The indicators that traders use to determine the future prospects of individual securities and of the market at large are wide ranging. However, not all indicators are created equal. This article identifies five indicators have been shown by empirical evidence to be useful tools for predicting when a security is likely to outperform its sector or even move in a specific direction.
A “stock market indicator” is simply the output of formulas that reduce specific attributes of a security or market environment to numerical values. Traders use these indicators in their research process because they believe that their values communicate probabilistic information about the future price movement of securities.
It is a common belief within the trading community that using indicators as part of a systematic trading approach can help reduce the bias in the decision-making process. The theory behind this point of view is supported by the work of intellectual heavyweights, such as Daniel Kahneman, a Nobel Prize winner in Economic Sciences. He has argued that important financial decisions, such as stock-picking, should be based on algorithmic formulas not intuition.
In theory there is a limitless range of raw data and mathematical formulas that can be used as inputs to build indicators. As such, there is a wide ranging body of indicators available to traders today. While different types of traders are prone to use different types of indicators, they all share a similar function: indicators are used as tools that signal when to enter or exit a trade.
A large body of academic work has identified the slope of the yield curve as one of the more reliable indicators of whether equities will rise or fall over the medium-to-long term. The term yield curve is commonly used to describe the relationship between short and long-term interest rates on fixed-income securities issued by the U.S. Treasury.
During healthy economic conditions, the yield curve slopes upwards, meaning bonds with shorter maturities offer investors lower interest rates than bonds with longer maturities. This makes sense: debt issued at longer maturities is usually riskier than debt issued at shorter maturities because the longer the duration of the bond, the greater the risk there is that a borrower could default on payments, or that future inflation could erode the value of interest payments.
When the yield curve takes this upward-sloping shape, it signals higher future economic activity. In such a situation, equities are considered likely to perform well because the future earnings of companies are inclined to benefit from the upcoming economic growth.
On the other hand, an inverted yield curve signals expectations of slowing economic growth. The curve inverts when the short-term interest rates on treasuries exceed the long-term interest rates of equivalent debt offerings. The inversion reflects the outsized demand for longer dated treasuries from investors who, fearing a future decline in economic growth, seek a safe and steady yield over this period. These investors expect that in the future short-term interest rates will likely decline along with the capacity for equities to provide an attractive return.
While in theory any pair of interest rate maturities could be used to determine whether a yield curve is technically inverted, most economists elect to monitor the spread between the 2-year and the 10-year. When the interest rate on 2-year treasuries exceeds the rate of the 10-year, the spread turns negative, signaling future weakness in the economy and likely spillover into the stock market. During recessionary periods high beta stocks, such as those associated with growth and cyclical companies, are often the hardest hit.
According to a study by the Federal Reserve Bank of San Francisco, the U.S. curve has inverted before every recession since 1955. After inversion, a recession surfaced in the 6 to 24 months following.
Not only is value investing one of the oldest and most popular styles of stock investing, but value factors have also been empirically validated to enhance security returns.Value investors seek to generate value in the long-term by investing in undervalued stocks whose strong fundamentals suggest that the value of the business will appreciate in the long term.
Investors determine the value of a stock based on a range of indicators, but three of the more popular metrics include the price-to-book ratio, price-to-earnings ratio, and price-to-sales ratio.
Investors use the price-to-book ratio to determine whether a company's market price is reasonable in comparison to its balance sheet.
The price-to-book ratio is calculated by dividing a stock's share price by its book value -- a calculation equivalent to the total assets of the business minus any liabilities. Stocks that possess a lower price-to-book ratio relative to their peers are usually considered undervalued. This ratio also helps investors compare the inherent value of individual stocks within a single industry. Moreover, stocks trading at a price that below their book value can in theory offer a margin of safety. Nevertheless, an uncharacteristically low price to book ratio can be a sign of trouble.
The price-to-book ratio is particularly useful for the analysis of companies that report inconsistent earnings. In such cases, other key metrics like the price-to-earnings ratio may not be relevant measures of valuation. In a nutshell, the price-to-book ratio can give a clearer picture of the relative value of the stock.
The price-to-earnings ratio (PE Ratio) is one of the most well known equity valuation metrics, applicable to single name stocks as well as to sectors and indices. The PE ratio is calculated by dividing a company's stock price by its annual earnings per share. A stock with a low PE ratio relative to its sector is considered undervalued.
The price-to-sales ratio is yet another favored metric that investors can use to evaluate the value factor of equities. The PS ratio is calculated by dividing a company's total market capitalization by the total sales or revenue. A lower PS ratio compared to competitors and to the industry average may signal a stock is relatively undervalued.
Invented by its namesake, the American Nobel prize-winning economist Robert Shiller, the Shiller P/E ratio is a gauge of valuation for the equity markets at large. This means that variable is best for evaluating the relative value of broader equity indices rather than individual stocks.
The indicator, which has historically functioned as an efficient estimator of future returns, is also called a cyclically adjusted price-to-earnings (CAPE) ratio. This is because the Shiller P/E ratio uses smoothed real earnings to eliminate the impaçt on net income and profit margins that may arise from short-term factors such as supply shocks or changes in a business cycle.
Research shows that the Shiller P/E ratio is most effective as a predictive indicator of future equity returns when applied to timescales of 10 to 20 years. The ratio is based on the idea that investors can identify whether the stock market is overvalued or undervalued by comparing its current price with the past year's inflation-adjusted earnings.
Studies have shown that stocks that beat the market tend to outperform in the future. The academic term for this phenomenon is "momentum".
How can traders quantify the momentum factor? Technical indicators such as Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) are simplified measures of momentum that are accessible to any investor via basic charting tools.
There are, however, more refined momentum indicators that have a verifiable track record of producing future returns that beat their benchmarks. One such indicator is called the high momentum measure, a product of research from the esteemed hedge fund AQR.
This indicator is produced from a methodology that first defines momentum as “the total return of the stock (including the reinvestment of dividends) over the prior 12 months, excluding the last month,” and later ranks stocks by this measure. It’s important to note that this strategy is implemented by managing a diversified portfolio of high momentum stocks, as opposed to the trading of individual names.
When it comes to stock-picking, greater risk does not always lead to higher returns. In fact, research has demonstrated that in the long run, stocks that exhibit lower volatility tend to outperform the market as a whole.
Beta is recognized as the most widely used indicator for the purpose of identifying low volatility securities. The indicator measures the volatility of an individual security relative to the volatility of the broader market.
So why do stocks with lower volatility tend to outperform over the long run? Low volatility in securities is associated with better returns because it helps to control risk during market declines while still allowing for upside when markets finally recover.
Traders who are inclined to use indicators when they trade can clearly benefit by validating their relationship to forward returns through backtesting. Years ago this task might have been too complicated for the average trader, but today there are an increasing number of no-code backtesting platforms such as Tradewell that help make backtesting a fairly fast and easy process.
To validate the predictive value of an indicator, a trader need only log on through a browser and run trading rules against historical data in order to simulate how an indicator-based strategy would have performed in the past. Users of Tradewell can also take advantage of its unique data visualization features, including timing charts and return distribution curves to refine their strategies.
When trading securities such as stocks or ETFs, indicators are especially helpful because they allow traders to be more systematic in their approach instead of reliant on emotions. Of course, simply trading with indicators is insufficient. The indicators that a trader uses matter greatly.
And a number of indicators have shown merit as consistent predictors of the directional movement of securities. Identifying the indicators whose predictive quality is documented and avoiding those that lack the equivalent documentation is an important step in becoming a better trader.
Start with the free version and upgrade when you need a larger metric library and longer lookback periods.
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