2. Stock
Market
Model
Generalize the model
Identify the five points any
environmental model
Give an example of an indicator or
study that could reasonably be
substituted for one item in each of the
three components
3. Types of Indicator
Indicators
Internal Indicator
(Internal indicators relate to the
price action of a market or
index )
External Indicator
(External indicators include
anything outside of price
action)
4. Internal Indicators
• Internal indicators relate to the price action of a market or index
• The usual list of suspects, along with a multitude of variations: moving averages,
momentum, advances and declines, and volume trends.
• All of these can be found in the bottomless bag of tools used by the creative technical
analyst.
• Internal indicators into two distinct types: trend following and trend sensitive
• Trend Following :
• Harmony with the market's primary trend, and with enough weight in a model they
act as our stop—loss when needed.
• Used well, they can help investors let profits run and cut losses short.
• These indicators include moving—average crosses and slopes and some measures of
momentum, used either alone or aggregated.
• Trend—following indicators are rarely neutral and can generate great returns, but
sometimes give notoriously false signals.
• By their very nature they are late. Consequently, they require patience.
5. Internal Indicators
• Trend—sensitive indicators , also known as overbought—oversold indicators,
include mean reversion, momentum variations, and deviation from the trend.
• These indicators have a tendency for picking tops and bottoms and can
influence models when price trends reach extremes.
• They are very accurate but not adopt at generating significant gains.
• Since they spend a good part of the time in the neutral zone they tend to work
well in multi—indicator models asserting themselves only at potential
extremes.
• Rounding out internal indicators is market breadth, an extremely useful tool in
determining the technical environment.
• A/D data (advances, declines, unchanged), new highs and lows, the percent of
stocks in a universe meeting a specified criteria (e.g., above or below a moving
average), volume data (advancing and declining volume), and combinations of
A/D and volume.
6. External Indicators
• External indicators include anything outside of price action
• The monetary environment,
- Crowd psychology, valuation, and economic conditions. At NDR we tend to
lump valuation and crowd psychology in the sentiment category.
- We also tend to include economic indicators that can influence markets (e.g.,
inflation) in the monetary category and sometimes, to a lesser extent, the
sentiment
• Finally, I realized that to build a truly diverse, objective model requires finesse,
diligence, a bit of artistic panache, and a strong knowledge of macroeconomic
relationships, ranging from company fundamentals to macroeconomic
fundamentals to Fed watching. Ironically, computing power takes a back seat in
building good models.
7. Fab Five (Environmental Model)
• The Fab Five is an environmental model that uses what we call
modes.
• Its job is to assemble the major internal and external factors that
affect markets and combine them to produce a single objective
verdict: bearish, neutral, or bullish.
What is an environmental model?
It's one that can keep risk at arm's length without
sacrificing too much on the long side.
8. Fab Five (Environmental Model)
• Such models effectively gauge how good conditions are for
investing: do we have calm waters or are we about to enter the lower
40 latitudes?
• An environmental model takes into account what the Federal
Reserve is doing, what the so—called smart money is doing, how
speculators are feeling, what interest rates and inflation are doing,
and, above all else, what the primary trend is.
• Using a weight—of—the—evidence approach gives us an educated
feel for the risks in the market.
• The environmental model's job is not necessarily to give concrete buy
and sell signals. Its job is to measure the level of risk in the market.
9. Fab Five (Environmental Model)
• To create the Fab Five, we combined individual models covering
our favorite areas of the market
• Fab Five model has only four components—sentiment, monetary
readings, Combo, and the tape—but the tape is given double
weight. I'll start with it because it accounts for two–fifths of the Fab
Five.
• The top clip has an additional series on it that represents an equity
line based on going long the S&P 500
• when the model is above the upper bracket, going into T–bills
• when the model is between the brackets, and shorting the S&P 500
• when the model is below the lower bracket.
• This equity line is only for perspective; it's there to give a close–up
view of how the model has behaved in the past.
11. The Sentiment Component
• Fortunately, analysts and market historians have access to a
smorgasbord of sentiment indicators.
•These include polls of investors, newsletter writers,
professionals, nonprofessionals, and so on; people who put
their money where their mouths are.
•For example, a high price/earnings or price/dividend ratio
reflects optimistic investors, while a low P/E or
price/dividend ratio shows fearful investors. We can also say
the same thing about market momentum in the context of
optimism or pessimism.
12. The Sentiment Component
• The sentiment
component of the Fab
Five uses some of these
concepts in its seven
indicators. Each
indicator delivers +1, 0,
or –1 to the overall
component, with one
exception: our Daily
Sentiment Composite
(shown later in Figure
20.16), which gets
double weight.
13. The Monetary Component
• The availability of money equates to liquidity, and measures of
liquidity help us get a handle on risk.
• Monetary situation comes from two major sources:
(1) the price of money, meaning interest rates
(2) the supply of money.
• Rates of change in interest rates - yield consistently good results
against the stock market.
• Moody's corporate Baa yields as a 26–week percent change. It's just
that simple:
• when interest rates are heating up, it's bad for stocks.
• When interest rates are coming down, it's good for stocks.
14. The Monetary Component
•Return Index, but they work just as well for the S&P 500. The
contribution to the monetary component is +1 below –3
percent, 0 between –3 and 6 percent, and –1 above 6 percent.
•Graph shows Moddy’s Baa bond yield rising and falling with
values of gain per annum above 6%, between minus 3 and
6%, and below minus 3
16. Combo Component
•Combo because it's composed of six stock– market models,
each with a different mix of indicators.
•The six range from the very simple to the very complex, but
they each have the same weight.
•The contribution to the Fab Five Combo component is –1
when both are negative, 0 when mixed, and +1 when both
indicators are positive.
• Mix of trend–sensitive, monetary, and sentiment indicators
(sound familiar?). Half of the model is trend–sensitive (based
on breadth, to be specific) and half is external. This model was
highlighted in Tim Hayes' 2000 book The Research Driven
Investor.
18. Tape Component
• Seven individual indicators in the tape component.
• As with all the other Fab Five components, and in keeping with our KISS
philosophy,
• These indicators are each assigned—1, 0, or +1, and the result is produced
through simple addition.
• Simple, trend–following indicator is what technical analysts call a golden cross
(a point at which a short–term moving average breaks above a long–term
average, signaling a bull market to come).
• It is positive when the 50–day moving average of the S&P 500 is above its 200–
day average and negative otherwise.
• The box on the top part of the chart summarizes the indicator's performance
since 1929. At Ned Davis Research the box is called a mode bat.
