Annual Performance Review for 2010

| January 8, 2011

This year, and at the beginning of every year hereafter, we will conduct a comprehensive review of our forecasting, investing and trading performance during the previous year. Accountability is very important to us, and this performance review is simply another way for us to demonstrate our commitment to providing you with a highly reliable service. The audit process itself is admittedly tedious and time-consuming, but we believe it ultimately provides great benefit to both you and us.

FORECASTING AUDIT

In every short-term, intermediate-term and long-term forecast, we provide outlooks based on technical and cycleanalysis of the markets that we monitor. Our outlooks identify two scenarios, one bullish and one bearish, along with the approximate probability of the more likely scenario, providing there is one. In general, these outlooks fall into one of four categories.

  • If both scenarios are equally likely, they each have about a 50% chance of occurring.
  • If one scenario is slightly more likely, it has about a 60% chance of occurring.
  • If one scenario is more likely, it has about a 70% chance of occurring.
  • Finally, a highly likely scenario is at least 80% likely to occur.

The likelihoods associated with these outlooks are intentionally imprecise. We don’t believe it is possible to calculate probabilities with a high degree of precision when it comes to financial market forecasting, so each category covers a relatively large range and offers only a rough estimate. However, rough estimates are all you need as an investor or trader to be successful over the long run. A disciplined strategy of aligning yourself with likely scenarios and then protecting your assets when outcomes are in doubt will invariably produce gains over time. With the odds consistently on your side, you will be successful.

The key, of course, is to have reliable probabilities on which to base your decisions. We may claim that a given scenario is ~70% likely, but what assurance do you have that this assessment is reasonably accurate? The only way to know for sure if our forecasting process is reliable is to review the results of past predictions. We performed this auditing process for all daily and weekly forecasts during 2010 and the results are summarized in the following tables.

Click here to download the daily forecast audit data spreadsheet

 

Click here to download the weekly forecast audit data spreadsheet

Each column displays the actual performance of a given forecast category during 2010. The top row, labeled “All Markets,” compiles the results for every forecast in every market that we monitor, and then subsequent rows display the results for individual markets. As usual, there was a great deal of variance from market to market, especially in the equally likely category, reflecting underlying long-term trends. Twelve full months of data were reviewed for all markets except for the Japanese Yen and the Gold Miners Index, which have only been analyzed since June. If you would like to check the results of the audit yourself, click on the link below the table to download the spreadsheet containing the data.

Overall, our forecasting process performed very well during 2010. Our computer models produced a total of 3,580 daily and weekly forecasts during the year and the actual probabilities of each category are displayed below.

The equally likely category was much higher than normal at 60.8%, reflecting the fact that many of the markets we monitor were in strong uptrends for a majority of the year. The other three categories that favored a given scenario were significantly higher than their target zones with ~60% likely scenarios occurring 68.6% of the time, ~70% likely scenarios occurring 80.1% of the time and ~80% scenarios occurring 91.3% of the time. Our computer models are intentionally conservative with their projections, especially when it comes to scenarios that are at least 70% likely, but these results suggest that we have been a little too conservative recently. We will use this audit to fine-tune our forecasting process moving forward, but the important takeaway from these results is that our computer models are performing very well when it comes to identifying likely scenarios. In other words, when we forecast that a given scenario is ~70% or ~80% probable, you can be confident that it is at least that likely.

CYCLE ANALYSIS AUDIT

In July, we started performing short-term and intermediate-term Cycle Analysis (CA) on the S&P 500 index, the 10-year treasury note yield, the US dollar index and gold. Once a confirmed short-term cycle low (STCL) or intermediate-term cycle low (ITCL) is in place, we use CA to determine the window during which the next cycle low is likely to occur. We have tested our methodology using several decades of historical data, and the results of this validation process indicate that approximately 70% of all cycle lows should occur within the predicted window. Of the lows that develop outside of the window, about 20% should occur before it begins and 10% should occur after it ends. The following table summarizes the performance of our CA during 2010.

There was a total of 26 cycle lows across all markets, and 18 (69.2%) of them occurred in the predicted window, aligning closely with theoretical expectations. Of the remaining 30%, an equal number developed before and after the window, which is also as expected given the small sample size of only 26 total lows.

While it is important for actual forecasting results to closely align with theoretical expectations, the ultimate goal of CA is to reliably identify cycle lows as they are developing. In this regard, we had a very successful year, as 22 (84.6%) of the 26 lows were correctly identified as they occurred. Even when a given low does not develop within the predicted window, having an accurate time frame for its arrival still enables it to be reliably identified, regardless of whether it is “early” or “late.” Overall, our CA process performed exceptionally well and we do not foresee making any meaningful changes to the methodology.

MODEL INVESTMENT PORTFOLIO

The PMI Index, which tracks the value of our model investment portfolio, produced a gain of 6.7% during 2010.

We moved the portfolio to a fully defensive position at the beginning of the year when our computer models forecast the likely development of a long-term topping formation and our Secular Trend Score (STS) declined to -90, signaling heightened risk in stocks from an investment perspective.

The predicted topping formation developed as expected during the first eight months of the year and stocks experienced violent swings higher and lower. Stocks finished the year with a sharp move higher as the S&P 500 index rose 20% during the last four months to post a gain of 12.8% for the year.

Given that the broad stock market, as represented by the S&P 500 index, is the benchmark by which we measure the relative performance of our model portfolio, the PMI Index underperformed by 6.1%. However, asset preservation is our priority in the current secular environment and the PMI Index remains well ahead of stocks since its inception at the beginning of the secular bear market in stocks in the year 2000.

Inception Date: January 3, 2000
Compound Annual Return Since Inception: 11.6%
Total Return Since Inception: 236.5%
S&P 500 Total Return Since Inception: -12.3%

CYCLICAL TREND TRADING SYSTEM

Our cyclical trend trading system generated a sell signal in June when our Cyclical Trend Score (CTS) moved into sell territory during the violent decline from the April high.

As dictated by the trading system rules, CTS sell signals generated during a cyclical bull market that is less than 1.5 years old are considered invalid, so the sell window displayed on the chart above would have not normally resulted in a confirmed trading signal. The reason for this limitation is that potential inflection points in young cyclical bull markets tend to be highly volatile, making it difficult to successfully identify optimal entry points that afford protection from whipsaws. However, this rule also has one exception, that being an environment in which a preponderance of leading economic indicators forecasts a return to contraction during the next 6 to 9 months. The motivation for providing this one exception to the 1.5 year rule was to profit from market events such as the 1937 cyclical bear market that follow a weak recovery during the middle stage of a secular downtrend. The CTS sell signal in late June occurred about 1 year and 3 months after the start of the current cyclical uptrend, placing it within the 1.5 year window of a “young” cyclical bull market. However, the 1.5 year rule exception was also in place as a wide array of reliable recession indicators had signaled that a return to economic contraction was likely, so a confirmed signal was generated. Unfortunately, the trade was quickly stopped out in late September, calling into question the validity of the rule exception.

One of the most important characteristics of a successful trading system is balance. There should always be a well-defined, well-understood balance between the potential reward and risk for any given trade. The focus of our cyclical trend trading system is the identification of highly probable inflection points in the cyclical trend, thereby providing entry points with an excellent chance of success. Because the confluence of market characteristics that the CTS searches for is rare, the system does not generate signals very often; during the past 70 years, it has issued only 29 confirmed signals. However, its extremely high standards also cause it to miss many potential opportunities. The exception to the 1.5 year rule related to bearish economic indicators was an attempt to take advantage of a few more of those trading opportunities that would otherwise be ignored, but the question must now be revisited: is the additional risk taken on as a result of the rule exception worth the potential reward? Without this rule exception, the trading system has successfully identified 90% of the cyclical turning points during the past 70 years. Is it worth ever violating the young cyclical bull market rule in an attempt to improve system performance by a percent or two? The outcome of the latest trade would argue no, and we have removed the exception provision from our cyclical trend trading system rules as a result.

In the financial markets, as in life, failures tend to afford much better learning experiences than successes, that’s why is important to have the right learning processes and techniques, like the power of autosuggestion that can really improve the mind mental power. When investments and trades go as planned, your strategy is vindicated, but when the markets move against you, the loss provides you with an opportunity to critically analyze your methodology and potentially take steps to improve it. Unfortunately, most market participants take no such action. Instead, they choose to dismiss trading losses and simply do their best to forget about them before moving on to the next trade. Don’t make that mistake. If you do not already, take the time to carefully evaluate every trade or investment that does not go as planned and then learn from it. Not every losing position is the result of a failure on your part, of course. There are no certainties when it comes to the financial markets, merely possibilities and probabilities, and sometimes the least likely scenario will simply come to pass through no fault of your own. However, when a trade results in an outcome that you did not properly plan for or expect, that is a chance for you to grow and improve your future performance.

SUMMARY

Our forecasting based upon technical and cycle analysis provided extremely reliable outlooks throughout the year, with our likely (~70%) and highly likely (~80%) categories resulting in actual probabilities of 80.1% and 91.3%, respectively. If anything, our methodology was too conservative in its probability forecasting, and we will take steps to align theoretical and actual values more closely moving forward. Cycle analysis had a very successful year as well, correctly identifying the window during which the next cycle low would occur 69.2% of the time and identifying developing lows in real-time 84.6% of the time. The PMI Index underperformed the S&P 500 index by 6.1%, but the year was characterized by extremely volatile moves higher and lower in stocks, and we believe that our defensive portfolio positioning was well justified. Finally, our newly introduced cyclical trend trading system generated a sell signal that was quickly stopped out for a small loss, and the trade engendered a change to the system rules that will likely improve trading performance moving forward.

Overall, it was a violent, volatile year in the markets that we monitor, which is precisely what we expected at this stage of the secular bear market in stocks that began in 2000. The secular bear is still several years away from its terminal phase, so we expect the current environment of volatility and violent swings higher and lower to persist during the coming year. We look forward to profitably navigating these interesting times with you.

Category: Articles, Commentary, Market Update


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