The Safe Investing Blog

It’s time! Time for the annual performance review of Invest Safely’s Weekend Stock Market Outlook.

As you know, each weekend I publish an outlook for the U.S. stock markets, comparing signals from three different trading methods to determine if we’re in an uptrend or a downtrend.

This is one way to monitor market conditions, which let you know when to put your money to work or take it off the table.

With a little effort, the weekly outlook can be used as a simple trading system for S&P500 index funds. With a trading system, you can measure profit.

At the end of each year, I go back and evaluate performance based on, you guessed it, how much money you could have made using the stock market outlook signals to trade 100 shares of S&P500 index funds.

This year, I also added some metrics on the system itself, which can be used to measure risk and return.

Looking Back

In 2015, the market outlook was a success. Using the signals protected your capital from losses and even generated some profit; returns from the general markets were flat or even negative.

In 2016, the market outlook ran into some obstacles. The signals continued to protect your capital, but price changes between the signal and when I assumed an order would be executed influenced results significantly. After some analysis, I made an adjustment to my back testing, and performance improved substantially.

So over the past two years, the weekend market outlook outperformed “buy and hold”. Then again, we saw some actual corrections in 2015 and 2016. Last year, we didn’t see ANY! Take a look at this chart from Advisor Perspectives.

In 2017, we didn’t come close to a 5% drawdown, let alone the 10% correction level. Basically, it was risk-on all year. You have to go back to mid-2016 to find the last drawdown of more than 5%, and it’s been almost 2 years since we had a correction (>10% drawdown). That’s ridiculous! Since safe investing is based on aggressively protecting your capital from losses, it seems like 2017 will be another sub-par year for the stock market outlook.

Stock Market Outlook – 2017 Performance = Okay

Performance for the stock market outlook was red across the board, underperforming a buy and hold strategy for the S&P500 by 2-3%.

	Symbol	Type	Buy / Hold	Market Outlook	Delta
S&P500	^SPX	Index	18.7%	15.6%	-3.2%
S&P500	SPY	ETF	18.5%	15.2%	-3.3%
S&P500	FXSIX	Mutual Fund	18.2%	16.3%	-1.8%
S&P500	VOO	ETF	18.6%	15.3%	-3.3%
S&P500	VFINX	Mutual Fund	18.4%	16.8%	-1.7%
Nasdaq	QQQ	ETF	30.5%	23.6%	-6.9%
Russell 2000	IWM	ETF	11.7%	4.9%	-6.8%

As mentioned, U.S. markets spent most of the year in an uptrend. Downtrends were short and shallow.

During that uptrend, money was flowing into the market almost indiscriminately and underlying issues were glossed over. You didn’t need a lot of protection. Any small drop was a buying opportunity; BTD (Buy the Dip). Nothing could stop the rally; not politics, not geopolitical conflicts, not even severe weather! A good problem to have if you’re all-in on stocks!

As we discovered in 2016, this market behavior also creates issues for trading systems. Prices fall gradually, trigger a sell signal, and then find support shortly thereafter.

Curiously, the stock market outlook performed slightly better for mutual funds vs. ETFs. Part of that difference comes from fees and expenses (ETFs vs mutual funds). The rest is likely based on the method each firm uses to compute a price for the S&P, rather than any input from my end.

And you can see why it’s important to compare apples to apples; the stock market outlook is based on S&P signals, which didn’t translate to the Nasdaq or the Russell 2000 very well, underperforming by almost 7%.

2015-2017 Total Return

From a total return standpoint, the stock market outlook is no longer outperforming buy/hold on a cumulative return basis.

	Symbol	Type	Buy / Hold	Market Outlook	Delta
S&P500	^SPX	Index	30.1%	29.0%	-1.2%
S&P500	SPY	ETF	30.6%	28.8%	-1.8%
S&P500	FXSIX	Mutual Fund	30.5%	30.7%	0.3%
S&P500	VOO	ETF	30.9%	29.0%	-1.9%
S&P500	VFINX	Mutual Fund	32.3%	33.0%	0.7%
Nasdaq	QQQ	ETF	51.8%	49.5%	-2.3%
Russell 2000	IWM	ETF	28.8%	18.9%	-9.9%

Analysis

Like last year, I overlaid uptrends and downtrends from the stock market outlook on the S&P500 price chart: red for downtrends and green for uptrends. Also included are the entry and exit points: green circles for entry and red circles for exits.

There isn’t much going on (as expected as we were in an uptrend almost all year). I see a shallow downtrend in March and April, and then another short downtrend in August. Here’s how prices faired verses the 50 and 200 day moving averages, along with trading volumes:

Zooming into the March/April downtrend, we see that prices struggled at the 50-day moving average for two weeks in late March, closed below that level for another 2 weeks, and then blasted higher.

August’s price action was a bit more volatile, but a similar pattern emerged: two closes below the 50 day moving average and then recovery.

False signals are a risk that goes hand in hand with mechanical trading systems. Ideally, your system will be reactive enough to protect your capital from large downtrends, but passive enough to overlook small downtrends and let your gains run. Unfortunately, every large downtrend starts off as a small one, and you’ll only know which in hindsight.

Adjustments

There were several adjustments made for this year’s performance review.

The first adjustment applied to performance measurement, and comes courtesy of the Safe Investing community. I received an email, asking why I didn’t include a Vanguard fund. I harp on lowering costs, yet didn’t include the industry standard for low cost funds.

It’s a great question/suggestion. There’s no reason not to include it, so I included the performance of the signals versus two Vanguard S&P500 index options (VFINX mutual fund & VOO ETF).

The second adjustment concerns costs; this time related to commissions. In February of 2017, several brokers lowered their commissions for trading stocks and ETFs.

Specifically, Fidelity lowered commissions to $4.95 per trade to compete with low-cost brokers. Since I was using Fidelity as the reference for my $7.95 per trade fee, I adjusted the commissions for trades made in 2017.

The third adjustment involves the stock market outlook itself: I stopped reporting “mixed” from an overall indicator standpoint. In the past, I used “mixed” to show conflicting signals. But trades only occur when the market switches to an uptrend or a downtrend. Since majority rules when it comes to uptrend or downtrend signals, I stopped calling out a “mixed” market for the overall signal; either the market was trending up or down.

And finally, even with 3 different technical analysis techniques, the stock market outlook still had downtrend signals though a downtrend didn’t materialize. There are really two options:

1. Do nothing
2. Adjust the signals/change methodologies

For reference, the current signals are:

• 20/50-day moving average (general trend)
• 50-day moving average + trading volumes (institutional investor behavior)
• Elliot Wave Theory (overall market behavior / psychology)

Overall, combining the three methods to generate buy and sell signals worked. In fact, had it been used for trading, it captured most of the profits over the past 3 years (29% out of 30.1% = 96%), while reducing the time money would be “at risk” in the market (125 weeks versus a total of 157 trading weeks from 2015-2017). So, no changes are absolutely necessary.

And even though the system has underperformed buy and hold, none of the individual trades over the past three years lost money. That’s excellent.

There is a potential problem with the current signals. I want three unique viewpoints, but the moving average and the price/volume overlap; both use the 50-day moving average (the 20 and/or 200 day moving averages weren’t used for signal generation).

I could change the moving average timeframe to something other than 50. Or I could use a different technical analysis technique all together. Either choice requires research and back-testing.

For example, using the 200-day moving average as a signal generator creates much higher returns than the 50-day, over a 10, 20 and even a 65+ year time frame. And that’s before subtracting commissions.

Or, if we limit the time frame to the last 20 years, using a 50-day / 200-day moving average cross-over creates the highest return.

Of course, I would also need to combine the moving average signal with the other two, to get a true measure of my “majority” rules technique.

For price/volume and Objective Elliott Wave, adjusting the signals isn’t possible (rules are based on an enormous amount of historical data), so I would need to change methodologies. Basically, a non-starter at the moment.

As you can see, there are several levers for you to pull (technique, timeframe, etc.). Market behavior also changes over time, so what worked 30 or 40 years ago may not be as effective today. I’ll leave it up to you to decide if changes are worthwhile for your trading strategy. For now, I’ll leave the moving average alone.

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Looking Forward

Will 2018 be the year this uptrend gets derailed or will we see a repeat of 2017?

Last year, the S&P500 returned 18% and didn’t have a single down month all year! I know a lot of great investors and traders who didn’t come close to that level of return…guess we should all HODL.

I find it hard to imagine another 18% return without a least one correction. But that’s why we use a system; check your emotions and opinions at the door, and follow your rules. (ed – A majority of this content was written at the end of January, prior to the massive sell off in early February.)

One thing I am sure of…we’re closer to the end of this bull market than the beginning.

May you be blessed with MASSIVE returns in 2018!

Joel
Invest Safely, LLC

If you find this research helpful, please tell a friend. If not, tell an enemy. I share articles and other news of interest via Twitter; you can follow me @investsafely. The weekly market outlook is also posted on Facebook and Linkedin.

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— APPENDIX —

Remember: All models are wrong, but some are useful. The objective here to improve performance. By showing you some analysis (which closely mimics the one used for all my trades), I’m giving you an example of the safe investing processes in action.

Data

For analysis of the stock market outlook, I used historical data from Yahoo Finance.

2017 Stock Market Outlook Signals

Methodology

I carried forward the methodology from 2016; using 3 techniques to assess the state of the S&P 500. Each weekend, I determined whether the outlook (uptrend or downtrend) has changed, based on signals from those 3 methods.

• 20 and 50 day moving averages
• Price and trading volume (distribution days and uptrend/follow-through days)
• Objective Elliott Wave (via Tony Caldero)

By cross-referencing three different methods and only changing the overall trend for the stock market outlook when they all align, I continue to attempt to reduce the number of false signals.

Trading Criteria – Investment Type

Since we can’t directly buy shares of an index, we need to go with the next best thing; funds. I chose two S&P funds (SPDR SPY and Fidelity FXSIX) and two Vanguard funds (VOO and VFINX) based on their availability in trading accounts. I also include funds for the NASDAQ (Powershares QQQ) and Russell 2000 (iShares IWM), to show how market signals from one index apply to other indexes.

Trading Criteria – Buy and Sell Prices

The forward looking outlook is posted on Sunday, based on stock market price action from the prior week. Since that week is already in the books, there is no way for you to “trade” at the same prices that shaped the outlook. The “price” used for calculating performance is now the market open price the week following a signal change.

Trading Criteria – Transaction Fees

I’m assuming that trades are placed in an account with Fidelity, so transactions cost $4.95 per trade. Everyone should be using a low-cost broker.

Trading Criteria – Position Sizing

For this study, I used a position size of 100 shares to keep the math simple. If I were buy shares of an index ETF, position size would be customized based on the size of my total portfolio and my risk tolerance (how much I’m willing to lose before selling the position).

Trading Criteria – Buy and Sell Signals

Shares are purchased if the market outlook changes to an uptrend. If the outlook is mixed, watch and wait. If the outlook changes to a downtrend, the entire position is sold.

Issues & Objections – Trade Prices

If a signal is generated, simulated trades are entered based on the market’s opening price on the following Monday (the day after the outlook is posted).

Are you always going to get the opening price? No. Will the opening price always be the best price? No. Price slippage between your signal generation and trade execution is one of the reasons that individual results WILL vary.

As an example, one astute observer pointed out that I’m using opening price across the board, yet it’s not possible to purchase mutual funds at their opening price.

Issues & Objections – Trends & Timing

Are you always going to buy an uptrend, sit on your hands when the market is “mixed”, or sell exactly when a downtrend takes hold? No. General trends are great for giving you a sense of the overall investing environment. But each of your positions needs to be evaluated on its own merits.

A Note on Investment Processes:

From an investment management perspective, I’ve used trend following for many years. I find that reviewing rules-based indicators each week helps me stay disciplined.

Hypothetical Presentations:

To the extent that any portion of the content reflects hypothetical results that were achieved by means of the retroactive application of a back-tested model, such results have inherent limitations, including:

1. Model results do not reflect the results of actual trading using assets, but were achieved by means of the retroactive application of the referenced models, certain aspects of which may have been designed with the benefit of hindsight
2. Back-tested performance may not reflect the impact that any material market or economic factors might have had on the use of a trading model if the model had been used during the period to actually manage assets
3. Actual investment results during the corresponding time periods may have been materially different from those portrayed in the model

Past performance may not be indicative of future results. Therefore, no one should assume that future performance will be profitable, or equal to any corresponding historical index. For example, the S&P 500 Composite Total Return Index (the “S&P”) is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market. Standard & Poor’s chooses the member companies for the S&P based on market size, liquidity, and industry group representation. Included are the common stocks of industrial, financial, utility, and transportation companies. The S&P is not an index into which an investor can directly invest. The historical S&P performance results (and those of all other indices) are provided exclusively for comparison purposes only, so as to provide general comparative information to assist an individual in determining whether the performance of a specific portfolio or model meets, or continues to meet investment objective(s). The model and indices performance results do not reflect the impact of taxes.

Certain information contained herein has been obtained from third-party sources believed to be reliable, but we cannot guarantee its accuracy or completeness.

This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by me, from any specific funds or securities.

Investing involves risk (even the “safe” kind)! Past performance does not guarantee or indicate future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy be suitable for your portfolio or individual situation, will be profitable, equal any historical performance level(s), or prove successful (including the investments and/or investment strategies describe on this site). No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.