In Part 1, I introduced my Primary-ID model that identifies major price movements in the stock market. In Part 2, I presented Secondary-ID, a complementary model that tracks minor price movements. In this article, I combine these two rules- and evidence-based models into a composite called Cycle-ID and discuss the virtue of a single model.
I examine the efficacy of Cycle-ID from three separate but related perspectives. The first area is the utility of the composite. What are the benefits of moving from a binary scale (bullish or bearish) of Primary-ID and Secondary-ID to a ternary scale (bullish, neutral or bearish) of Cycle-ID? The second topic is synergy. Can the composite perform better than the sum of the parts? Finally, how can we use Cycle-ID to custom-design strategies similar to those of risk-parity for the purpose of matching market return and risk? Do these more complex investment strategies add value?
Cycle-ID – a composite model for cyclical markets
All investors need to achieve a dual objective. The first is capital preservation by minimizing losses in market downturns. The second is wealth accumulation by maximizing market exposure during market upturns. Not losing money should always be the main investment focus but making money is why we invest in the first place. Investors often achieve one objective at the expense of the other. For instance, many so-called secular bears avoided the 2000 dot-com crash and/or the 2008 sub-prime meltdown, but missed the 2003-2007 and the 2009-2016 bull markets. My cyclical-market models are aimed at preserving capital during stormy seasons as well as accumulating wealth in equity-friendly climates.
The signal scores of both Primary-ID and Secondary-ID are binary: +1 is bullish and -1 is bearish. Cycle-ID is the sum of the two models and therefore its scores are +2, 0 and -2. What do the three Cycle-ID scores mean? A Cycle-ID score of +2 indicates that both primary and secondary price movements are positive. In other words, the stock market is in a rally phase (a positive Secondary-ID) within a cyclical bull market (a positive Primary-ID). A Cycle-ID score of -2 indicates that both the primary and secondary price movements are negative. Put simply, the stock market is in a retracement phase (a negative Secondary-ID) within a cyclical bear market (a negative Primary-ID). When Cycle-ID is at zero, the stock market is either in a correction phase (a negative Secondary-ID) within a cyclical bull market (a positive Primary-ID), or in a rally phase (a positive Secondary-ID) within a cyclical bear market (a negative Primary-ID). Since the two cycle models are in conflict, one would naturally assume that the market is neutral. However, there is a counterintuitive interpretation of the zero Cycle-ID score that I will present later.
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
By Theodore Wong, read the full article here.
