METHODOLOGY AND INVESTMENT STRATEGY
WHAT ARE INDICATORS AND COMPOSITE INDEXES?
An indicator is something that provides a clue to a matter of larger significance or makes perceptible a trend or phenomenon that is not immediately detectable. An indicator's main defining characteristic is its ability to quantify and simplify information in a manner that promotes an understanding of environmental problems decision makers face.
The mathematical combination of a set of indicators is usually called an "index" or a "composite indicator." In other words, an index is a compound measure that aggregates multiple indicators. Composite indexes are based on sub-indicators that have no common meaningful unit of measurement and no obvious method of weighting. That is the model designer’s work.
WHAT ARE QUANTITATIVE AND QUALITATIVE INDICATORS?
As the term denotes, a quantitative indicator indicates a quantity. The quantity can be a pure number, an index, ratio, or percentage. Quantitative indicators are very widely used in research as they give a very clear measure of things and are numerically comparable, moreover at different times. Most often, quantitative indicators are generally preferred as they do not need feelings or judgment to quantify them. They just need mechanical methods that are theoretically expected to give the same results, no matter who measures them. [Example: price earnings ratio >25].
Qualitative indicators may not have numeric measures as such. Rather, they depict the status of something in more relativistic terms. A specific analysis using the “mind’s eye” may be required to obtain a result. [For example, stock market technical analysis using moving averages for forecasting future price movements based on past price movements].
There is neither comparison nor competition between quantitative and qualitative indicators. Both have their respective values, relevance, and importance and are often complementary.
OUR MARKET RISK MODEL
Black Diamond Research offers composite indexes to help investors quantify risk and anticipate cyclical market trends – on the downside or upside. Our tools help you to maximize your profits from stock market investing while minimizing your portfolio risks.
We have selected, categorized, combined, and weighed dozens of qualitative and quantitative variables to structure our composite indexes.
An indicator sends a warning signal if it is equal to 1. Zero indicates no warning signal. The sum of all warning indicators divided by the total number of items is equal to the composite index’s value (%). Depending on what the index is measuring, the higher the figure, the riskier or safer the associated financial environment is.
Indicators are not weighted equally. Those with the highest success ratio have a stronger weighting balance than others.
The data sourced to build our stock market indicators and market risk models come from U.S. financial and economic statistics. The benchmark index we track is the S&P 500 Index.
If you do not invest in U.S. equities, please remember that the NYSE is the world’s largest stock exchange by total market capitalization and that global markets are inter-connected. Therefore, what happens in the U.S., whether it is a recession, financial crisis, or other market shock, propagates to European, Asian, and emerging stock exchanges almost instantly.
Our index data is normally published in the first week of each month for data availability purposes.
STOCK MARKET COMPOSITE INDEXES
The Black Diamond Stock Market Bearish Composite Index is composed of 88 indicators: 68 qualitative and 20 quantitative. These variables are weighted and distributed into 13 categories such as market breadth, sentiment, technical analysis, or combination of stock market indicators. From this source, we have designed proprietary sub-indexes that target different objectives. All indexes and subindexes vary from 0% to 100%.
Bearish Composite Index: aims to anticipate downside market trends;
Bear Subindex: display factors to anticipate bear markets (a 20% fall or more);
Correction Subindex: objects to detect corrections (a 10% fall or more) or crashes;
Quantitative Subindex: uses only quantitative indicators from the market risk model;
Qualitative Subindex: uses only qualitative indicators, requiring a “mind’s eye” to be analyzed.
At the end of the bullish cycle, there is an accumulation of warning indicators.
The Black Diamond Stock Market Bullish Composite Index comprises 41 stock market indicators.
Bullish Composite Index: seeks to detect buying opportunities and long-term lows in order to profit from a coming bull market (a 20% rise or more).
At the end of the bearish cycle, there is an accumulation of indicators signaling buying opportunities.
Below is a summary of these two composite index structures based on the number of stock market indicators:
Our models are not rigid and may absorb new indicators from our ongoing research. Please note that from 2000 to 2007, some data wasn’t available: indicators utilization was equal to 74% in 2000 and grew to 100% in 2007.
In the present methodology section, the track record starts in July 2000 and ends in January 2012. Index data for the past five years is not disclosed and is only accessible to subscribers.
The chart below presents the Bearish Composite Index vs. the S&P 500 Index from July 2000 to January 2012.
The value of the Bearish Composite Index tends to grow moderately during the first part of the bull market. The number of warning indicators accelerates in the final stage, generally when sentiment takes control of prices over fundamentals.
The following chart compares the S&P 500 Index to periods in which the Bearish Composite Index had a value superior to 60%, on the same time lapse.
The Bearish Composite Index has correctly anticipated bear markets since 2000:
The charts below show the Bullish Composite Index and zones in which it was superior to 60% vs. the S&P 500 Index benchmark. Bull markets were correctly anticipated by the Bullish Composite Index since 2000.