The document discusses the model-building process for a market-timing model. It describes including various types of indicators such as internal/price-based, external/macroeconomic, sentiment, valuation, monetary, and momentum. These indicators are tested individually and combined to form a composite reading. The composite reading can then be used to guide asset allocation decisions in a disciplined and objective manner. The goal is to create a stable, predictable model that avoids emotional decisions and captures risk and reward signals.

1. Module - 62
Model Building Process
CMT LEVEL - I

2. The Model-Building Process
• The Market–timing model can form the basis of an investor's
market outlook by providing a benchmark for adjusting
exposure to different types of assets.
• By using objective, quantitative information and testing its
predictive value against historical data, an investor can avoid
making decisions based on emotion, gut feel,
• A model with a variety of indicators, which individually have
value in highlighting risk and reward, can offer a more stable,
predictable, and reliable reflection of the market than any
single indicator can.

3. The Model-Building Process
“internal” and
“external”
indicators
Sentiment
and Valuation
Indicators
Monetary
Indicators
Economic
Indicators
Moving
Averages
Crossings and
Slopes
Momentum

4. Internal” and “external” indicators
• Internal indicators are based on the market itself. They
include price trend and momentum, as well as corollary
indicators,
• Our goal is to be in harmony with that trend. Internal
measures typically account for half (or more) of the
indicators in our timing models.
• External indicators aren't derived from the market directly,
but are known (or thought) to significantly influence it. The
best example of an important external indicator is interest
rates. Their level and direction have a major impact on the
direction of stock prices.

5. Sentiment and Valuation Indicators
• Sentiment Indicators are several regularly updated polls or
surveys of various investors, including market newsletter writers,
futures traders, and individuals.
• These polls typically just ask the respondents whether they have
a bullish (positive) or a bearish (negative) view on stocks and
then aggregate the responses to give the percentage of the
group that is bullish or bearish at any given time.
• When a great majority of investors have the same view of the
market, it is typically a warning to expect a reversal contrary to
the majority opinion.

6. Sentiment and Valuation Indicators
• The price investors are willing to pay for a stock, relative to
its underlying assets or earnings, indicates their level of
confidence or optimism about the prospects for that stock
(or in the aggregate, the market).
•When investors are very optimistic they will pay higher
prices, as reflected in high price/earnings or price/book value
ratios, while pessimistic investors will buy only at low
valuation levels.
• We see how much investors are paying for current valuations
and compare that to historical norms.

7. Monetary Indicators
• These reflect what is happening to the price of money
(interest rates) and the supply (availability) of money.
• Interest rates are a primary driver of stock returns, because
high rates make debt securities relatively more attractive
than equities to investors, and also drive up businesses' cost
of raising capital.
• Indicators based on the level and trend of interest rates (or
bond prices, which are inversely related to rates) are
common in our stock–market models.

8. Economic Indicators
• broader category of external indicators can be classified
simply as economic indicators.
• These track economic vitality or inflation.
• Examples are gross domestic product (GDP), the consumer
price index (CPI), and surveys showing current and expected
economic conditions
• These indicators typically have the most effect on bond
prices and interest rates, and thus on the actions of the
Federal Reserve and on stock prices.

9. Moving Averages
• One well–known way to get a handle on the underlying
trend in stock prices is to use a moving average (MA).
• When plotted on a chart, this continuously updated fixed–
period average moves, along with the actual price data
•It is smooth out the largely random short–term wiggles in
the price of a stock or a market index, revealing the
underlying trend.
•the longer the time frame is, the more smoothing will occur
and the less sensitive the results will be to the latest price
changes.

10. Crossings and Slopes
• The price can whip back and forth around the moving
average and thus change its signal too frequently.
• To get around that, a model can be built that recognizes
signals, up or down, only if they're based on moves of a
certain minimum size.
• A change in trend is signaled when the short–term average
(rather than the price itself) crosses above or below the
longer term average.
• This reduces the frequency of whipsaws, or short–term
signals caused by random volatility in prices

11. Momentum
• Momentum is typically measured as a rate of change, as in
the distance an object travels in a given period, or the
amount by which stock prices rise or fall in a given time span.
• To calculate a 10–day momentum, simply divide the current
price by the price 10 days ago and subtract 1 from the result.
• A positive value indicates that the price trend is up, and a
negative value implies a downtrend.
•The high momentum reading implies that prices will
continue on an upward path for some time, while a very low
(negative) reading implies that a downtrend is under way.

12. Market–timing/asset” allocation model
• Gather as much objective, quantitative data as
possible.
• Make certain that the information is accurate and can
be updated in a relatively timely manner.
•Test individual data series and the various
manipulations of the data mentioned above against
the market to determine if they have any potential
predictive value.
•Make sure not to over–fit the data to historical prices.

13. Market–timing/asset” allocation model
•Select different types of indicators (e.g., trend, monetary,
sentiment, etc.) based on their historical reliability and
their ability to complement one another.
•Combine the indicators into a model that gives a single
composite reading. The indicators can be weighted
equally or by their relative importance or historical
accuracy.
•Test the resulting model to see if it provides reliable
results.
•Use the model as the basis for disciplined investing.