Research Case 2: The Traffic Light System

Many studies of market timing have shown that when you factor in timing errors and commissions, investors would be better off leaving their investments alone.  I will not argue against this.  In fact, I agree with it.  After accepting this argument, however, I still believe market timing may be preferable – even if it produces a lower return. 

Why?  Because with a good market-timing system there is a better chance that the investor will be around to earn that smaller return.  Holding an investment viewpoint or opinion is very similar to the action of anchoring yourself at a location against a physical force.   If you are facing a strong wind, you have to anchor your feet in firm ground or get blown away.  Similarly, when you hold a market viewpoint that viewpoint must be anchored in facts and theories that you know are true and correct.  You must solidly believe them, and they must be founded on established and tested ideas.  Otherwise, you will not be able to hold to your investment position, and your viewpoint will flip-flop in the face of almost any concept or compelling idea that comes along.

On the flipside, countless people write about technical analysis, yet most usually end up on the wrong side of the trade.  The problem isn’t with the information they are providing. The basic data and theories they are presenting are correct.  The problem is that they often omit practical instructions on how to apply the information in a real-time frame.  Market timing presents the purist with a major theoretical problem: the standard academic models for stock prices hold that stock prices are basically random and unpredictable.  If we are to believe that market timing is possible, we must have a different model in mind than the common academic buy-and-hold model.

To time the market successfully we must establish a method to determine when the market has switched from a random state to a more predictable one.  This requires research, skill, patient, and most importantly, the willingness to change one’s mind when one is wrong – or rather a set of rules to govern behavior.  One must learn how to do this in such a way that one’s confidence in one’s own judgment is not undermined.  That is what we are attempting to do here.  The Traffic Light identifies when the market is in a state that provides a higher probability of success based on the internals and overall trend of the market, allowing the system to ride that trend to a profit.

System Overview 

The Traffic Light is focused on sound market timing to be a successful trading system.  This system’s goal is focused on identifying market tops and bottoms early on, which is how it reduces risk.  The test system utilizes a fairly simple method that allows us to stay in tune with the markets in just a few minutes a day.  Initially, we referred to this system as “The Market Direction System” because it trades in the direction of the market, but for simplicity sake, we began calling it “The Traffic Light,” because we utilize a traffic light to display the current market condition.

Within the system the market is always in one of three different conditions:

  • Conditions are favorable to the market moving higher = Green Light
  • The market is showing signs of weakness = Yellow Light
  • Conditions are favorable to the market moving lower = Red Light

Determination of the current condition is based on the direction the major indexes are headed, and an analysis of volume trading taking place.  For terms of this system, when we speak of the indexes we are referring to the NASDAQ, the DOW, and the S&P500.

The current condition of the market for this system will be displayed by a traffic light in our weekly report.

Green Light

When the traffic light turns green it means that the market is either in a new uptrend, or an uptrend has resumed after a pause.  Either way, a green light is a signal for the system to go long stocks.  Normally the light will change to green on a follow-through day.  A follow-through day is a day where one of the major indexes makes a move of at least 1.2% on volume that is higher than the volume of the previous day (the higher the better). 

Green Light = 100% invested in equities.

Yellow Light

The traffic light will turn yellow when the market hits either a key resistance level or starts showing signs of distribution. This means that caution is warranted.  It does not necessarily mean the system will fully liquidate holdings, but it does mean it is on heightened alert, which may initiate the system into reducing market exposure by 50% until the traffic light turns green again.

Yellow Light  = Market exposure may be reduced down to 50% invested in equities.

Red Light  

When distribution days stack up the market will go into a correction.  Distribution days are days where one of the major indexes (the NASDAQ or S&P 500) are down significantly (0.20%) on higher volume than the prior day.  This is a clear sign of institutional selling, also known as distribution.  When you see a string of distribution days in a short amount of time, it often means the current uptrend is starting to roll over into a correction.  This triggers a sell signal when it occurs because the markets are under pressure and it is best to step aside.  Usually, the light will turn red when the market racks up 5 or 6 distribution days within a 30-day period (generally, but not always).

Note

A Red Light causes the system to liquidate all long positions and dependent on market internals may go short the market.  Short positions in the market are normally initiated when the 50-day moving average is below the 200-day moving average and the market is in a general long-term downtrend, and/or during a bear market rally when the price of equities is extended from key/logical price points.  Volume analysis and market internals are key to getting this right.  

How to use the Traffic Light 

The system is currently being tested on Exchange Traded Funds.  Subscribers can monitor system performance of either.

  • Exchange-Traded Funds: Triple leveraged ETFs like TQQQ 
  • Traffic Light turns green: The market is in either a new uptrend or an uptrend has resumed.  The system will invest 100% of assets into equities
  • Traffic Light turns yellow: The market is either at resistance or under pressure, but not yet in a correction.  In this case, the system may reduce long exposure by 50% of assets
  • Traffic Light turns red: The system liquidates all long positions, and in some instances will short the market

Trackers Used

TQQQ or comparable 3X leveraged ETF

  • TQQQ or comparable triple leveraged ETF
  • NASDAQ Composite Index as a comparable buy-and-hold strategy

Summary

Market Timing System asset allocations are determined by the current market conditions.

Traffic Light Status =  % Invested

  • Green Light = 100% Invested
  • Yellow Light = May be reduced to 50% Invested
  • Red Light = 0% Invested (or short)
  • The market is in a correction (100% G Fund/cash) and then a new uptrend begins.  Once the Traffic Light turns green the system will go 100% into either the C, S, or I Funds, or for ETFs, the SPY or QQQ
  • When the market comes under pressure and the Traffic Light turns yellow, the system will reduce long exposure by 50%
  • When the market resumes its uptrend and the Traffic Light turns “green” again the system goes back to 100% invested
  • The system will set an automatic sell stop-loss order -2.6% below the entry point to protect capital

NOTE:  At times in a strong market we will utilize 2X and 3X ETFs for leverage.

This is a private site for members only. If you are interested in observing this research in real-time, contact us by clicking here.

Disclaimer

IMPORTANT!!!!  Notice & Disclaimer about any and all content I create, send, or share with anyone, in any form regarding this research:  

This is research.  This is not investment advice.  I cannot be any clearer about this.  I am researching these systems to document their performance in real-time over a period of years for further research.  Be aware that while these systems are commonly referred to in the media, the strategies involved may not be suitable for your situation or risk tolerance.  I am not offering YOU investment advice.  I am merely conducting research on the viability of these strategies and documenting them for future research.

I will not be liable for any loss or damage whatsoever (including human or computer error, negligent or otherwise, or incidental or consequential loss or damage) arising out of or in connection with any use or reliance on the information derived from this research.  The previous statement is here not only because the lawyers insisted, but because it is true.  Consider that I have no idea what your financial goals may be, I am unfamiliar with your risk tolerances, I do not know your personal income, age, savings, financial circumstances, dependents, net worth, what tax bracket you are in.  Heck, I do not even know where you live in.  There are some people who would find these things quite relevant.

I am merely researching alternative options for viewing the markets and documenting it for further research.