Ned Davis Research announced methodology enhancements to the model that informs the Ned Davis Research CMG US Large Cap Long/Flat Index on September 6, 2019, driven by the goal of improving the timing and potential performance of the model while maintaining its original intent and design. As of November 1, 2019, these updates are reflected in the model.
Market Breadth Is Key
Investors have used technical indicators—like a simple 200-day moving average or 50-day versus 200-day moving average cross—for years to establish buy and sell rules. In a similar way, the model behind the Ned Davis Research CMG US Large Cap Long/Flat Index was designed to risk manage equity exposure for growth and downside protection. The difference with the model, however, is that it measures price trends more broadly and incorporates the ability to potentially capture “V-bottom” bounces.
Market breadth1 has historically tended to weaken before top-line prices have at major market peaks, and breadth thrusts2 often occur around the start of major bull market recoveries. For this reason, market breadth continues to be our preferred approach to trend following models.
The Index continues to be based on a market breadth model that measures the price trends of 24 industry groups in the S&P 500 and expresses the health of the market via a composite breadth score (“breadth score”). As before, the model determines the Index’s allocation to equity or cash based on both the magnitude and direction of the breadth score.
Timely and Time Diversified Factors
The original methodology measured each industry group against seven potential factors, such as a moving average cross or a moving average slope. In the enhanced version, the process is simplified. The number of factors is reduced to five (4 trend and 1 mean-reversion) and the target time horizons will be diversified to aid the timeliness and robustness of the signals.
Moving Average Slope: short/intermediate-term
Moving Average Cross: short-term
Moving Average Cross: intermediate-term
Moving Average Cross: long-term
Oversold: intermediate horizon z-score style mean reversion indicator
Of note is the z-score style mean revision indicator that may help identify oversold conditions and signal opportunities to participate in market bounces. A z-score is the number of standard deviations from the mean value and is useful in identifying extreme price movements. Given that markets tend to “V” bottom after major market dislocations, it may aid the model by identifying extreme levels that may indicate buying opportunities.
The aggregated scores of each industry creates the breadth score, which is then compared to its 21-day simple moving average to determine its direction. Direction is used along with the magnitude of the score itself to determine equity allocations. The methodology previously compared the breadth score to its score 42 days prior, so the enhancement reflects a slight pickup in the signal speed while seeking to avoid near term choppiness.
Simplified Threshold Levels and Allocations
Potential equity allocations have been simplified. Instead of 100%, 80%, 40% and 0%, they are now 100%, 50% and 0%. In place of using multiple breadth score thresholds to determine allocations, the one key threshold level used is a breadth score level of 50. As before, the allocation amounts are based on the magnitude and direction of the breadth score.
Breadth Direction (Current Score - 21D SMA)
At or above 50
One interesting aspect of the revised scaling system is the ability to allocate to equity after potential oversold conditions where the breadth score is below 50, but direction turns positive. These are often the hardest times for investors to make a move, and the volatility of the market is generally reflective of the higher risk regime at the time. The enhanced model seeks to allow investors to participate early in a possible recovery, but reallocates at a more conservative level of 50% equity, at least until breadth improves enough to see its score rise above 50.
Responsive to Market Conditions
The model enhancements and revised allocation strategy is simple and straightforward, yet maintains a scaled approach to investing that seeks to place the investor in the right allocation zone based on market conditions. Due to the enhancements, the model is expected to trade more frequently, but with improved timeliness and flexibility.
According to analysis by Ned Davis Research, there would have been 79 trades from February 1995 through September 30, 2019. That equates to approximately 3 to 4 trades per year and represents only a slight increase over the original methodology, which would have produced 55 trades or 1-2 trades per year over the same time period. Trading frequency is, of course, driven by market conditions. The bulk of the trades are expected to occur during volatile/down cycles, while there would be very few trades in extended bull markets.
Current Model Allocation
The last allocation change for the model was March 25, 2019, the second one of the year. The equity allocation target changed from 40% to 100% and has remained there on the continued strength of the market. Since the last allocation change the breadth score has remained elevated, supporting the 100% equity allocation. As of November 1, 2019, under the enhanced methodology rules, the breadth score of 72.62 would indicate a similar position of 100% equity. The model is updated daily and can be viewed here: View the daily updated model.
Important Definitions and Disclosures
1Market breadth is an assessment of how many stocks are participating in a given move in an index or on a stock exchange.
2Source: Ned Davis Research. Breadth thrust is a technical indicator used to ascertain market momentum and signals the start of a potential new bull market after what may have been an oversold market.
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