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The STEM.MR model (Short-Term
Extreme Model - Mean Reversion) has the shortest
outlook of any of our models.
It was developed because several of the shorter-term sentiment indicators
we follow have displayed a mean-reverting tendency in the past. Meaning,
when they go "too far" in one direction, they tend to snap back to their
average value. Often when they snap back, it correlates with short-term
market turning points.
Depending on market conditions, a signal
could last anywhere from an hour to several days. Typically, however, the
market makes a decision one way or the other and it is usually clear
fairly soon whether the signal will be effective or not.
The blue line is the model, and the red and green boundary lines are
1.5 standard deviations from the six-month mean. 80% of all readings
should stay within these boundaries, and when the model approaches or
(especially) exceeds one of the boundaries, we should pay attention.
If the model exceeds the green (lower) band, then we can safely say that
short-term sentiment has reached a pessimistic extreme and we should begin
to look for upside reversals at any time.
If the model exceeds the
upper (red) band, then the optimists may have gotten ahead of themselves and the
market may be due for a breather.
Model signals are most effective when going with the trend - for
example, giving oversold signals while the larger trend is positive.
Even a simple trend filter like the 200-day average can be effective.
When it is rising, pay most attention to oversold model signals and less
attention to overbought ones.
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