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32. A Stock Market Model

Learning Objective Statements

1. Define an environmental model
2. Contrast internal and external indicators
3. Sketch the basic components of Davis′ Fab Five model

A Stock Market Model

1. The goal of any NDR model is to keep us open—minded and disciplined, and to let our profits run
while avoiding big mistakes.
2. We realize models can be quite fickle, no matter what their ingredients are or how they are built.
3. This model is no exception (there are no exceptions!). The game is to recognize potential
capriciousness and pay attention to the effectiveness of each individual component and to the overall
mix of indicators.
4. One must always be vigilant when depending on models
5. The Fab Five is an environmental model that uses what we call modes.
6. Its job is to assemble the major internal and external factors that affect markets and combine them to
produce a single objective verdict: bearish, neutral, or bullish.
7. Offering only three possibilities might seem a bit too simplistic, like asking someone to rate a product
on a scale of 1 to 3, instead of 1 to 10.
8. But the goal is to keep things simple, and as you will see later, each mode can be open to subtle
interpretation.
9. Just what is an environmental model? In essence, it's one that can keep risk at arm's length without
sacrificing too much on the long side.
10. Such models effectively gauge how good conditions are for investing: do we have calm waters or are
we about to enter the lower 40 latitudes? An environmental model takes into account what the Federal
Reserve is doing, what the so—called smart money is doing, how speculators are feeling, what
interest rates and inflation are doing, and, above all else, what the primary trend is.
11. Using a weight—of—the—evidence approach gives us an educated feel for the risks in the market.
12. The environmental model's job is not necessarily to give concrete buy and sell signals.
13. Its job is to measure the level of risk in the market.
14. We look at two types of indicators:
a. Internal indicators
i. Internal indicators relate to the price action of a market or index and include the usual
list of suspects, along with a multitude of variations: moving averages, momentum,
advances and declines, and volume trends.
ii. All of these can be found in the bottomless bag of tools used by the creative technical
analyst.
iii. I've seen enough momentum tricks alone to last a career. Ditto for moving averages.

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iv. There seems to be no end of possibilities when it comes to manipulating an index or its
components in order to come up with a so—called objective opinion on a market's
direction.
v. We break down internal indicators into two distinct types:Trend—following and
Trend—sensitive
vi. Rounding out internal indicators is market breadth, an extremely useful tool in
determining the technical environment.
b. External indicators
i. External indicators include anything outside of price action: the monetary environment,
crowd psychology, valuation, and economic conditions.
ii. At NDR we tend to lump valuation and crowd psychology in the The Sentiment
Component.
iii. We also tend to include economic indicators that can influence markets (e.g., inflation)
in the The Monetary Component and sometimes, to a lesser extent, the sentiment
category.
iv. So basically we're looking at two sets of external indicators: monetary and sentiment.
15. To build a truly diverse, objective model requires finesse, diligence, a bit of artistic panache, and a
strong knowledge of macroeconomic relationships, ranging from company fundamentals to
macroeconomic fundamentals to Fed watching.
16. Ironically, computing power takes a back seat in building good models.

Fab Five
1. To create the Fab Five, we combined individual models covering our favorite areas of the market.
2. However, the model has only four components—The Sentiment Component, The Monetary
Component, Fab Five Combo Component, and the Tape Component—but the tape is given double
weight.

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3. Figure 30.1 shows the past 10 years of the Fab Five model.

4. The mode boxes at the bottom summarize the results for the full date range as well as for the past 10
years.
5. The top clip has an additional series on it that represents an equity line based on going long the S&P
500 when the model is above the upper bracket, going into T–bills when the model is between the
brackets, and shorting the S&P 500 when the model is below the lower bracket. This equity line is
only for perspective; it's there to give a close–up view of how the model has behaved in the past. The
stats tell a story, but not the whole story.

# Summing Up the Fab Five

1. Each component model is reduced to +1, 0, or –1 (with the exception of the tape component, which
gets +2, 0, or –2), and the result is a simple sum.
2. This leaves the overall model's range at –5 to +5, with the brackets set at –1.5 and 1.5

# How We Use the Fab Five

1. I opened this chapter explaining that the Fab Five is an environmental model that provides a unified
view and ties together sometimes opposing investment themes.
2. If the model is outright bullish then our outlook will be on the bullish side.
3. If it's merely flirting with the upper bracket we might temper our bullishness. We might make a
distinction between high neutral and low neutral, depending on whether the model is moving up or
down. For example, if it shifts from bearish to neutral, we might consider that hopeful. But going from
bullish to neutral could make us cautious.

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4. We would never deviate too far from the Fab Five's basic verdict. If it's bullish we won't be bearish: we
might be mildly bullish, but never bearish.
5. Even though this model isn't designed for trading, traders can still use it to make decisions about
whether they should have a bullish or bearish bias. If the short side is your thing then you should be a
little more careful if the Fab Five is in bullish mode, and vice versa. At any rate, we still look to other
inputs when evaluating our market position, but always in the context of the Fab Five.

Tape Component
1. There are seven individual indicators in the tape component.
2. As with all the other Fab Five components, and in keeping with our KISS philosophy, these indicators
are each assigned—1, 0, or +1, and the result is produced through simple addition.
3. The first indicator for Tape Component is the Golden cross.
a. The first indicator in the tape component is shown in Figure 30.2.

4. Stochastic is the Second Indicator

5. Third Indicator is Breadth
a. Moving away from direct price action, we turn to one of our favorite broad–market tool sets:
breadth. This indicator is one of Ned's favorites. It's based on another fairly simple yet effective
concept: evaluating the impact of volume supply and volume demand.
b. To stabilize the volatility and gain a useful perspective, we typically sum both supply and
demand over a substantial period ranging from days to months. The percent of summed
supply volume plus the percent of summed demand volume always adds to 100. They meet in
the middle at 50 percent.

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c. The universe we are using for these calculations is the NDR Broad Market Equity Series
All–Cap Index. This index represents 99 percent of the market value of the common shares
trading on the big three exchanges. Its history goes back to September 1980.
d. The mode box in Figure 30.4 shows that when demand has been above supply, as it has been
79.0 percent of the time, the S&P 500 has advanced at 11.8 percent a year. But when supply
is above demand, the market retreats 1.2 percent per annum. This indicator's contribution to
the Fab Five tape component is +1 when demand is above supply and -1 otherwise.
6. Fourth and Fifth Indicator is to look for excitement in the stock market
a. There are many ways to look for excitement in the stock market: exuberance, whether rational
or irrational, can be measurable.
b. A couple of our favorite indicators look at the relationship between advancing and declining
volume, or advances versus declines.
c. Figure 30.5 evaluates the ratio of advances to declines. The ratio is actually a 10–day sum of
NDR Multi–Cap advancing issues divided by a 10–day sum of declining issues. The NDR
Multi–Cap universe covers the top 97percent of tradable market cap and includes the NDR
Large Cap plus the NDR Mid –Cap plus some of the NDR Small Cap (enough to get the
market cap to 97 percent).

d. When the advance/decline ratio exceeds 1.9, we call that a breadth thrust. The table in Figure
30.5 shows the history of this indicator back to 1947. Now I know what you're thinking: Hold
on—if the Multi–Cap started in 1980, just exactly how did you do this? Especially given that
lecture about following only common stocks on the NYSE? Well, we consider ourselves
market historians, and we love historical data—as much as we can get. So yes, we borrowed
the NYSE advance/decline data going back to 1947 to help illustrate the point that breadth

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thrusts can be quite significant. It also turns out that, according to our database, stocks other
than common stocks made up only 20 percent of listed NYSE issues in 1980.
e. Now how exactly do we get these thrusts to work for us? Typically, we try to determine how
long initial momentum is likely to last based on history and then refine our prediction from
there. In the case of the indicator shown in Figure 30.5, 80 market days seemed to work well.
But what if a signal is repeated in that period? One could approach it in at least two ways:
either by simply resetting the count every time a new signal occurs in the 80–day window or by
ignoring that signal. After some quick testing we decided on the latter
f. The contribution of this indicator to the Fab Five tape component is either +1 or 0. It can never
go negative.
7. Sixth Indicator is a cool breadth gauge, the high–low logic indicator—developed by Norman Fosback
and shown in Figure 30.6—is it.

8. Seventh Indicator is to go with Mo.

a. A long–standing tenet of NDR is to go with Mo.
b. If the market's momentum is up, we're in; if it's down, we're out. We use this model as a gauge
of technical health.
c. Big Mo is a diffusion index that represents the percentage of bullish individual trend and
momentum indicators taken from 96 of our own BMES subindustry indices. The trend
indicators are based on the direction of a subindustry's moving average, while the momentum
indicators are based on the rate of change of the subindustry's price index. The ratio of
momentum to trend indicators is around two to one.
d. The indicator shown in Figure 30.8 introduces a modification of our standard mode bat: the
directional mode bat. The two mode boxes in the upper left show results based on whether Big
Mo is higher or lower than it was six weeks earlier. In the bottom section, the brackets are
fixed at 56 and 79, and the results are quite different depending on Big Mo's direction.
Whether the model is improving (rising) or weakening (falling) can give valuable information in

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addition to the model's current level: when Big Mo Tape has been high and rising, the returns
have tended to be best, while a low and falling model reading has been associated with the
weakest returns

e. The weight of this indicator in the tape component of the Fab Five is tricky but sensible. When
Big Mo is rising and above 56 we assign a +1; when it's rising and below 56, it gets a 0; falling
and above 79 is another +1; falling and between the brackets is a 0, while falling and below 56
gets the only −1 reading. If Big Mo is unchanged on a six–week basis the reading from the
prior week is used.

The Final Tape Component

1. Since there are seven components to the model, the range should be –7 to +7. But remember, the
thrust indicator can't go negative, so the overall sum ranges from –6 to +7.
2. The brackets for the model are set at –1.5 and 25.5 (bottom chart section).
3. As with all of the components of the Fab Five, this model is designed to work in four separate time
frames.
4. Its contribution to the overall [[Fab Five]] is –2, 0, or +2 (remember, it gets double weight).

The Sentiment Component

1. It has Seven Indicators
2. Each indicator Delivers +1,0,-1 with the only exception of Daily Sentiment Composite (Which gets
double weight)

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3. The First sentiment Indicator is Advisors' Sentiment Report

4. The second Sentiment indicator is PE Ratio
a. This indicator's contribution to the Fab Five sentiment component is +1 below 14.5, 0 from
14.5 to 22.5, and –1 above 22.5. This is one of the few Fab Five indicators that is calculated
monthly.
5. Third one is a relative measure of earnings to interest rates.
a. The contribution to the Fab Five sentiment component is –1 below the bottom bracket, 0 in
between the brackets, and +1 above the upper bracket.
6. Fourth Sentiment Indicator is The TRIN (also known as MKDS or the Trading Index)
a. Contribution to the sentiment component is –1 when both TRINs are negative or one is
negative and the other is neutral, 0 when they sum to 0, and +1 when both are positive or one
is positive while the other is neutral.
7. Fifth Sentiment Indicator is a fundamental indicator and is based on its analysts' three– to five–year
PE projections for the stocks in their universe.
a. The contribution to the Fab Five sentiment component is +1 when the six–week smoothing of
the VLMAP drops below the upper bracket and –1 when it moves from below to above the
lower bracket. That sell signal at the end of 2012 looked bad, but in Fab Five reality, it was
negative for only seven weeks before it hit oops, or neutral, mode.
8. Sixth Sentiment Indicator is Daily Trading Sentiment Composite.
a. The contribution to the Fab Five sentiment component is +2 when the daily sentiment
composite is below the lower bracket, 0 in between the brackets, and –2 when above the
upper bracket.

Sentiment Summary
1. The final sentiment component, shown in Figure 30.20, is a sum of the indicators discussed (plus one
more P/E indicator) for a range of –8 to +8 (remember, the daily sentiment composite has double
weight).

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2. The brackets are set at –1.5 and 1.5.

3. It attributed to Fab Five

The Monetary Component

1. Our third major piece is the Fab Five monetary component.
2. The adage “money moves markets” is probably as old as the markets themselves; without demand in
some form of purchasing power, there would be no markets.
3. The availability of money equates to liquidity, and measures of liquidity help us get a handle on risk.
Of course, the source and quality of money also matter, and our view of the monetary situation comes
from two major sources: (1) the price of money, meaning interest rates; and (2) the supply of money.
4. Rates of change in interest rates—regardless of what maturities we're looking at or whether we're
examining government or corporate securities—yield consistently good results against the stock
market.(First Monetary Indicator)
5. annual rate of growth of industrial production and the commodity price component of the producer
price index (PPI) subtracted from the 12–month change of the M2 money supply, illustrates the
relationship between monetary and economic environments, with industrial production and PPI
commodities representing the economy and what is produced with available money.(Second
Monetary Indicator ).
6. Deviation–from–trend is the third Monetary Indicator.
7. Inflation is the fourth Monetary indicator
8. AMEX Securities Broker-Dealer Index is the fifth monetary indicator
9. Normalized Federal Reserve Board data is the sixth monetary indicator
10. Fed's influence on the monetary base is the seventh monetary indicator

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Monetary Component Summary

1. The final monetary component in Figure 30.28 is a sum of the indicators discussed in the preceding
section (plus an additional interest rate indicator, not discussed) for a range of –8 to +8.

2. The brackets are set at –1.5 and 2.5. Because the brackets are asymmetric, it's easier to get a sell
than it is to get a buy.
3. As with all of our other Fab Five components, this model was constructed to work in all four of our
preset time frames.

Fab Five Combo Component

1. We call it Combo because it's composed of six stock–market models, each with a different mix of
indicators.
2. The six range from the very simple to the very complex, but they each have the same weight.
3. We've found that it helps to have a variety of models, each with its own indicator mix.
4. Aggregating these models produces a consensus to help clarify risk and reward.

Combo Model Summary

1. Since there are six total indicators, the range of the model shown in Figure 30.35 is –6 to +6.

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2. The brackets are set at –1.5 and 2.5, and to be consistent with the other major Fab Five components,
the model is designed to work in four preset date ranges.

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