š¦ Market Regime Sophisticated Detection System
Our Secret to Drawdown Defense And Achieving Extra-Ordinary Risk-based Return
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āOnly when the tide goes out do you discover whoās been swimming naked.ā ā Warren Buffett
āBuy and holdā deserves its reputation, but it also comes with a cost: you have to live through the full drawdown when Mr. Market panics. Plenty of investors wished they had gone to cash before the COVID selloff OR 2021ā2023 inflation surge, and re-entered near the bottom.
Stock market regime detection is all about figuring out the current āmoodā of the market. Think of it like weather forecasting for stocks ā markets go through different phases, like bull (rising prices), bear (falling prices), or sideways (no clear direction).
Legendary trader, Mark Minervini, have stressed one simple truth: your strategy has to respect the prevailing market regime.
Mark Minervini, an internationally recognized independent trader, author, and two-time U.S. Investing Champion. He gained legendary status by winning the U.S. Investing Championship in 1997 and again in 2021.
In an interview, he mentioned that
ā¦..I call a hard penny environment Itās just not an environment that is I you know I didnāt get into the stock marketā¦ā¦..Iām going to wait for what I call an easy dollar environment And thatās when you know youāre picking up money off the floor.
However, the uncomfortable truth is that those turning points of market regime changes are obvious mainly in hindsight. We donāt have a crystal ball, and Iām skeptical of anyone who claims they do.
This observation has strong empirical support in finance literature. Harvey et al. [1] demonstrated that real-time detection of regime shifts is fundamentally more challenging than ex-post identificationāregimes that appear clear in historical data often show substantial uncertainty at their edges when analyzed in real time.
What Iāve found more realistic is to focus on detection rather than prediction. Major market shifts donāt usually arrive on a neat seasonal schedule; they tend to show up as regime changes i.e. sudden shifts in volatility, and investor behavior that can overwhelm ānormalā diversification and distort intrinsic-value signals in the short run.
Academic research validates this detection-focused approach. Maheu and McCurdy [2] showed that bull and bear markets exhibit duration dependenceāthe longer a regime persists, the higher the probability it continuesāmaking short-term prediction inherently uncertain.
Our work tries to build a repeatable process to recognize those changes early enough to manage exposure (accepting that I will sometimes be late, and sometimes be wrong), rather than relying on a single lagging price trend rule. The aim isnāt to avoid every drawdown; itās to reduce the odds of the kind of loss that interrupts compounding unnecessarily.
š” Our RAG System
Our research team has invested tremendous effort in developing a data-driven approach to interpret market regime and categorize market conditions into a RAG system (š“ Red / š” Amber / š¢ Green) for our Alpha Allocation Portfolio.
Hereās how we respond to each market regime:
š¢ Normal mode - Execute strategies as planned with standard positioning
š” Cautious mode - Reduce aggressive strategies and increase cash allocation
š“ Dangerous mode - Prioritize capital preservation and seek growth opportunities outside equity markets
Below is our RAG system market regime detection from 2020-2025. The underlying is S&P500 index price chart.
To illustrate the power of adopting our RAG for portfolio management, we illustrate a very simple strategy using the RAG.
Rule:
Backtest period - 2020-01-01 to 2025-12-31
Hold S&P500 ETF in normal & cautious mode, hold protective asset in dangerous mode.
(p.s. adjusting exposure in cautions mode will increase the risk-based return but leave it for simplicity)
Result:
ā Profit is +27.3% better than S&P500
ā Sharpe Ratio (risk-based return) is +47.7% better than S&P500
ā Max drawdown is +16% better than S&P500
All performance metrics are better when adopting our RAG system!
For those who are interested in our RAG, you can download our RAG from 2020-2025 data for investigation.
Disclaimer: The RAG system is designed for our internal portfolio management and is shared publicly to demonstrate how we utilize market regime detection to guide our Alpha Allocation Portfolio decisions. This information is provided for illustrative and educational purposes only and does not constitute investment advice. We assume no liability for any losses or damages arising from the use of this information. Past performance does not guarantee future results.
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Reference:
[1] David I. Harvey, Real-time detection of regimes of predictability in the US equity premium, Journal of Applied Econometrics: Volume 36, Issue 1, 2020
[2] John M. Maheu, Identifying Bull and Bear Markets in Stock Returns, Journal of Business & Economic Statistics, January 2000, Vol 18
Disclaimer: This content is solely for informational and educational purposes. The content herein does not constitute, and shall not be construed as, financial, legal, or investment advice. It is not an offer, solicitation, or recommendation to engage in any transaction involving securities or other financial instruments.
All insights presented reflect the authorās independent observations and analysis as of the date of publication. This content is not tailored to the specific investment objectives, financial situation, or particular needs of any individual recipient. Accordingly, readers should not make any investment decision based solely on this content without seeking independent professional advice and performing their own due diligence.
Investing in financial markets involves significant risk, including the potential loss of all capital invested. Historical performance data and backtesting results are provided for illustrative purposes only and are not a reliable indicator of future returns. FirstGlow Capital and its affiliates disclaim any liability for losses arising from the use of or reliance on the information contained in this journal.
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