Stock Market Investment Strategy
The primary objective of our indexes is to help investors “avoid the bear,” thanks to the Bearish Composite Index. The other main goal is to help them “ride the bull” by capturing the positive and avoiding the negative within a long-term market upward trend.
Because it is very difficult to pick the bottom or top of the market, Baron Nathan Rothschild once said: “You can have the top 10% and the bottom 10%; I will take the 80% in the middle”.
Using this chart, courtesy of Lance Roberts, Chief Strategist/Economist for Clarity Financial, here is how the concept works:
Buy and sell signals from indexes may come a little early, right on time or a little late. However, the main goal is to capture most of the long-term upside (~80%) and miss most of the downside.
To this end, you can build your investment strategy by combining the signals of the Bearish and Bullish Composite Indexes, which are synergistic. The composite indexes provide the buying and selling periods within the market cycle, as presented in the following graphic chart:
In other words, you can define index cut-off values in accordance with your chosen investment objectives and risk exposure: buy when the Bullish Composite Index is high (for example >60%) and sell when the Bearish Composite Index is significant enough (for instance >60%). This strategy would be considered balanced and conservative, as illustrated on the chart below:
Furthermore, you can do the same with sub-indexes. For instance, if you want the market risk model to evaluate intermediate-term downside risk, you can use the Correction Subindex:
The Correction Subindex may help you avoid market turbulence characterized by high volatility, such as that experienced during the “fiscal cliff” crisis of 2011:
On the contrary, if you want to focus on the long-term, you can use the Bear Subindex:
Index Cut-Off Settings
An index cut-off value set at an extreme level may highlight more sensitive bearish and accurate bullish signals. Here are three examples using the Bearish Composite Index, Correction Subindex, and Bear Subindex with different cut-offs:
These three examples fully comply with the 80/20 investment philosophy during the two major market cycles that occurred since July 2000.
Index performance may be affected by your index cut-off settings choices.
An Excel spreadsheet including all index data is released each month. It is downloadable via our website to enable you to make your calculations and construct strategies as needed.
Detecting the Peaks
Peaks in signal expressed by Composites Indexes and Subindexes can be used to improve timing accuracy and thereby, higher investment performance.
Have a look at the different signal peaks (materialized by a “P”) between July 2000 and January 2012:
Below are the months that saw the Bullish Composite Index peak at 10%+ (thin green line) and 50%+ (thicker green line) levels. The red vertical lines represent times when the Bearish Composite Index peaked at 40%+ levels:
Therefore, you can use the following chart if you desire to track, for instance, the Bullish Composite Index peaks above 50% within your strategy, in addition to the Bearish Composite Index with a cut-off set at 60%+:
To balance your risks, you may decide to restructure your portfolio, depending on the value of the index used.
Next is an example of how an equity investor can redefine portfolio risk exposure by using the Bearish Composite Index. The greater the value of the Bearish Composite Index, the higher the cash or safe haven allocation and the lower exposure to equities within the portfolio.
As you can see, you have many strategic options at your disposal.
In this section, the Bearish Composite Index, the Bear Subindex, and the Correction Subindex all have their cut-off value at 60% – within a conservative strategy.
Set on its 60% trigger alert, the Bearish Composite Index warned 344 days before the 2008 bear market became official:
The following chart represents the anticipation time lapse during crisis episodes since July 2000 for the Bearish Composite Index, the Bear Subindex, and the Correction Subindex:
Below is the time lapse between the warning given by the Bearish Composite Index and the market top. The index can send a warning signal before the top is attained: the anticipation time lapse is therefore negative. The index can send a warning signal after the top is reached: the anticipation time lapse is consequently positive. For instance, the Bearish Composite Index warned 70 days before the S&P 500 reached its top on October 9, 2007.
Finally, here is the total percentage loss avoided thanks to the Bearish Composite Index, the Bear Subindex, and the Correction Subindex, once an alert has been given:
Avoiding major drawdowns is essential to succeed in equity markets over the long-term. On the chart below, we present the 12 worst months since July 2000 versus the periods considered risky by the system.
The red zone corresponds to the period from the first sell alert (Bearish Composite Index for the first time above 60%) to the first buy alert (Bullish Composite Index first time above 60%) within the current cycle.
The green zone corresponds to periods during which the Bullish Composite Index is signalling very oversold conditions. Volatility is very elevated and investors generally panic during this period.
The weakest months are logically concentrated in the first zone as the bear market develops (they must be avoided) and in the second zone as panic emerges (they must be used as opportunities to buy).
Since July 2000, only one out of the 12 worst months – represented by black vertical lines – has occurred elsewhere, due to the flash crash on May 6, 2010 and Euro fears.
In this section, we use the terms “risk-on” and “risk-off” defined by Investopedia here.
Let us suppose we have a portfolio composed of the S&P 500 Index, considered as an asset.
By using a conservative investment strategy, with the Bearish and Bullish Composite Index triggers set at 60%, we can define two kinds of periods:
Risk-on zone: the portfolio is active between the first buy signal sent by the Bullish Composite Index and the first sell signal sent by the Bearish Composite Index (period in green on the chart below);
Risk-off zone: the portfolio is inactive between the first sell signal sent by the Bearish Composite Index and the first buy signal sent by the Bullish Composite Index (period in red on the chart below).
This means the S&P 500 is bought between red and green zones and sold between green and red zones.
The track-record obtained versus the S&P 500 Index between July 2000 and January 2012 is illustrated below:
The graph below illustrates a hypothetical $100 investment made on October 31, 2000, the date of the first sell alert from the Bearish Composite Index during the Tech bubble.
The green curve represents the evolution of a portfolio that avoids the 12 worst months over the defined time horizon.
The blue curve represents the development of a portfolio that is active during risk-on periods only.
The most interesting point is the difference between the blue and green portfolio curves.
The blue portfolio tends to outperform the green one during risk-off periods, as it is frozen and protected from any downside move until the first buy signal. This allowed the blue curve to lead until the recovery from the 2008 crisis. The buy signal from the Bullish Composite Index came too early (using the 60%+ cut-off) and activated the blue portfolio in December 2008. Consequently, both curves were back together. Between 2009 and 2012, the green portfolio increased its leadership due to the 2010 and 2011 crises (April 2010 was one of the 12 worst months).
The performance data shown represents past performance, which is no guarantee of future results. Indexes such as the S&P 500 are not securities in which investments can be made.
Stock market investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective and risks carefully before investing. Learn more at www.sec.gov or www.esma.europa.eu
The indexes published by Black Diamond Research assess risk levels and are a quick way to gauge what our stock market indicators, risk models, trend analysis and studies are suggesting. We do not suggest using our tools in any kind of mechanical way. They are meant to help support any existing stock market technical analysis or fundamental research you may be doing.