Understanding the 90% Rule in Stock Investing

The 90% rule, also known as the 10-month moving average rule or the DeMark rule, is a popular trend-following strategy designed for long-term investors. It’s a systematic approach to market timing, aiming to capture major market gains while sidestepping substantial losses. Developed by Thomas DeMark, a renowned market technician, this rule provides a clear signal for when to be invested and when to be out of the market.

How Does the 90% Rule Work?

At its core, the 90% rule focuses on the advance-decline line (A/D line). This is a breadth indicator that measures the number of stocks advancing in price versus the number declining. It’s a broader gauge of market health than just major index movements.

The rule dictates that you should:

• Be invested: When the advance-decline line is above its 10-month moving average.
• Sell 90%: When the advance-decline line closes below its 10-month moving average.
• Reinvest: When the advance-decline line crosses back above its 10-month moving average.

The "90%" is a key element. It doesn’t mean selling 100% of your portfolio. Instead, it suggests keeping a small portion (around 10%) invested. This allows for participation in any quick market rebounds and can help reduce the risk of missing out on the initial stages of a new bull market.

Why Use a 10-Month Moving Average?

The choice of a 10-month moving average is not arbitrary. It’s designed to filter out short-term noise and focus on the longer-term trend of the market. Shorter moving averages, like a 50-day moving average, can generate too many false signals in volatile markets. A 10-month moving average provides a smoother, more reliable indicator of the underlying market direction.

This approach is about risk management. By systematically exiting the market during downtrends, investors can protect their capital from significant erosion. This capital preservation is crucial for long-term wealth accumulation.

The Advance-Decline Line: A Deeper Dive

The advance-decline line (A/D line) is a vital component of the 90% rule. It’s calculated daily by taking the number of advancing stocks and subtracting the number of declining stocks. This daily figure is then cumulatively added to the previous day’s total.

A rising A/D line generally confirms an uptrend in the broader market. Conversely, a falling A/D line often signals underlying weakness, even if major indices appear to be holding steady or rising. This divergence can be an early warning sign of a potential market correction.

The 10-month moving average of the A/D line smooths out daily fluctuations. When the A/D line dips below this smoothed average, it indicates that market breadth is deteriorating, suggesting that fewer stocks are participating in the upward move, or more stocks are falling. This is the trigger for the 90% rule’s sell signal.

Advantages and Disadvantages of the 90% Rule

Like any investment strategy, the 90% rule has its pros and cons. Understanding these can help you decide if it aligns with your investment philosophy.

Advantages:

• Capital Preservation: Its primary strength is protecting capital during major bear markets. By exiting positions, investors can avoid the devastating losses often associated with market crashes.
• Systematic and Disciplined: The rule provides clear, objective buy and sell signals, removing emotional decision-making from investing. This discipline is key to successful long-term investing.
• Simplicity: While it requires monitoring, the core logic of the rule is relatively straightforward to understand and implement.
• Long-Term Focus: It’s designed for long-term investors who want to participate in market growth but avoid significant drawdowns.

Disadvantages:

• Whipsaws: In choppy or sideways markets, the A/D line can repeatedly cross its moving average, leading to frequent trading and potentially missing out on gains. These are often called "whipsaws."
• Lagging Indicator: Moving averages are lagging indicators. By the time the signal is generated, a portion of the market move (up or down) may have already occurred.
• Missing Early Stages: Investors might miss the initial, sharp recovery phase of a bull market if they wait for the signal to reinvest.
• Requires Monitoring: While systematic, it still requires regular monitoring of the A/D line and its moving average.

Practical Application: A Hypothetical Scenario

Imagine an investor, Sarah, who has a diversified stock portfolio. She decides to implement the 90% rule.

1. Market is Up: For several months, the advance-decline line stays comfortably above its 10-month moving average. Sarah remains fully invested.
2. Deterioration: Over a few weeks, the A/D line starts to falter. It eventually closes below its 10-month moving average.
3. Sell Signal: Sarah receives the signal. She sells 90% of her stock holdings, moving the proceeds into cash or short-term bonds. She keeps 10% of her portfolio invested.
4. Market Downturn: The market experiences a significant downturn over the next few months. Sarah’s protected capital remains largely intact.
5. Rebound: The A/D line eventually shows signs of recovery and crosses back above its 10-month moving average.
6. Reinvest: Sarah receives the signal to reinvest. She buys back into the market, deploying her cash to rebuild her portfolio.

This hypothetical scenario illustrates how the rule aims to protect capital during declines and allow participation in recoveries.

Comparing Market Timing Strategies

The 90% rule is one of many market timing strategies. Here’s a brief comparison with another common approach:

| Strategy | Primary Indicator(s) | Buy/Sell Signal | Focus

The post What is the 90% rule in stocks? appeared first on Pups and Friends | Premium Accessories for Your Best Friend.