by Chris Ebert

Not everyone has the time or the energy to follow the stock market. This can be a crucial flaw in an investment plan such as RRSP, 401k, 403b, IRA or similar types of accounts. Such accounts are designed to allow folks to contribute funds to the stock market when many of these same folks are working full-time jobs that preclude them from having the necessary time and energy to study the stock market. Thus, these investors are prone to wiping out their hard-earned investments when the stock market gets stormy.

market crashMost employer sponsored investment plans offer several ways to allocate funds. Generally there are three main types of offerings, low-risk Cash and Money-market funds, moderate-risk Bond funds, and high-risk Stock funds. Since stock funds tend to offer a chance to grow investments quickly (hence names including Aggressive Growth Funds or Growth-Income Funds) they can be alluring to folks trying to save for retirement. But these funds, by their very nature, come with a risk. They can and do decline in value at times, and declines can be massive when the stock market is experiencing turmoil.

It is difficult for many investors to avoid the downfalls of the stock market, due to the inherent difficulty in timing the market. If an investor knew when to get out of the stock market, he could avoid the downturns that draw down investment balances. Moreover, an investor who does get out of the stock market at the right time may have no idea when to get back in, thus missing opportunities for explosive gains. As a result, many simply take the good with the bad, the gains with the losses, in hopes that things work out over the long haul.

One indicator that may help investors time the market to improve gains is known as the S&P 500 Temperature. This temperature gauge was developed right here at zentrader and is updated here and on twitter as conditions change.

Here’s How it Works

Whenever the S&P 500 Temperature is above zero, it is generally a good time to own stocks, including stock Mutual Funds that are common in many investment plans. When the Temperature is below zero it is often not a good time to own stocks, but to allocate funds to cash or money-market funds. A cash fund tends to grow slowly or not at all, so it is not attractive when stocks are experiencing gains. But when stock prices are falling, moving balances into a cash fund can protect those gains.

As a general rule:

  • Buy stocks and move investments into stock mutual funds whenever the S&P 500 Temperature goes above zero

  • Sell stocks and move investments into cash or money market funds when the S&P 500 Temperature falls below zero

Below is the current S&P 500 Temperature as of June 20, 2015:

SNP Temperature 66

Since no indicator is perfect, the S&P 500 Temperature can sometimes give a false signal. Many types of retirement investment plans have enacted rules to prevent participants from timing the market. These rules prohibit excessive movement of balances between different investments offered by the plan. For example, a participant could face restrictions if he attempted to move into a cash fund on Monday because the Temperature fell below zero, only to move back into an Aggressive Growth stock fund on Wednesday when the Temperature shot up to 50.

The solution is rather simple: don’t move all the balances at once. Instead, by partially re-allocating balances, an investor can often avoid account restrictions. Such a strategy is not meant to circumvent the rules, but rather to allow an investor to protect his account while playing by the rules already in place. As an example, it might be considered prudent for a young investor to allocate 70% of an account to stock funds and 30% to money-market funds when the Temperature is above zero, then change the balances to 50% in each when the Temperature falls below zero. A further change to 30% in stock funds might be in order if the Temperature remained sub-zero for several weeks.

Navigating the stock market freeway in this manner is not so much a matter of putting the vehicle in Park or Drive, but rather about stepping on the accelerator when it makes sense to do so, and backing off when that seems appropriate.

How the Temperature Works

The Temperature of the S&P 500 can be measured by picking a point that would likely allow widespread bearish sentiment into the stock market, and then finding how many points the S&P is currently above that bearish point. The distance between today’s S&P and the bearish point is the temperature.

For example, if the S&P is 100 points above a point that would be considered bearish, it can be said that the S&P 500 Temperature is 100. That would mean the S&P could decline 100 points, safely, without bringing upon the panic selling that often comes when bearish sentiment takes hold. Thus, as long as the Temperature stays above zero, it is likely that stock prices will recover from every sell-off, and continue to rise over the moderate-long term (looking weeks and months ahead).

The Temperature is calculated as follows; but for those who don’t have the time or energy to perform the calculations, it can be found pre-calculated here at zentrader and on Twitter using the links above.

As it turns out, a certain type of common option trade known as a Covered Call is a very reliable indicator of bearish sentiment in the stock market. When Covered Calls are profitable at expiration, sentiment is almost always bullish; but when Covered Calls are unprofitable, that sentiment almost immediately turns bearish. This is particularly true of Covered Calls opened on a broad ETF such as $SPY (NYSEARCA:SPY), especially using a specific option known as an at-the-money Covered Call. The accuracy becomes even more pronounced when the Covered Calls are opened 4-months prior to their expiration day.

The chart below shows a 1-year performance of the S&P 500. Periods when Covered Calls were unprofitable are when the S&P is in the red zone:

OMS 06-20-15Temperature

Click on chart to enlarge

The value of studying 4-month at-the-money $SPY Covered Calls becomes apparent when one considers that bearish sentiment can take hold long before stock prices have fallen far enough to meet the traditional definition of a Bear market. Traditionally, prices must fall 20% before traders will say the Bears are in control. Since Covered Calls often turn unprofitable before the 20% threshold is met, traders who use Covered Calls as an indicator can usually get an early heads up that it’s time to think about selling, without needing to wait around to see if prices fall 20%.

By selling when the Temperature falls below zero, and then buying when the Temperature rises back above zero, a trader can avoid much of the damage of a Bear market without giving up the gains of a Bull market. For investors who are restricted from excessive trading and market-timing, re-allocating balances, as detailed above, can also accomplish this task.

Historic Accuracy of the S&P 500 Temperature

As can be seen on the 1-year chart above, the S&P 500 Temperature is the distance of the current S&P 500 above a Bear market (as defined by Covered Call trading). Last October the indicator gave a rare false signal. The Temperature dropped below zero (anything below the red line represents a Temperature below zero). However, it was a false signal because it is obvious that stock prices quickly rose to record highs soon afterward.

That’s why it’s important to be able to buy stocks as soon as the Temperature gets back above zero; and it’s why those with investment account restrictions must carefully consider the partial re-balancing procedures suggested above. Nobody likes to miss a stock market rally; and it’s even more frustrating when it’s due to a market-timing restriction.

The expanded 10-year chart below shows the importance of the red line – the importance of a Temperature of zero. Each time the S&P crosses the red line is a signal to trade. A trader has not obligation to honor each signal, but it is nevertheless helpful to know the signal was given.

Options Market Stages 2005 to 2014

Click on chart for larger full-resolution version

For traders without restrictions, the ability to get in the market the moment the Temperature rises above zero, and the ability to get out the moment it falls below zero can best be seen on a long-term 10-year chart. Each time the S&P fell below the red line would have been a signal to sell, each time it rose back above the red line would have been a signal to buy.

There are very few false signals (last October being the most recent false signal). In fact there are very few signals at all – usually only a few times per year. That makes it possible for those who have limited time and energy to be able to follow the signals faithfully. There is no need to watch the stock market every day, just when the Temperature crosses the zero mark (the red line). Re-balancing an account thus becomes a straightforward task rather than a guessing game. Of course, each trader and investor is different, and the Temperature gauge may not be right for everyone. But, for those who want to take charge of their accounts while helping protect funds from catastrophe, the S&P 500 Temperature may prove extremely beneficial.

 

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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