Home > VectorVest 7 > Best Practices > Timing the Market > Market Timing Explained
VectorVest Views 7/09/04
Conventional wisdom says that stock prices move in a random fashion and you cannot "time the market." While I would agree that prices of individual stocks tend to be chaotic, our Market Timing Graph clearly shows that the average price of over 8,000 stocks, as reflected by the Price of the VectorVest Composite, VVC, moves in a remarkably deliberate fashion, forming up and down waves as time goes by. It clearly shows that the market is rising when the Price of the VVC goes up and the market is falling when the Price of the VVC goes down. Our job, then, is to ascertain the direction of these trends as they are unfolding.
THE PRIMARY WAVE. Our studies show that day-to-day movements in the Price of the VectorVest Composite are not statistically significant. Week-to-week movements, however, are very much worth noting. When the Price of the V V C is higher than it was one week ago, the Primary Wave is Up. When the Price of the V V C is lower than it was one week ago, the Primary Wave is Dn. The Primary Wave provides a relatively fast, fairly reliable indicator of market direction.
When the Primary Wave changes direction, say from Up to Dn, Prudent Investors should use it as a warning signal that the market trend is showing signs of changing from up to down. They should become defensive, i.e., defer the purchase of stocks, tighten stops, sell Covered Calls, buy Puts and so on. Aggressive Investors and Traders should use this signal to switch from favoring upside strategies to favoring downside strategies. (Aggressive Investors and traders should always key their bias to that day's trading activity). For those of you who are "Riding the Wave," a change in Primary Wave from Up to Dn should be a signal to stop replacing long positions and to accumulate cash. A particularly strong change in the Primary Wave may be used as a signal to go from long to short positions. This information is presented in the Daily Color Guard Report.
THE TWO-WEEK RULE. Our studies show that a slower, but more reliable signal of market direction is obtained by analyzing the two-week movements of the Price of the V V C. When the Price of the VVC goes up two weeks without an intermediate down week, it gives a preliminary signal of a sustainable Up trend. When the Price of the VVC goes down two weeks without an intermediate up week, it gives a preliminary signal of a sustainable Dn trend. You are invited to look at our Market Timing Graph in the weekly mode to see how well the Two-Week Rule works. Over the last 13 years, the two-week signal has been reversed by a two-week counter move only about once a year.
When a signal from the Two-Week Rule changes direction, say from Up to Dn, Prudent Investors should recognize that the market has gone from an uptrend to downtrend. They should implement the defensive actions cited above and also consider selling their weaker stocks. Aggressive Investors and Traders should use this signal to implement downside strategies such as selling stocks short and buying Puts. Again, these investors should key their actions in accordance with that day's market activity. For those of you who are "Riding the Wave," a change in the Two-Week signal from Up to Dn should be a signal to go into cash and to go short if that day's market activity is downward. This information is also presented in the Daily Color Guard Report.
CONFIRMED SIGNALS. The VectorVest Buy, Sell Ratio, (BSR), is an extremely powerful indicator of market conditions. The market is robust when the BSR is greater than 1.00 and weak when the BSR is less than 1.00. Therefore, we use the BSR to give confirmed up and confirmed down signals. A Confirmed Up signal is given when the Two-Week Rule has signaled a sustainable uptrend and the BSR has gone from below 1.00 to above 1.00. A Confirmed Dn signal is given when the Two-Week Rule has given a signal of a sustainable downtrend and the BSR has gone from above 1.00 to below 1.00.
Our experience has shown that the use of confirmed signals to buy long on Up signals and sell short on Dn signals is far superior to employing simple buy and hold strategies. Confirmed Calls work best in markets having sustained uptrends and long downtrends. The Confirmed Dn signal we gave on March 17, 2000 was the most crucial we have ever given. The Confirmed Up trend from March 21, 2003 to March 15, 2004 was the longest we have ever seen. So Confirmed signals should not be ignored. It is important to recognize, however, that confirmed signals are often slow in developing.
To cite a recent example, the Price of the VVC bottomed on May 17, 2004. The Primary Wave turned from Dn to Up on May 21 and the Two-Week Up signal was given on May 28. A Confirmed Up signal was not given until June 29. The main reason for this result is that market's rally was weak, so the BSR took forever to go above 1.00. Therefore, we have aimed to make timing calls closer to critical turning points, prior to receiving Confirmed signals.
TURNING POINTS. The key to making really big profits lies in making correct market timing calls as close to a turning point as possible. While one can often sense turning points, it is impossible to actually call them with any degree of regularity. Although we have never nailed an exact top or bottom, we have come very close on many occasions. We use a variety of methods to identify turning points as closely as possible and they will be discussed in future essays. For now, you have the essentials of Market Timing Explained.