A leading indicator to spot financial market Black Swan Events?

Black Swan Events or 4-sigma moves (e.g. 1987 Black Monday and 2008 crash) in the markets are by definition hard to predict.  Hard, but not impossible.  Experienced traders utilize prudent risk management to shield themselves from monstrous losses, and some can even profit immensely from them.  However, for us average folks, is there some kind of simple warning signs that could give us a heads up to these sort of extraordinary moves?  In this post, I will introduce a simple leading indicator that seems to do the job quite well.  I will talk about what it is and why it seems to work.  Of course, this is merely based on limited observations and is not to be construed as a vigorous analysis.

The particular indicator I am referring to is the Google Investing Index (GII).  Figure 1 below shows the GII vs. S&P 500 from 2004.  The blue line is the GII, the red line is the S&P 500.  What I have observed is that rapid (in a month’s time) rise from a negative reading to +20% reading of GII correspond with a shift in sentiment in the market rather well.  Referring to Figure 1 below, this condition occurred 4 times since 2004.  I marked these 4 occurrences on the graph with green dots.  As you can see, they correspond with the double top on S&P, first dive in the crash, the big one in October 2008, and then even confirming the 666 reversal in March 2009.  It seems to be a leading indicator for down moves but lagging on upward reveral.

Mostly noticeably though, is that the GII gave extreme readings, and in the direction of our condition (negative to positive jump), days before the big crash in October 2008.

Google Investing Index vs. S&P 500 (green dots mark signals)

While this can be mere coincidence, here is why I think this index holds some truth.  The GII measures the amount of search traffic for topics relating to investing in the U.S.  And with Google dominating the online searching market (65% as of October 2009 according to comScore), we can assume GII to measure what the general public is interested in.  Now, as we probably know, market extremes are driven by irrational emotions.  There’s an old saying that goes like this, on market highs, when even the taxi driver is giving you stock advice, it’s time to get out of the market.

When all the people have invested already, who’s left to buy and drive the price even higher?  This is ultimately a supply and demand effect.  While we can’t count heads in the market, we can estimate market sentiment.  The GII is just one more way of doing that.  And it does so by giving us a reading of the market sentiment according to the general public.  You know, the last ones in the party to pickup the mess the pros have  have left behind.  That is exactly what sets the GII apart from the plethora of existing market sentiment indicators.  It is a market sentiment indicator on mass psychology, but a crude one at that.

Scoring 4 out of 4 positives is good, but the small sample size render this a mere observation of interest.  I do not recommend trading on this indicator.  However, it does seem promising to serve as an additonal input to an analytical system…

In summary, here is the condition of this GIS (for Google Investing index for market Sentiment) indicator.

• the condition is true for a turn in the market when GII jumps from a negative to +20% or more within a month.

Lastly, notice that the GII is still low at the moment while many are calling the top is imminent, or even that it has happened at 1120 in recent weeks.  Thus, according to GIS indicator, this market rally is still intact.

Related posts:

1. Back to Basics: Market sentiment via 2-line EMA on S&P500
2. Reducing overall market exposure according to market volatility
3. Mid-week Market Review, October 15, 2008
4. Pre-market Analysis December 1, 2008
5. A sign this financial bloodbath is ending soon?