Last year I produced several posts that described a methodology utilizing long term momentum changes between asset classes and the relationship among asset classes to help anticipate the business cycle. That series is linked below.
When I worked in the institutional setting I would place hundreds of assets, ratios, spreads of individual corporate bonds and equities into a 4 quadrant MACD momentum matrix. I would then condense the raw data into thematic groups and see what the matrix implied about the business cycle. As an individual investor with limited time and fewer resources, I generally plot 80 assets and spreads and find that sufficient to extract a view.
For most of the last two decades the liquidity regime provided by monetary and fiscal policy disrupted the economies natural cycle. But, I believe that policy inflections have occurred and that asset prices will again become more connected to the real economy and less connected to policy. Analysis such as this will again become more useful.
Methodology: Individual markets and ratios are plotted in the quadrant that best describes their combination of momentum and price action. The precise point where the individual plots fall in the matrix is not nearly as important as the overall pattern of multiple plot points and the general weight of the evidence. It is important to realize that the momentum state is not always obvious. Accept that its messy and use your best judgement in deciding on quadrants. The idea is to build a general view of the market and economic cycle.
What defines the momentum quadrant? The monthly perspective moving average convergence divergence oscillator (MACD). The individual quadrants reflect the relationship between the 13 and 26 month exponentially smoothed averages.
Quadrant One: Waning Bear: In this quadrant momentum is bearish with the shorter average below the longer average, but the difference between the two is becoming less. Momentum is still lower, but at a decreasing rate.
Quadrant Two: Strong Advance: In this quadrant momentum is bullish with the shorter average above the longer average and the difference between the two is becoming greater. Momentum is higher at an increasing rate.
Quadrant Three: Waning Bull: In this quadrant momentum is bullish with the shorter average above the longer average, but the difference between the two is becoming less. Momentum is still higher, but at a decreasing rate.
Quadrant Four: Strong Decline: In this quadrant momentum is bearish with the shorter average below the longer average and the difference between the two is becoming greater. Momentum is lower at an increasing rate.
Trading Range: A market in a trading range is removed from the matrix until it breaks from the range even if MACD momentum has been falling/rising for months.
Over the next few posts, we will briefly address the construction of the matrix, and attempt to draw conclusions around the market and economic cycles. If you are interested in the methodology, please visit the links below for in depth discussion.
And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.
Stewart Taylor, CMT
Chartered Market Technician
Taylor Financial Communications