Years ago, early in our marriage, my wife and I went to a car dealership with her dad to make one of those all important, young couple purchases: a new car.
While my wife and her father were chatting with the salesman, I was all over the car pushing every button, pulling every lever and opening every compartment. I wanted to know what was what, where things were, and how it all fit together. The three of them were a bit taken aback as I moved from the front seat to the back, methodically finding knobs and uncovering compartments that the salesman didn’t even know existed.
Our marriage survived that episode and I’ve got a great relationship with my father-in-law but we didn’t buy the car.
I am a tinkerer by nature. My dad once rebuilt a motorcycle engine in the living room of the small apartment he shared with my mom shortly after they were married. The point is, I like to know how things work. I’m not afraid to pull something apart, look at the insides, and then put it back together. I always use all the screws and only rarely does a spring or ball bearing go missing.
So when it comes to the markets, I’m also interested in pulling indexes apart and looking at trends among and across various components.
Here is a behind-the-scenes look at my process:
Component Trend Indicators
Rather than just identifying a trend at the index level, I like to look beneath the surface and determine how broadly that trend is distributed.
Instead of looking just at the trend in the S&P 1500 Composite index, I’ve developed an industry group trend indicator that looks at the trends for the 72 industry groups (24 each from the S&P 400, 500 & 600).
Trend identification is pretty straightforward. For each of the industry groups, I identify the direction of the 10-week average and the 40-week average and whether the current weekly close is above or below the 10-week average and where the 10-week average is relative to the 40-week average.
There are 72 industry groups and four observations for each, but the modern processing power makes this aggregation fairly straight forward. Our industry group trend indicator is a smoothed average of the weekly positive percentage. We do something similar from a global perspective. We break the MSCI ACWI into the country-level indexes (currently 50 of them) and calculate a global market trend indicator in the same way we construct our industry group trend indicator.
Relative Strength Rankings
In addition to looking at the strength of the overall (and underlying) trends on an absolute basis, we can also weigh various components against each other and look for relative leadership.
Rather than just a comparison between two related (or even unrelated) assets, we are breaking an index into discrete components. All the stocks in the S&P 500 are represented within the 11 sectors — we are not leaving something out or introducing something new. We rank relative performance across multiple time periods, stretching from one week to 52 weeks.
The short-term ranking is the aggregate of relative strength across 1 week, 2 weeks and 4 weeks. The intermediate-term ranking is an aggregate across 6 weeks, 8 weeks and 13 weeks. The long-term ranking looks at relative strength over the past 26 weeks, 39 weeks and 52 weeks.
In an effort to identify sustained strength and not short-term mean reversion, our overall weekly relative strength rankings are based just on the intermediate-term and long-term ranking score.
Looking at the direction of the overall ranking, and relative strength across the various time frames (from 1 week to 52 weeks) can provide information about areas that are improving and/or deteriorating in relative strength. We publish sector-level rankings every week. We track it (though don’t publish it) at the industry group level and use it as an input for our work elsewhere.
Hopefully this gives you a better sense of what these indicators represent and how I think about the market.
Feel free to reach out if you’ve got any questions or comments.