Knowing the current market sentiment is at the core of tactical asset allocation. In bull markets, we want to improve returns while managing our risk exposure in bear markets. To determine the current market sentiment, TuringTrader.com developed a proprietary sentiment indicator, nicknamed Market Vane.
Our Market Vane indicator follows a multi-faceted approach: On a monthly schedule, we evaluate stock market momentum, economic growth, and the potential upside of stocks over bonds. Also, we consider implied volatility and recent drawdowns on a daily schedule. Market Vane can apply ample filtering to avoid whipsaws yet respond quickly to marketplace changes by combining these five sources. As a result, Market Vane provides high-quality guidance for the fundamental risk-on versus risk-off investment decision.
At the core of TuringTrader's Market Vane is a set of three momentum indicators. Because these indicators change relatively slowly, they are sampled monthly for additional filtering and to avoid whipsaws. Regardless of Market Vane's sampling process, we calculate all indicators daily to help investors anticipate upcoming changes:
- Stock Market Momentum attempts to forecast stock market returns based on recent historical prices.
- Economic Momentum attempts to forecast economic sentiment based on the recent development of weekly unemployment figures.
- Stock vs. Bond Performance attempts to forecast the excess gains that the stock market might offer over holding bonds, based on recent historical prices.
While Market Vane's monthly indicators provide a great foundation, they do not react swiftly enough to follow sudden market changes. To remedy this shortcoming, Market Vane uses daily indicators that may override the monthly decision:
- VIX Margin to Exit measures the current VIX relative to an exit threshold anchored on a rolling average of implied volatility.
- Drawdowns Margin to Exit measures S&P 500 rolling drawdowns relative to an exit threshold anchored to the index's most-recent peak.
Putting Things Together
Market Vane interprets its five components in a binary fashion. Values of zero or higher indicate bullish market conditions calling for exposure to U.S. stocks. Values below zero signal bearish market conditions, calling for exposure to assets with low or negative correlation to U.S. stocks, e.g., U.S. Treasuries and gold.
Combining the five components into a single reading is a multi-step process:
- On the last day of every month, we perform a simple majority vote on the monthly indicators. If the two or more indicators signal bullish conditions, the result is bullish, otherwise bearish.
- Unless any of the two daily indicators signal a high-risk situation, we plan to use this majority vote for the following month. Should a daily indicator signal bearish conditions, this overrides the majority vote for the next month.
- Every day, we recheck the daily indicators. If any of these two indicators signal a bearish condition, this overrides the majority vote.
To summarize, we allow transitions from bullish to bearish conditions any day, triggered through the daily indicators. The opposite change, from bearish to bullish conditions, only happens at the end of the month. With this mechanism, Market Vane is stable enough to avoid whipsaws yet adjusts to sudden changes quickly. For investors curious about our Market Vane indicator's inner workings, we recommend reading our background article.
There are many uses for Market Vane's sentiment indicator. From a 30,000ft perspective, the indicator's purpose is to guide switching between bull and bear market strategies or risk-on and risk-off portfolio configurations. Market Vane is designed to work with bull market strategies focused on U.S. stocks and bear market strategies built around bonds and other asset classes with low or inverse correlations to U.S. stocks.
In its simplest form, investors can use the indicator to switch between just two ETFs: One tracking the S&P 500 and another tracking 10-Year U.S. Treasuries. And while this is an overly simplistic strategy, it demonstrates Market Vane's value:
Here are the metrics of this simple 2-ETF switching strategy: