After the ’08/’09 meltdown and well before Central Banks promised to do whatever it takes, I looked at technical analysis to see how it could be combined with fundamental analysis to protect and grow investment assets.

I appreciate the charting aspect of technical analysis but I never found any true empirical research to help me create (with confidence) a technical analysis overlay for spotting a change in trend for stocks.

What I discovered and kept coming back to was a simple trend / momentum approach utilizing the 200 day moving average of the S&P 500 described in Meb Faber’s paper A Quantitative Approach to Tactical Asset Allocation. What I liked about the approach was that it was simple, it worked, and it provided protection with greater asset growth than a buy and hold / strategic asset allocation approach.

The key I learned from testing the approach was that it is imperative to keep the month end parameter intact. By doing so, you can prevent a majority of false positives from occurring. False positives that are commonly generated from weekly or daily pricing.

I also came across a paper CAN THE VIX SIGNAL MARKET DIRECTION which presented ideas for a framework in which the VIX could be used as an indicator to determine a change in the trend of stock prices.

In testing the use of the trend (200 day moving average) in VIX using monthly frequencies I discovered that a combination of a change in both the trend in stock prices and the VIX must occur if there is to be an effective signal for change in trend for stocks (for more information see “A rising VIX is not necessarily a sign of a change in trend”).

The following chart illustrate the results and signals.

With the exception of one false positive in March/April 2002, you can see the four major signals that spotted a material change in trend of the S&P 500 before and after the market tops of 2000 and 2007.

Click to enlarge

 

For investors concerned about preserving capital, the simple trend and volatility overlay illustrated can be used to position a portfolio more defensively when the VIX confirms a change in trend in stock prices.