This month I would like to introduce a market timing system that is used by the Cabot Heritage Corporation. The details are available for free on their website at www.cabot.net. The system is similar in style to the VLA System already presented previously, but uses additional indexes to determine the market trend. I first learned about the Cabot market timing system from the Hulbert Financial Digest. The HFD has ranked Cabot highly in recent years, and their China Timer was the number one performer in 2007 according to a post on Marketwatch.
The system consists of four components: the long term trend, the intermediate trend, the two-second indicator and the Master Sentiment gauge. The Master Sentiment gauge is an auxiliary tool only available to subscribers so we will not be using it here. Later, I may incorporate another sentiment gauge.
The Long Term Trend
The long term trend is determined by the Cabot Trend Lines. These are 20 week and 39 week moving averages of the Merrill Lynch 100 Technology Index and the S&P 500 Index. (It is not stated, but I am assuming that the moving averages are simple moving averages.) If both of the these indices are trading above the lower of the moving averages, then the long term trend is down. Otherwise, it is up. I would require that, at a minimum, the indexes close the week above the lower moving average to give a long signal.
The Intermediate Trend
The intermediate trend is determined by the Cabot Tides. These are the 25 day and 5o day moving averages of five indexes. ( It is not stated, but I am using 25 day and 50 day exponential moving averages here.) The five indexes are the S&P 500, NYSE Composite, Nasdaq Composite, S&P 600 Small Cap and the Merrill Lynch 100 Technology Index. If at least three of these indexes is advancing then the market is considered to be up. To be advancing, the index must be trading above the lower of the two moving averages and that moving average must itself have advanced for at least two consecutive days.
This is a short term indicator used to help identify market tops. If the number of NYSE new lows is greater than 40 ( although not mentioned now, in the past it was stated that the requirement was for new lows to be greater than 40 for 5 days ) as the market is making new highs, it can be an indication of a market top. If the market is more that 5 days off of its high, then ignore this indicator.
We will use the system as follows:
After a market neutral or sell signal, we will go long the QQQQ on an intermediate term buy signal if the long term trend is up.
After a market neutral or buy signal, we will go short the QQQQ on an intermediate term sell signal if the the long term trend is down.
We will exit long positions and go to cash on an intermediate term sell signal if the long term trend is up. We will exit short positions and go to cash on an intermediate term buy signal if the long term trend is down.
The S&P 500 closed the week below its 39 week sma on 12/31/07 indicating the long term trend had turned down. The MLO (Merrill Lynch Tech Index) closed below its 39 week sma the following week. Presently, both indexes remain well below their 39 week smas indicating that the long term trend remains down regardless of the intermediate term trend. Looking back at 2006, the MLO closed above its lower 20 week sma on 8/16/06 confirming the long term trend has turned up. This was very close to the time that Investor's Business Daily confirmed a market follow-through day. On 12/31/07 more than three of the Cabot's Tides Indexes were below the lower of the 25dema and 50dema. Therefore, the system went short on 1/2/08 at 51.27. This is congruent with the VLA System. Presently, four of the five Cabot's Tides Indexes are above their lower 25demas. However, one more day will be needed for the moving averages to advance two consecutive days. If this occurs, the system will exit and go to cash on Tuesday at the open, and wait for either the long term trend to turn up or a renewed sell signal.
While I appreciate the desire to predict market outcomes based on patterns and cycles, the following passage from "What Matters Most Is Profit" by Welles Wilder illustrates how we should approach the markets. Unfortunately, I have misplaced my copy of the book, so I will paraphrase.
A father is sitting in front of his computer monitor showing his young daughter how a "special" indicator is saying the market will be going down. He continues to get frustrated as the market moves higher and higher. He tells his daughter, "Just wait it going to go down any minute now". She replies, "But daddy, it looks like its going up to me".
The point is that regardless of our opinions, predictions and expectations, we must follow the markets lead. We can do this by following price, breadth and volume. Our goal is to make money in the markets, not to inflate our egos by being right with our predictions.
It is my hope that the ideas presented here will assist the reader in becoming a profitable trader and any constructive comments toward that end will be much appreciated.