The Greedometer® gauge is not an indicator generated purely from back-testing. Here is a short history of Greedometer development and its real-world application at Triangle Wealth Management.
Research began in 2005, and lead to an early version deployed at Triangle Wealth Management – towards the end of that year. The early version was based on a combination of the S&P500 Profit Margin, S&P500 adjusted P/E, VIX, and ECRI’s WLI.
More input parameters were added over the course of 2007 and 2008 until there were 8 inputs. The early version of the algorithm provided enough insight to assist in the limiting of client losses during the 57% S&P500 collapse (October 2007 to March 2009) — to approximately 6.5%. There was sufficient confidence in the early version of the gauge that TV advertisements were run in January 2009 indicating the Dow would drop to the 6000s that year. As we now know, it did.
What came next was a massive QE1 risk-on rally from the March 2009 trough to the April 2010 peak. Another leg down in the collapse (in 2009) was anticipated for several reasons — not least the S&P500 adjusted P/E at the March 2009 bottom remained roughy twice the value seen at every other previous secular stock market bottom over the previous 130 years.
You may recall 2011: the S&P500 dropped nearly 20% from late April to early July. The collapse was halted by QE2‘s announcement in August. Another bear market rally ensued. In early 2011 there were 8 inputs to the Greedometer gauge, and development was largely done. At the time, the gauge was warning of another collapse (7300rpm- the highest reading ever registered — a tie with the pre-crash 2007 peak reading). What transpired was a near-20% drop in the S&P500 from late April to early October (a far faster drop than the opening salvo of the 2007-09 collapse). Anticipating an interim rally in July to the same stock market peak as was seen in April (with a crash to follow), an advertisement was run in the Wall St Journal. Here it is.
Repeated monetary policy driven bear market rallies necessitated a faster moving algorithm that would assist with understanding investment risk with a finer granularity. In late 2011, research began on the mini Greedometer. It was deployed in April 2012.