Seven weeks ago, I wrote an essay called "The Primary Wave." Here is an excerpt from that essay: "Imagine that you are standing on the beach, watching the waves roll in. You are noting the watermarks and see that, more often than not, they advance to higher levels on the beach. A storm is brewing on the horizon, the wind is whipping up, and the waves are getting higher. Barely noticeable in the distance, a boat is docked at a pier. After a while, the storm passes, the wind recedes and the waves lessen in size. The watermarks, however, continue to move higher and the boat rises in its moorings. The tide is rolling in."
This scene was used to illustrate how we use the Price of the VectorVest Composite to interpret the daily and weekly price movements of the stock market. We called the trends associated with these movements the Primary Wave. But there's more to interpreting market direction than meets the eye. In the scene cited above, one could have been fooled by observing only what was readily visible, i.e., the size and turbulence of the waves, the high winds and the advancing watermarks. Once the storm had passed, one would logically have expected the watermarks to recede. But they didn't. Another powerful force, the tide, was involved and caused the watermarks to advance instead of recede. In the same way, we often are totally entranced by daily events and the price movements of the market when we should also be aware of the underlying trend.
VectorVest identifies the underlying trend via its Market Timing Indicator, MTI. This indicator is computed by combining the Price of the VVC, RT and the BSR into a single indicator. This indicator was designed to do four things:
1. Go above 1.00 prior to a Confirmed Upturn,
2. Stay above 1.00 during a Confirmed Upturn,
3. Go below 1.00 prior to a Confirmed Downturn, and
4. Stay below 1.00 during a Confirmed Downturn.
A study of our Market Timing Graph shows that the MTI has performed these tasks in exemplary fashion. For example, it has never failed to perform tasks (1) and (3) as designed, and it has successfully performed tasks (2) and (4) 97.2% of the time over the last five years. In addition to indicating the direction of the underlying trend, the MTI also provides an excellent indication of a trend's strength and momentum. Therefore, it is useful in helping identify turning points. For example, the market is clearly over-bought when the MTI goes above 1.60 and it is over-sold when the MTI goes below 0.60. These extreme levels of the MTI have marked turning points of major rallies and downturns on numerous occasions.
Over the last three weeks, we have discussed all of the major ingredients used in timing the market. Consider the Price of the VectorVest Composite, the RT and the BSR as basic building blocks, the Primary Wave as a fast, fairly reliable indicator of market direction and the MTI as the master of The Underlying Trend.
P.S. Next week I'll discuss the Color Guard.