We are going through a phase right now where the daily gauge for the S&P 500 is healthy but the long term gauge is below twenty. How afraid should we be? Let’s first compare next day returns when the short term gauge is above 60 verses when the long term gauge is above 60:
The long term gauge did better in the ’09-’11 period and the short term gauge has done better since then. They had similar draw-downs during the ’08 nightmare. Each has their flaws but keep in mind, over this period the S&P 500 rallied about 700 points while total return using the daily filter exceeded 1240 pts. and the long term filtered returns were greater than 1500 points. The worst draw-downs were 300 and 200 points respectively.
Now let’s see how much returns improve if we wait for both indexes to be bullish (>50):
Clearly waiting for both costs you money. You make 20% less and you are long 15% less often. The draw-down figures are not materially different or improved.
Now let’s flip it over. Let’s ask – what if the short term gauge is healthy and the long term gauge is not. I show two scenarios:
Under such conditions of conflict it’s hard to make money. In the end the daily will win – you can make money because the short term holding period renders the longer term gauge less useful. To truly understand the bet we’re making we have to differentiate between the inputs in each case.
The long term index has no input for the trauma window, and it uses the Advance/Decline ratio so there is a trend following component. If we are very early in the PTW then a poor weekly gauge level may be of less concern, especially if you believe the AD line is of little current value.
These conditions are comparatively rare. Over the last ten years today’s conditions where the long term gauge is >70 and short term gauge is