Is the bull market just wounded, or is it dead and soon to be replaced by a bear market? One new indicator released by the firm Reality Shares Advisors suggests that the bull is dead and the bear is on the way — at least for the S&P 500.
The new index, known as the Guardian Gauge, predicts the market direction based on two factors: volatility and price-momentum. These factors are analyzed using various long-term moving averages within each of the ten sectors of the S&P 500, then combined into a Guardian Score (GS) that is the maximum value between indicators based on the two factors. In essence, either volatility or price-momentum can be the driving event. When the GS is above a threshold value of 1, that particular sector is expected to rise; below a GS of 1, that sector is expected to fall.
The ten GS values are combined into a Guardian Index (GI) value, which is simply the number of sectors with GS scores greater than 1. When more than seven of the ten sectors are expected to rise (GI greater than 1), a bull market is predicted. The Guardian Gauge simply changes the GI value into a color-coded gauge, with green sections from 8.5-10, a yellow section from 7.5-8.5, and progressively darker shades of yellow, orange, and red below 7.5.
As of this writing, the Guardian Gauge is at 5, with half of the sectors as negative indicators. Four of the positive markets are relatively healthy (Financials, Consumer Discretionary, Industrials, and Materials) but the fifth one (Telecommunications) is barely positive. The overall Guardian Gauge has produced a negative market indicator for the last 21 days. To find out today's factor, check out this link.
The methodology makes sense, but the GS thresholds and the designations between the GI numbers and market performance are somewhat arbitrary. How well does the Guardian Gauge do when applied retroactively to past data? It would have saved you money within the last two bear markets.
The Guardian Gauge would have suggested that you reduce market holdings in all but three of the trading days from September 15, 1999 to May 22, 2003. The S&P sank 20.87% during that period as measured by the S&P 500 Total Return Index. During The Great Recession, the Guardian Gauge would have advised you to exit the market from Jan 10, 2008 and to return on July 14, 2009. The S&P Total Return Index lost 33.78% during that period.
The Guardian Gauge works in the broader view as well. From the end of 1956 to the end of 2014, if you had invested in the S&P 500 Index during positive indicators and shifted to 3-month Treasuries during negative times, your average annual return would have been 8.92% compared to 7.62% with the S&P 500 Index alone.
Guardian notes several scenarios where the GI is more likely to underperform. Since the GI is looking for broad-based recovery, bull markets such as the dot-com bubble from 1998-2000 that are excessively driven by a few sectors are not properly pegged. Time lags are possible — since long-term moving averages are used, sharp drops in the market are not realized as quickly. It is also possible that some sectors are rising too slowly to create a trigger event.
Market-timing mechanisms must always be used with care, even for those with longer predictive time horizons. For long-term investing it is better to simply ride out the bear markets — the bull market overtakes the bear in the end. However, if you are inclined to try a market timing strategy and are willing to take the risk, the Guardian seems like a logical factor to consider in your decision.