# A Look Under the Hood of Our Indicators

There are many ways of constructing an indicator. Foundational in almost any construction is that you have relationships that make sense—easier said than done.

It is all too easy to throw together massive amounts of data and instruct a computer to find an optimal relationship among the data and something you are trying to predict. Unless you are trying to solve something in which a solution can be defined with calculations that can be done in a relative short time, such as the game of checkers (it is always a draw with perfect play), you are unlikely to come up with something that will work with future data sets.

Finding relationships that “make sense,” of course, only brings you part way there to the goal. You also have to find rules associated with the relationships. Sometimes those rules can be of the buy and sell variety such as a golden cross, which is defined when a 50-day moving average crosses on the upside a 200-day moving average. Sometimes the results of the indicator can be expressed in probabilities such as, for example, under current conditions there is a 70 percent chance that zinc will be higher three months from now.

With probability-based indicators, the decision you have to make is what probabilities should go with what kind of leverage. For example, if the probability was 50 percent and it was equally likely that zinc would rise or fall, the leverage you use would be 0, and you would not have a position. At the other extreme if the probability were close to 100 percent that zinc would rise (or fall) you would use maximum leverage.

Our indicators are primarily of the probability variety and we typically will only enter a trade when, based on the past, the probabilities appear to be at least 70 percent. And generally, we will stay with trades until the probability approaches 50 percent. Of course, it almost goes without saying that we have to work very hard to make sure that economic dynamics continue to be incorporated in our indicators.

We are agnostic in terms of what variables or relationships we use. As long as what we use passes the common-sense test, we will use it. Thus, today, as we approach the end of a dreary month, not so much for our trades, which by and large have done well, but in terms of indicators that really aren’t giving us many clues.

Indeed, today there is not one indicator which is at the point of giving us a clear buy or sell signal, though the indicator for gold, the metal, is still pretty close to an outright sell. Our indicators for oil stocks and the S&P 500, the two that inform our two open positions, while not at buys are still some distance from the point at which we would sell our positions.

Worth mentioning is that the relative strength of the small fry, as measured by the un-weighted NYSE average, has been very strong. This is bullish in the sense that small cap stocks are the last place to hide if the market senses a major change in the near term. This derivative indicator is our version of a “golden cross,” and one that we will continue to monitor in the days, weeks, and months ahead.