The major trend in the stock market is still positive, but the pace of the rise has slowed over the past few months. Today we take a look at one indicator of momentum that can shed some light on where the market may be headed next.
Like most investors who have been through a few market cycles , I try to stick to a few trading rules in order to avoid making dumb market-timing decisions.
- Don’t fight the tape
- Don’t fight the FED
- Watch the business cycle
- And don’t get ahead of your indicators
These rules have one thing in common. They are there to remind me not to jump the gun when the market goes through periodic bouts of volatility. As more and more market pundits climb on board the “correction is just around the corner” bandwagon, I’m trying hard to resist the temptation to join them. With a positive tape, a friendly FED, and a healthy business cycle, I don’t want to get ahead of my indicators. Nearly every time I’ve done that, I’ve lived to regret it.
The Zone of Death indicator (a phrase that was first coined by economist Robert Dieli at NoSpinForecast), is based on the year-over-year percent change in the S&P 500 index. When he plotted this line on a long term chart, Dieli noticed that when it passes through the 10% level from above, it tends to accelerate to the downside until it gets to a reading of minus- 10%. So he described the area of the chart between plus- 10% and minus- 10% as the Zone of Death because once the line entered this area, there was a good chance that the bull market would die. Here’s what the chart looks like, going all the way back to 1955.
A keen observer will note that the line on the chart has a tendency to bounce around as it penetrates the top of the ZOD. These false signals create a lot of noise, and make the indicator unreliable as a forecasting tool. So I ran the numbers using a 5% threshold, to see whether this would improve the reliability of the signal. It did. When the line penetrates 10% from above, it’s a yellow flag. But when it penetrates 5%, it becomes a red flag. There are far fewer false signals. The chart below shows what happened in the 2008-2009 bear market.
Today the line stands at 7.36%. This means that for this indicator, there is a yellow flag in place.
But it would be premature to take any action at this point, because the primary trend of the market is still higher, and the FED is still supporting the risk-on trade. Combine these two positives with the fact that the business cycle is still in an expansion period, and you reach the conclusion that at least for the time being, you should stay invested in equities.
Even when the market is nearing the Zone of Death, it’s important to not get ahead of your indicators.