CHAPTER 2 The Model-Building Process

SAM BURNS

UPDATED BY NED DAVIS

The first chapter described the types of indicators we use to try to manage risk in the stock market in general. This chapter will further outline our model-building process. Then Chapters 3 and 4 will give the details of actual stock and bond models.

The Model-Building Process

A 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, or the pronouncements of the market guru du jour. 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. Such a model can anchor the investment/asset-allocation process.

Where to Start: Model Inputs

Any model is only as good as its inputs, and if those inputs contain errors, aren't timely, or are simply irrelevant, the model will provide little benefit. So the first thing investors who want to build or maintain a quantitative timing model must do is make sure that they have clean (error-free), reliable data that is updated regularly. One must also take into account data revisions, which are common in economic reports, and make sure that the information used is consistent ...

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