Rotblut: Don't Rely on a Single Indicator

Yesterday was another rough day for the markets. My crystal ball is not good enough to predict where a bottom will be but, so far, the fear about what could happen (e.g., a double-dip recession) has been worse than what is happening. Fear brings opportunities, so I would use the current weakness to consider rebalancing and look for bargains. At the very least, you should create a shopping list of stocks and ETFsyou would buy if they got cheap enough.

I always encourage investors to look at a variety of indicators. By itself, any single indicator can lead you astray. More importantly, many indicators sound like they would be predictive, but are actually not very profitable.

An example is the "death cross," which appeared on S&P 500 charts this week. The ominous-sounding event occurs when the 50-day moving average crosses below the 200-day moving average. For those of you who are not chartists, a moving average calculates the average price over a specified number of days, such as 50 days. The next day, a new average price is calculated based on the new set of 50 days, which now starts one day later than the last set. (Hence, the average moves one day forward.) This forms a series of dots, one for each day, which is tracked with a line on charts.

A death cross means the average price for the last 50 days is less than the average price for the last 200 days, a sign that the short-term trend in stock prices is negative.

This may sound somewhat scientific, but the event is not really as bad as the name sounds. A short-term downward drop in stock prices can be painful, but it does not tell you if stock prices will keep falling.

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Back in July 2010, Mark Hulbert looked at the historical performance of the death cross and found that it has not been reliable over the past two decades. "Overall, in fact, there has been no statistically significant difference since 1990 between the average performance following death crosses and all other market sessions," Hulbert concluded.

Plus, I would add that today's weakness was attributable to anxiety about global economic growth, not to any particular chart pattern.

It's not just the death cross. There are various indicators that people tout as reliable or at least indicative of where stock prices are headed. For example, on the fundamental side, there is Robert Shiller's CAPE ratio. This number calculates the S&P 500's valuation based on the index's inflation-adjusted price and average 10-year earnings. As an article in next month's AAII Journal will point out, this indicator has its flaws.

I should also mention that even when a stock, or any asset, appears to be excessively cheap or expensive, it can stay that way for a while. As many traders can attest, the market can remain irrational far longer than you can remain solvent.

This is why, when trying to predict a trend or go against an existing trend, you want to have as many indicators in your favor as possible. You want outside confirmation that your opinion is correct because there is always someone on the other side of the trade with a different opinion than yours. The need for confirmation applies to both calls on the market and decisions on whether a specific security is a bargain or not. You can still end up being wrong, but if you stack the deck in your favor, the odds of being wrong will be smaller than if you based your decision on a single indicator.

This Week's Gratis Tip

A better approach than relying on a timing indicator to tell you when to get into and out of a stock is to stay focused on maintaining an appropriate allocation to stocks and bonds in your portfolio. What Different Conditions Will Affect My Asset Allocation? lists the three major factors affecting how your portfolio should be constructed.

Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.