Last week, I wrote about a simple system that used the performance of large-cap stocks relative to small-cap stocks to determine when to be in and out of the stock market http://www.optionetics.com/marketdata/article.aspx?action=detail&aid=24454. At the risk of sounding like a person who suffers from intellectual laziness and is always looking for “the easy way”, it occurred to me after I published last week’s piece to ask the question, “I wonder if I can write something similar to what I wrote last week?” As it turns out, I can.
So just to prove that there is more than “one way to skin a cat” (or more accurately to “trade an index based upon its performance relative to another index”, so you can see why I went with “skin a cat”), we will look again at large-cap versus small-cap stocks.
Jay’s Other “Rocket Science Free System” (JORSFS)
As verbiage has a natural tendency to get wordy, let’s just get right to the steps involved:
A = Daily close for ticker RUI (Russell 1000 large-cap index)
B = Daily close for ticker RUT (Russell 2000 small-cap index)
C = A / B (tracks the ratio of RUI divided by RUT
D = 9-day exponential moving average of C (more in a moment)
E = 260-day moving average of C (again, more in a moment)
F = D – E (the 9-day average minus the 260 average)
Still with me? Great. Let’s try to sum it up in simple English. We are simply applying two moving averages to the ratio of RUI divided by RUT on a daily basis. When RUI is outperforming RUT the ratio will rise and vice versa. Likewise, when the ratio is rising the 9-day average will gain ground on the 260-day average (OK, perhaps this is one case where simply English doesn’t necessarily help all that much. So let’s try a few pictures.
Figure 1 displays a chart extending from 1990 to the present and that shows the RUI/RUT ratio with the 9 and 260 day exponential averages overlaid.
Figure 1 – RUI/RUT Ratio (blue) with 9-day (red) and 260-day (green) exponential moving averages (1990-Present)
To make the interplay just a bit more clear, Figure 2 displays the same information but only since 12/31/2008.
Figure 2 – RUI/RUT Ratio (blue) with 9-day (red) and 260-day (green) exponential moving averages (12/31/2008-Present)
Essentially, when the red line is above the green line the RUI/RUT ratio is in an "uptrend" and when the red line is below the green line the RUI/RUT ratio is in a "downtrend."
Exponential Moving Averages Explained
I understand that when I try to write to a slightly broader audience but start using terms like “exponential moving averages” I run the risk of losing a few people as their eyes start to glaze over, their focus starts to wane and in some cases, their heads start to hurt. Still, since I have already invoked the phrase “exponential moving averages” I am now obliged to define just exactly what the heck I am talking about. So for better or for worse, here goes:
X = 2 / (moving average length + 1)
Y = 1- X
C = (Previous moving average * Y) + (today’s indicator value * X)
Was that too painful? So let’s talk about a 9-day exponential moving average for the ratio between RUI and RUT.
X = 2 / (9 + 1) = 0.2
Y = 1 – A or (1 – 0.2) = 0.80
Previous 9-day moving average (of RUI/RUT ratio) = 0.9529
Today’s ratio of RUI / RUT = 0.9450
C = (0.9529 * 0.8) + (0.9450 * 0.2) = 0.9513
All right, well I must admit that that exercise was not a whole lot of fun. I guess that’s why God invented the spreadsheet.
Back to Our Model
So what do all of the squiggles in Figures 1 and 2 actually tell us and more importantly is it possible to use these squiggle’s to make money? Two answers:
a) They tell us whether RUI is outperforming RUT or vice versa, and;
b) Yes, or so it would seem
So here are our trading rules:
-If variable F (the 9-day average minus the 260-day average) is positive (for the truly mathematically challenged, that means above 0) then we want to be invested in large cap stocks.
-Conversely, if F is below then we will simply hold cash.
-A technical note: although I do all of the calculations using the indexes RUI and RUT, for trading purposes I recommend SPY which is heavily traded and trades almost exactly the same as ticker RUI.
-One more technical note: I use a one day lag – so if on Tuesday’s close the model goes from negative to positive then SPY is purchased at the close on the next trading day. The same applies when the model goes from positive to negative. SPY is sold at the close of the following trading day.
How has this simple method performed? I’m glad you asked. Figure 3 displays the growth of $1,000 invested using this method since January 1990 versus simply buying and holding ticker RUI.
Figure 3 – RUI/RUT Ratio System versus Buy-and-Hold
For the record, since 12/31/1989:
-$1,000 invested using the system grew to $6,706 (+571%)
-$1,000 invested in RUI using a buy-and-hold approach grew to $3,939 (+294%)
-The worst percent peak-to-trough decline using the system was -20.5%
-The worst percent peak-to-trough decline using buy and hold was -56.9%
In the last two weeks I’ve attempted to demonstrate that it is possible to not only make money but to beat the major averages without having to resort to “rocket science.” Will the methods that I’ve described continue to perform well in the future?
As always, time will tell.
Staff Writer and Trading Strategist
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