How Moving Averages Gauge Index Strength

11/25/2011 7:00 am EST

Focus: FUNDS

In Part One of MoneyShow.com’s interview with asset manager Channing Smith, he advised approaching the current market with caution. He reiterates that admonition today, in Part Two of the conversation, and explains how he uses moving averages and credit spreads to gauge market strength.

Kate Stalter: I believe that you tend to use some technical indicators in your analysis, Channing. Are there any technical sell signals that investors should be looking out for? Because sometimes the stock could even tank when the fundamentals remain good?

Channing Smith: Right, so what we’re doing at Capital Advisors , and what we do that’s different in the Capital Advisors Growth Fund (CAIOX), is we combine our fundamental analysis that everyone else does with technical indicators. And what we have found, when we went over the years and have studied going back to the 1800s, different variables that have influence on the market.

One of the key variables that we have, that we didn’t buy into originally, was moving averages. I never really bought into technical analysis, but after studying it and looking at the history over the last 100 years, there is a lot of very good information that you can gain from looking at this.

So, we look at moving averages. Right now what we’re seeing is that on the S&P 500, the 200-day moving average is around 1,271, the 100-day moving average is around 1,226 and the 50 is around 1,205.

So, as we speak today, the market is trading below its 200- and 100-day moving averages. What historically we have found is that the average monthly return for the S&P 500 has been nearly three times higher during periods when the index is trading above its ten-month moving average, compared to when it’s trading below.

The frequency of negative monthly returns was also lower in times when it’s below its moving average.

So, the other thing that we also look at is the frequency, and when we’re trading below key moving averages, the frequency of negative monthly returns is much lower during these periods, when the index is trading below its moving average.

The other metric that we follow very closely is credit spreads, and this is the difference between the yield between the sub-investment-grade bonds and the ten-year Treasuries, where the recent monthly returns in the stock market is favorable, when credit spreads are normal, compared to when spreads are very wide. So today we’re around 600 basis points on that, which is above normal, but it isn’t troubling at this point.

What we do is, we look at our fundamental view of the world, and we also look at these indicators because they have good predictive value. So, what we’re seeing right now is that the market momentum is not very good, and we’re kind of trading below where we need to.

Now, we’ve bounced around, but if we see a decisive break below where we are today, that would be a negative indicator for the market. And the credit spreads, we start to see those blow out, then we will get extremely more cautious.

We did this in 2008 when we saw credit spreads widen, and we moved up to about 35% cash in our fund. We took all of our other strategies that we have and moved those into cash.

One of the unique strategies that we have at Capital Advisors is we have a dynamic allocation, and this is a strategy that rotates between five different funds. This is international, emerging markets, commodities, the overall markets, and bonds.

And we use a moving average crossover, which, basically, if the moving averages are positive and we’re trading above that, then the different asset classes will be invested. If those key moving averages are breached, then those funds will go into a Lehman Aggregate Bond fund.

So this strategy has been 90% in bond funds since September. This is a good strategy. It’s not Modern Portfolio Theory. It’s a strategy that historically has performed very well with about half the risk. It’s better than the overall market, with less risk. So, we’re very proud of that strategy.

The other strategies that we have stay fully invested, but they overweight asset classes that are showing positive momentum or in positive trends, and then it underweights asset classes that are showing negative trends.

What we’ve seen, if you study the returns in asset classes, is there is persistence in this performance. So once an asset class begins to perform very well, these usually will persist for a good time into the future. Now, this strategy won’t catch the top and the bottom, but it keeps you in the fairway, is what we like to say.

The last thing I’d like to tell investors: When we look at technical indicators, we also like to look at the cyclically adjusted price-to-earnings ratio. So, this is a long-term valuation of the market, and this is really using Shiller P/Es.

It smoothes out over ten years—all the different economic cycles, all the different market cycles. And when we look at that metric, what we’re trying to say is, “Well if you joined us today, what is your starting point in the equity markets?”

And right now, that valuation is around 20.7, which is in the highest quadrant we’ve ever seen, and what that tells you is that the expected future returns from this starting point aren’t great, and a bull market does not start from a valuation at these levels.

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Kate Stalter: What is a good way for a person who is listening to this, who is at home, who manages their own investments—how can they integrate some of these suggestions you’ve offered today if they want to apply some of this to managing their own portfolio?

Channing Smith: Well, we have a number of research papers that we have on our Web site that could be accessed, and that’s www.capitaladv.com . They can go and read our different research. They can look at these metrics.

If they don’t have time to do that, then they can of course contact us and we can talk about potentially how we could implement our strategies in their portfolios. But it’s reading the paper, it’s thinking logically about what’s happening out there.

What we see in Europe right now has huge ramifications to the global system. Read a little bit deeper. That’s what we do. There are sovereign debt problems, but what is the true problem?

The true problem is that the sovereign debt is held by banks in Europe that can’t afford writedowns at this point. They are in an environment that we were in three years ago, where they’re extremely overleveraged, they’re seeing no growth in that region.

If they have to write down a lot of these investments, then the banks are going to be in trouble, and that is when you start to get into a situation where investors will say, “Well, what are the links to the American banks and how is this credit, if credit stops, how is this going to impact the global economy?”

And that’s where you get into a dire scenario. So, know what you’re watching. If we start to see bank runs, if we start to see turmoil in the financial system, then there is going to be a considerable impact.

I think a lot of investors and a lot of people who watch the media think, “OK, well, the ECB is just going to come in and solve this problem.” The problem is, we’re talking about 17 nations with different governments that have different treaties.

This is a very complicated issue and until it’s resolved, we would suggest that investors tread very carefully. Invest in quality and invest in names that you know are going to be around in ten years, and look for them at good valuations. That’s what we would suggest.

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