Reality Shares launches market strength indicator

Aug 20th, 2015 | By | Category: ETF and Index News

Reality Shares, a US-based niche index provider and ETF issuer, has unveiled a market-strength signalling model, called the “Guardian Indicator“, which aims to identify long-term directional changes in the S&P 500 Index. The model evaluates momentum and volatility indicators to propose either an entry or exit signal to the market.

Guardian Indicator protects portfolios from downturns in S&P 500

Eric Ervin, President and CEO of Reality Shares.

The proprietary model is likely to be well received by exchange-traded fund (ETF) investors who can take guidance from the signals to make tactical trades.

“Markets are subject to extended downturns driven by both fundamental and emotional factors, but Reality Shares’ Guardian Indicator provides a quantitative signal to identify market trends and help to mitigate the impact of price declines,” said Eric Ervin, President and CEO of Reality Shares. “The Guardian methodology uses a disciplined approach to help investors reduce volatility and risk in their portfolios, and has a wide range of applications for investors looking to navigate the noise and volatility of the markets.”

The momentum pillar of the market strength indicator uses simple moving averages to determine the likelihood of a protracted change in direction of the market. Specifically, the ratio of short-term over longer-term moving averages (for example the 50-day moving average divided by the 200-day average) has historically provided traders with a sense of these trends. When the short-term average rises above the level of the long-term (colloquially known as a ‘golden cross’), this is a sign of a directional change in the market and positive upwards momentum. Conversely, when the short-term average moves below the long-term level (a so-called ‘death cross’), this indicates a down-turn in the market. The validity of each indicator can usually be further reinforced through higher trading volumes during these times.

The volatility pillar evaluates downside deviation, a measure of volatility that only considers the extent of negative returns in calculating the moving average of volatility. The ratio of long-term to shorter-term volatility moving averages determines whether an entry or exit recommendation is signalled: lower levels of this ratio indicate increased negative volatility in recent times compared with historic levels, and are more likely to signal an exit from the market.

These two steps are applied to each of the ten sectors of the S&P 500. A red light from either pillar necessitates an exit signal for that sector. If three or more sectors are indicating an exit, the methodology recommends withdrawing entirely from the market. In this way, the indicator not only informs ETF investors of directional changes of ETFs tracking the S&P 500 but may also provide insight into which sector-specific ETFs to shift into to better manage the risk of a portfolio without totally abandoning investment in the US market.

Back-tested data from 1956 through to 2015 isolate 17 different periods where retreats from the market were proposed, with an average of seven months withdrawal per event. During this period, an investment in the S&P 500 that hypothetically shifted into three month US Treasuries during withdrawal periods would have produced superior Sharpe ratios compared to an S&P 500 buy-and-hold strategy.

While the back-tested data point to promising risk-adjusted returns, several scenarios have been pointed out that would cause the methodology to underperform the market. These include bull markets coupled with highly erratic price movements, which may signal an exit from the market under the volatility pillar; an overall bull market with limited sector participation, requiring an exit if three or more sectors are not performing; long periods of range-bound trading, which may signal several entries and exits; and a sharp drop in the market, wiping significant value from a portfolio before an exit is signalled.

As of early July 2015, the indicator is recommending investment in the S&P 500 as eight of the ten sectors return bullish indicators, while the energy and utilities sectors are highlighting withdrawal. The healthcare, consumer staples and telecommunications sectors are bordering a change of sentiment which may soon necessitate a shift away from the S&P 500 under the methodology rules. The sectors currently showing the strongest entry signals are the financial sector, followed by the materials and consumer discretionary sectors.

Various S&P 500 sector ETF suites are available, including the well-known Select Sector SPDRs from SSGA in the US and similar ranges from SSGA and Source in Europe.

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