively through its lower moving average (which is usually the 50-day, but can be the 25-day), it is giving a sell signal.
These five indexes represent a very broad reading of the entire market, and they tend to move in unison. For Cabot Tides as a whole to give a buy or a sell signal, we must see at least three of the five indexes give that signal.
It Works—Every Time
Here’s a good example of how this works in practice: After sitting out most of the 2008 crash (because we had watched the trend lines and were sitting 90% in cash in early September), the market sank even deeper in the spring of 2009. By the middle of March, however, Cabot Tides turned bullish, and the Trend Lines followed less than a month later. The historic 2009 rebound was underway, and our indicators caught the turn perfectly.
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. That’s the nature of a moving average. But this accuracy comes at a price. The price is the time that you lose in the first few weeks of a new market advance, and the penalty you pay for getting out of the market quickly when it takes a sharp downturn right after a new buy signal. 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. In that case, quickly turn defensive again and preserve your capital rather than trying to make big gains in the market.
At Cabot, we have found moving averages, when used correctly, to be a tremendous help in our market timing work. Our advice, therefore, is to pay more attention to moving averages. Getting out early in a bear market will keep your portfolio safer. Buying early in a bull move will get you into the market earlier (and at a lower price!) than the Johnny-come-latelys who will be getting in closer to the top. Do both, and you’ll be investing better, with better profits to show for it.More on Cabot Market Timing Indicators
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