Technical Thursdays: The Quality Migration Cycle

The Quality Migration Cycle is a very useful tool that no investor should be without. It provides the mega trend context by applying the Divergences Principle to the five size (market cap) categories – mega, large, mid, small, and micro - to give to perspective on the breadth of the mega trend in force. It assumes that size = quality, which is affirmed as such by the performance history of other quality metrics such as S&P quality ratings for stocks.

The application of QMC can be seen by looking at the first chart above*.

As the chart makes clear, the current market conditions show the beginnings of a breakdown in relative performance of the Small (IJR) and Micro (IWC) cap ETF index trackers. Lower lows for each while the remaining three size groupings have not made such a move during the recent phase of the current market correction.

The underlying principle of QMC is to help determine who is leading the mega trend parade at any given point in time. If all are marching in sync AND the mega trend parade is being led by the Smids and Micro, then the mega trend is intact. The logic being that lower quality issues should reward investors for the greater risk of owning them. However, when the mega trend parade is being led by the big boys AND the lower quality issues not only trail in relative performance but exhibit signs of breakdown (such as lower lows unconfirmed by the larger indices), then the prospects for a market topping process must be put into a potential bearish mix.

The fly in the bearish mix currently is the strength in Mid cap. It has not confirmed with a lower low but may do so in the near future. This cannot be determined beforehand. Nor should it, as indicators such as QMC are mega trend indicators helpful in making longer term market calls.

The Quality Migration Cycle helps an investor determine the market ending process of improving relative performance of the higher quality/larger issues as the lower quality sectors underperform in sequence. That appears to be the case currently. Micro failed first, followed by Small. Is Mid cap next? For that answer, see the second chart above* and the application of the long term Moving Averages Principle.

Here we see MDY on the verge of rolling over. Price is at its moving averages and the moving averages are close to crossing (50 below 200 day). However, unlike the Small cap (see third chart), MDY’s moving averages have not crossed nor are they trending down, a condition of a mega trend change as required by the Moving Averages Principle (MAP).

(see prior blog postings under the Topics Discussed category - scroll down, left side - for more on the MAP.)

Investment Strategy Implications

The QMC’s usefulness rests in providing the mega trend context as to where we are in a bull market cycle. At present, the cycle suggests that a market topping process is underway. However, a misapplication of the QMC would be anticipatory. The full cycle must be allowed to play out as what appears to be a market top may actually turn out to be a consolidation range, launch pad for the next up phase.

Context, yes. Tactical decisions (sector and style allocation), yes. Anticipatory, not advisable.

*click on the image to enlarge
Charts sourced from Bigcharts.com