(Under Construction)
I need to introduce two “nerdy” concepts, math related. My apologies in advance, however, with an Engineering background, math is ingrained into my personality and investment process.
Binary Questions
The first concept is a Binary Question. Binary is a term which represents two values. A question that has only two possible outcomes is termed a Binary Question. For example: Questions which can have answer like True/False or Yes/No are Binary Questions. We can take this one step further and if a response is Yes or Bullish we can assign a value of one. If the response is NO or Bearish, we can assign a value of zero.
PERCENTILE RANKING
The second “nerdy” concept is percentile ranking. A simple way to think of Percentile Ranking is a ranking system of a basket of data points that normalizes the data to produce a score between 0 and 100. A percentile rank of 80 means that the rank is greater than 80% of all other scores being compared. For our purposes the lowest percentile rank of 0 would be bearish and the maximum percentile rank of 100 would be bullish. A reading of 50 would be considered Neutral. Depending on the ranking we can lean either bullishly, bearishly or simply neutral.
TOOLS OF THE TRADE
Now for the good stuff. The above “nerdy” discussion on Binary Questions and Percentile ranking wasn’t that bad was it? These basic concepts form the basis of how we can use a variety of powerful, historically proven market techniques, in unison, to produce the “Weight of the Evidence”. The tools I’ve created for the Portfolio Management Room have been constructed with an Investment time frame in mind. Accordingly, these tools are specifically configured differentiate between volatility to ignore and volatility to respect. This is important as the market does not move up or down in a straight line. We are looking for what would be considered normal fluctuations in the market vs what is not normal. Without further delay, the following is a brief outline of the “Tools of the Trade” we use to assess the Weight of the Evidence each and every week. Following the description of each of the measures, I’ll summarize the approach and show a recent market example.
TREND FILTER (TF) – measures the strength and direction of the trend of a ticker symbol. I also refer to this metric as Trend Strength. The Trend Filter is comprised of a Short, Mid, Intermediate and Long-term time frames. Each timeframe is weighted in the calculation of the Trend Filter with an emphasis placed on the longer-term trend. The final Trend Filter Reading has been converted into a percentile ranking from 0 (bearish-red) to 100 (bullish-bright green). A reading of 50 would be considered Neutral.
MARKET BREADTH – a measure of the health of the market using Advances, Declines, New-Highs, New-Lows and % stocks above a moving average. Bullish and bearish breadth triggers are determined via binary responses to pre-defined indicator thresholds. The sum of the binary responses has been converted into a percentile ranking from 0 (bearish-red) to 100 (bullish-bright green). A reading of 50 would be considered Neutral. For clarity, Market breadth is calculated at a market and sector level, as applicable, for each ticker symbol.
Relative Strength (RS) – measures the strength and performance of a ticker symbol against a basket of ticker symbols. Relative strength is calculated on both on a short term and longer- term basis. Short Term Relative Strength (ST RS) is intended to capture short term swings in the market and has a look back period of up to one week. Long Term Relative Strength (LT RS) is intended to capture long term strength and has a look back period of 6 – 9 months. The final Relative Strength Measure readings have been converted into a percentile ranking from 0 (bearish-red) to 100 (bullish-bright green). A reading of 50 would be considered Neutral.
TECHNICAL RANK (TR) – an indicator of indicators. This indicator measures bullish and bearish configurations of up to 30 technical indicators over monthly, weekly and daily timeframes. Binary responses to pre-defined indicator thresholds are added together to form a Weight of the Evidence. The final TR reading has been converted into a percentile ranking from 0 (bearish-red) to 100 (bullish-bright green). A reading of 50 would be considered Neutral.
MARKET TEMPERATURE GAGE (MTG) – This metric is intended to measure the direction, strength of the market as a whole and is not specific to any one ticker symbol. An applicable over arching question in the market for all investors should be, “Is the current market suitable for investments?” This metric is intended to provide a high-level answer to that question. This metric uses breadth, price action and intermarket technical analysis to produce a percentile ranking from 0 (bearish-red) to 100 (bullish-bright green). A reading of 50 would be considered Neutral.
Building the Weight of the Evidence into a “Market Model”
Now that we have defined the tools to assess each ticker symbol we can assess each one of the metrics individually and then sum the individual readings to produce the Weight of the Evidence. Again, each tool has been configured to produce percentile rankings with bullish, neutral or bearish readings.
We can take the weight of the evidence one step further. We can also use the weight of the evidence to aid in the selection of portfolio allocations. If the Market Model is producing a Bullish thesis, it provides an opportunity to consider over weight positions in certain areas of the markets. Conversely, if the Market Model is producing a Bearish thesis, it provides an opportunity to consider under weight to no positions in certain areas of the markets. We are simply looking to invest in the strength of the market and avoid weakness. This permits us to grow and protect out capital concurrently.