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Smart index and its predictive ability

Fiala Petr
Published: 19.2.2020 | Last modification: 19.2.2020 08:57  | Comments: none
Creating algorithmic models is not just about applying mathematical-statistical methods to data. Using mathematics, an analyst might find high correlations where they are not. Common sense must be involved. How to determine, for example, that the market is in danger of some significant correction? Here is the question I asked myself in this context already in 2013: Is there a stock index that reliably predicts significant future declines? You can find the answer in an article I posted below.

In the last five years, I have been trying to create algorithmic models that can trade independently on the capital market. An algorithm is a set of rules that ensures the trading strategy to be successful. Our algorithm tilts the probability of success in our favor with these rules. But a computer is just a tool. If you do not have the appropriate rules and knowledge about market behavior, no mathematics will help. One of the critical tasks of such a model is how aggressive or defensive it is. There are times when it would be better not to trade. That could be the case in October 1987. During this period, the S&P500 fell by -21% in a single day and -30% in a month. Other similar situations are the BEAR market in the years 2000-2002, 2007-2008, a sharp decline in August 2015 or October 2018. How to know that such a situation is approaching?

I did not invent the SMART index now. I have published about its predictive abilities already around 2013. Most of the stocks in the market are highly correlated to the main stock index, S&P 500. Their price develops similarly to the price of the S&P 500 index. There are defensive titles (utilities, consumer staples, healthcare firms) whose price develops more slowly than the index. These stocks have a low beta. There are also stocks with a high beta that go faster than the index S&P 500. And then there are shares of the SMART index. These stocks are high beta; they are highly correlated to the S&P 500 in 95% of cases. The remaining five percent make it a great early warning tool that the market is about to change the trend. And it works up and down, very consistently since 1997, a little worse before this year.

The advantage of having a SMART index is obvious - the algorithm can signal on time that it is necessary to reduce the risk, that something nasty is approaching.

For those impatient who do not like reading, I will show the current situation of 2020. The graph shows how the SMART index, which is in the upper half of the picture (below is the S&P 500 index), signaled a decline in October 2018. On 3. October, the S&P 500 created a new price maximum; the SMART index was already declining throughout September. Moreover, the development of the whole 2018 was different; the Smart index lagged behind the SP500 and did not exceed the highs from January 2018. According to the Smart Index, the current development is entirely healthy. It does not signal anything negative. This can be interpreted as meaning that any decline in the S&P 500 will be re-purchased by investors, and prices should return to new highs.

The behavior of the SMART index in the past

Several graphs will show us how important this price index is to estimate market developments.

Picture: The year 1997: A market correction was signaled only a short time in advance, about 14 days. But the SMART index was very powerful, and its growth in 1997 was an excess that had to be corrected. In January 1998, the price was above the MA200 (moving average 200 days).

Picture: The year 2000 - March 24 marks the peak of the BULL market for technology stocks. The S&P500 index created another peak in September 2000, five months later. But not the technological Nasdaq 100. It fell in the next two years by -83%. Watch what Smart Index did before this price peak. The downturn was extreme and began three weeks earlier than the market top occurred. During the BEAR market, the Smart index held under MA200.

Picture: The correction of 2004 - after annual growth in 2003, shares were overbought. How to recognize that something is in danger? However, the situation in March 2004 showed this. Smart index, unlike the S&P 500, did not create new highs.

Picture: The market top of 2007 - the SMART index (top chart) signaled a price peak for half a year in advance, before the market peak in October 2007. The S&P 500 created new highs on October 11, 2007, at which time the SMART index was already below MA200. That was significant. Also, in the summer of 2007, when the S&P 500 created a new price maximum, the Smart index did not create a new one.

Picture: Price bottom in March 2009. While the S&P 500 was at new lows in March 2009, the Smart index was practically at the same level as in November 2008. This was a positive signal.

Picture: The situation of 2015 - the problems of this year signaled the Smart index very well - did not reach new highs. In October 2015, unlike the S&P 500, its price was below MA200, which is significant. Shares of the SMART index signaled another possible decline (which occurred in December 2015 and lasted until February 2016).

Algosystem s.r.o. is registered with the Czech National Bank as a portfolio manager under Section 15 of the Investment Companies Act No. 240/2013 Coll. The value of the S&P 500 stock index was 85 in January 1970, it is now 3370. This means an increase of 3864% in 50 years, arithmetically 77% per year. Not for nothing, Warren Buffet is one of the richest people in the world. He focused on equity investments. I think the stocks would be in everyone's portfolio.  They have significant support of central bankers, which is very important. Central bankers around the world are showing us that elites are interested just in one matter - stock market growth. Donald Trump talks about them practically every day. Owning stocks is the best protection against inflation. It is a piece of real property. By the way - my previous article showed that since 1995 inflation has been running at over 4% per year in the Czech Republic and over 8% for food, energy, housing, and healthcare. What our algorithm looks like can be found at https://www.algotrading.cz/en/model_ls/simulator_218spxl.

We want to be aggressive at the right time, aiming at a high yield of around 20% per year with 3 x ETF SPXL (SPXL tracks S&P 500 with three times more power, beta == 3). If you are interested in our model and would like to do business with it, contact us.

Petr Fiala


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