The Modified Davies Method Suggests the Time is Close

[Comment by PT: Readers not familiar with Frank’s MDM trading system should check out these previous articles on the topic: Modified Davies Method and Reader Question on the MDM. Technical analysis generally has the problem that the data of the past as such cannot really tell us anything about the future. However, data like market internals do tell us something about the degree of investors’ risk appetite, resp. risk aversion and how they are changing over time. Such information is often useful as an early warning indicator of impending trend changes. A side note: the MDM is solely focused on the Russell 2000 Index.]

Probably the most difficult thing to do in stock market investing is to identify a good time to sell. Many technical indicators have been devised to identify lows around the time they occur or soon thereafter, with a moderate degree of success, but to my knowledge that has not really happened for tops.

 

$RUTThe Russell 2000 Index (RUT) and the S&P small cap advance/decline line over the past year – click to enlarge.

 

My own Modified Davis Method does not do a very good job at this either. It does profit on the short side, but on balance just barely. In fact, were it not for the occasional severe bear market when my method will be short, or at most 50% long and thus leave significant funds at one’s disposal to invest near the beginning of the next bull market, it probably would not do any better than buy and hold over the long term.

But I have discovered a tendency which I think is nice to know, based on the length of the breadth divergence period preceding the signal to go short. Attached is a list of all of the short trades in the forward test, arranged by number of consecutive weeks of divergence in effect at the time of the signal.

It appears that the divergence must be in place for at least 13 weeks to have a good shot at a successful short. In particular, it also appears that there is a “sweet spot” from 41 to 79 weeks.

There, the probability of a profitable short trade has been 0.80. Over the entire period under consideration there were 5 shorts that resulted in double-digit profits, and 2 of them occurred in this interval. Beyond 79 weeks the probability of success declines significantly. Bear in mind that the method shorts at the 50% level, so these figures would be doubled if it shorted at the 100% level.

Overall there does not seem to be anything here that could be incorporated into the algorithm, and even if it could, that obviously could not be considered as part of the forward test. The only thing to do is to take every short as it comes, as one never knows for certain when “the big one” will begin.

At the last short signal (12/11/15), a divergence had been in effect for 31 weeks. At the time of writing, the figure is 33 weeks, and it will take a very strong market to end this condition. The current short position may not end profitably, but the next short may have a good chance of taking place in the above mentioned 41 to 79 week sweet spot.

 

List of all MDM short signals since 1969 and their results. Ordered by the duration of the breadth divergence preceding the signal (“sweet spot” periods underlined):

 

Short                                Consecutive weeks

Beg Date           Result         of divergence

========   ======   ==============

2002/05/10       9.82 %       1 week.

1991/11/22       -4.18 %       2 weeks.

2006/05/19       -0.14 %       3 weeks.

2007/07/27       -0.70 %       3 weeks.

2014/07/18       -0.99 %     3 weeks.

1976/04/15       -0.80 %     4 weeks.

2004/04/30      -0.76 %     4 weeks.

2005/08/26       -2.27 %     4 weeks.

2014/09/26       0.02 %     4 weeks.

1987/04/24       -1.73 %     5 weeks.

1996/06/21         2.39 %     5 weeks.

1978/10/20       0.77 %     6 weeks.

1995/10/27       -2.55 %     6 weeks.

1998/05/29       -0.15 %     7 weeks.

1983/08/12       1.29 %     8 weeks.

1989/10/13       2.39 %     8 weeks.

1986/07/25       1.06 %     9 weeks.

2006/07/14       -2.23 %     11 weeks.

1980/12/12       -2.54 %     12 weeks.

2015/08/07       1.72 %     13 weeks.

1998/07/24       8.59 %     15 weeks.

2007/10/19       4.27 %     15 weeks.

1972/06/09       1.72 %     19 weeks.

2002/09/20       0.54 %     20 weeks.

1976/08/20       -1.38 %     22 weeks.

1981/02/20       -2.80 %     22 weeks.

1962/04/27       8.53 %     25 weeks.

1979/03/02       -2.54 %     25 weeks.

1998/10/02       0.99 %     25 weeks.

1976/10/08       -1.15 %     29 weeks.

1987/10/09       14.00 %     29 weeks.

1986/12/26       -4.16 %     31 weeks.

2002/12/13       1.51 %     32 weeks.

1984/02/03       3.05 %     33 weeks.

2008/02/22       -1.32 %     33 weeks.

1979/05/11       -2.47 %     35 weeks.

1990/04/27       -2.40 %     36 weeks.

1981/07/02       7.27 %     41 weeks.

1999/02/12       -2.90 %     44 weeks.

1962/09/21       1.20 %     46 weeks.

1990/07/27       7.02 %     49 weeks.

1973/01/19       10.62 %   51 weeks.

2008/06/27       -0.87 %     51 weeks.

1966/05/06         7.95 %     52 weeks.

1979/10/12         0.40 %     57 weeks.

2008/09/26     11.87 %   64 weeks.

1982/01/08         4.57 %   68 weeks.

1984/10/05       -0.32 %   68 weeks.

1999/07/30         0.27 %   68 weeks.

2008/11/07         3.23 %   70 weeks.

1980/03/07         4.23 %   78 weeks.

1988/09/23         0.12 %   79 weeks.

1973/08/10       -0.60 %   80 weeks.

2009/01/16       -0.46 %   80 weeks.

1980/04/18       -2.57 %   84 weeks.

2009/02/13         6.16 %   84 weeks.

1982/05/28         2.64 %   88 weeks.

1973/11/02         6.02 %   92 weeks.

1991/07/05       -2.33 %   98 weeks.

2000/03/17         8.08 %   101 weeks.

1974/01/11       -2.24 %   102 weeks.

2009/07/02       -2.21 %   104 weeks.

2000/05/12       -2.25 %   109 weeks.

1974/03/29         4.55 %   113 weeks.

2000/07/28       -2.58 %   120 weeks.

1974/06/21      10.13 %   125 weeks.

2000/09/22     1.07 %   128 weeks.

2000/11/10     0.19 %   135 weeks.

1974/10/04     -5.90 %   140 weeks.

2000/12/15     -2.78 %   140 weeks.

2001/01/05     -2.44 %   143 weeks.

1968/02/09     -1.34 %   144 weeks.

1974/11/22       0.53 %   147 weeks.

2001/02/23     1.12 %   150 weeks.

1968/08/02     -3.37 %   169 weeks.

1969/02/20     0.43 %   198 weeks.

1969/06/06     6.18 %   213 weeks.

1969/11/21      15.93 %   237 weeks.

1970/06/26    -1.25 %   268 weeks.

1970/08/14     -4.64 %   275 weeks.

1970/10/23     -0.71 %   285 weeks.

 

Chart by: StockCharts

 

Frank Roellinger is a retired software engineer who worked for a major computer manufacturer for nearly 34 years. He has been an avid follower of markets for more than 30 years, with a strong preference for technical over fundamental analysis. After observing the results of many different ways to approach markets, he settled upon long-term trend following. He once hoped to develop a mathematically-based model of the stock market, but now sees little point in doing that, as his Modified Davis Method works as well as any other purely mechanical method that he thought he might ever find.

 

 
 

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