Building a Meta Strategy – The Traffic Light System

I have addressed the problems of making binary allocation decisions based on a single type of indicator – either being completely in or out of the market. In the real world we face continuously shifting probabilities rather than clear black and white states. The focus should be on creating a model for a systematic, gradual adjustment between risk-on strategies, that create exceptional return in bull markets under low volatility and risk-off assets, like cash or bonds. When the time is right, we can allocate to strategies on the other side of the spectrum, that thrive under volatile conditions, which are often accompanied by falling equity prices or choppy market moves.

Developing a simple yet balanced combination of indicators

Using several indicators (or different levels of signal strength in individual indicators) from fundamental and technical strategies could make allocation decisions fluid by assigning a score to the technical and fundamental market conditions to calculate exposures and adjust them continuously. This is a great solution when running a large pool of capital with a high powered algorithmic solution.

As an individual investor, I am also going down this path, but try to balance granularity with simplicity in execution. I want to avoid the high cost and practical complications of all too many adjustments.

As a simple analogy, I am using the idea of a traffic light on both the technical and the fundamental side and add a worst case stop loss:

  • Green: gives the all-clear to maximize profits in good times. This condition is met about 75% of the time and justifies maximum exposure to the most risky strategies.
  • Yellow: shows a deterioration in market conditions leading to a reduced portfolio exposure
  • Red: rings the alarm bells and triggers a move to safety
  • Re-entry from Red to Green: many systematic strategies obsess about entry criteria for no real reason – under the meta strategy framework being in the market is simply the default position. Exposure can be increased at any time a warning signal is reversed. As the golden cross has such a good track record (85% of entries lead to positive trades in a 60-day /275- day moving average crossover strategy), I consider it the all-in entry point even if fundamentals are still yellow or red – these are often slow in signaling after bear market bottoms when equity prices tend to improve much faster than economic conditions.

Technical indicators of different type and sensitivity are layered to form the first traffic light:

  • Green: no technical warning
  • Yellow: the most sensitive signal is triggered in any indicator (I use 2 different types of technical indicators each with 2 sensitivity stages – as I describe in the next post)
  • Red: the least sensitive signal is triggered in any indicator
  • Stop Loss Trigger: if all indicators signal red at the same time, then I move to safe assets in any case as a safety precaution.

Fundamental indicators filter the technical signals:

  • Green: the majority of my main economic indicators give the all-clear
  • Yellow: the earliest leading economic indicators turn negative and many other leading indicators deteriorate towards their alarm points
  • Red: the main leading indicators trigger an alarm

The state of economic fundamentals now determines how strongly I weight my technical score to time the move between leveraged long exposure to net short:

In essence the support of fundamental warnings gives a technical signal a higher probability of being correct. When economic conditions deteriorate, technical warnings are taken more and more seriously and cause different allocation decisions.

  • Fundamental Green: I largely ignore technical yellow signals, except to pause taking on new positions until conditions return to green and to reduce exposure to very risky strategies (e.g. short volatility). A more aggressive approach could also be justified and view these corrections as a good opportunity to increase risk as they are most likely to be temporary and stop loss triggers are fairly close – this is where art meets science in investing. When technical red conditions are met, I move 50% of portfolio exposure to safe assets.
  • Fundamental Yellow: I treat technical yellow signals as red signals and reduce exposure to my risky strategies by 50%. When red conditions are met, I reduce exposure further to 25% risky / 75% safe assets.
  • Fundamental Red: technical yellow signals trigger my stop loss and I move to safe assets as a precaution. With technical red conditions in place, I look to implement bear market strategies going short equities or long volatility.

This template gives me a clear course of action with a priority to aggressive exposure at the most opportune time and a quick switch to continually decreased risk when market conditions get worse. A worst case stop loss will get me out with my capital largely intact.

The beauty is, that we can integrate any type of indicator we find useful and allocate capital to any strategy we are particularly attracted to – as long as we understand its performance characteristics under different market conditions.

The simplest way to use the system would be to buy a S&P 500 ETF and reduce its position size by moving to cash in several stages according to the model.

The particular indicators I use for my own portfolio are up next.

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