CPM Investing LLC - Research Publications
MRI and Driver Notes
The figure on page 3 of the weekly report presents the market index price along with the Market Resilience Index series in the upper panel, covering the past 52 weeks. The market index price (e.g., DJIA) is displayed on a logarithmic scale using weekly data, with the scale omitted for simplicity. The price line drops to the horizontal axis at the most recent date.
The lower panel displays our physics-based forecasts of shifts in naturally occurring investor optimism and pessimism. The naturally occurring shifts are additive to any real-world news and events affecting stock prices.
These two sets of indicators are calibrated to work together. The drivers predict when investors will likely view news optimistically or pessimistically, while the MRI show the extent to which these expectations are realized.
1. Market Resilience Index (MRI) Series (Upper Panel)
The Market Resilience Indexes reflect broad investor sentiment, reflecting views on economic (e.g., economic growth) and market conditions (e.g., stock valuations) plus the natural forces predicted by the physics-based drivers. The MRI series is derived from index price changes, measuring return acceleration over periods ranging from weeks to quarters. These indexes help identify actual sentiment inflection points, providing signals for both short- and long-term asset allocation changes.
- Micro MRI (brown line): This index highlights shorter-term price trends. It moves cyclically, and its slope and level are key indicators. Its level is indicated by the percentile rank of the current value among all levels prior to the current date since the inception of the index. The scores and slope are shown in the legend. A trough at a low level signals a strong short-term buying opportunity, while a peak at a high level suggests a strong short-term selling opportunity.
- Macro MRI (light blue): This index tracks long-term trends in index prices, based on return acceleration. Like the Micro MRI, its level and slope are key indicators, with the current status shown in the legend. A high level followed by a shift to a negative slope typically signals an impending long-term downtrend.
- Exceptional Macro MRI (dark blue line above the Macro MRI): This indicator appears when the slope of the Macro MRI is likely to become more positive, signaling increasing market resilience. When it disappears, the Macro MRI may remain positive but experience a decreasing slope. After being present for a long period, the market often falters briefly when the Exceptional Macro ends, but then resumes its positive long-term trend.
2. Drivers of Naturally Occurring Shifts in Sentiment and Market Resilience (Lower Panel)
We have identified four physics-based drivers that forecast naturally occurring periods of investor optimism and pessimism. These drivers operate independently of economic and market forces, yet they explain over 70% of the variation in market price momentum measures (e.g., the 14-week RSI).
They do not predict specific news or events but instead forecast how investors are likely to react. During periods of naturally occurring optimism, investors tend to overreact positively to good news. Conversely, natural pessimism leads to exaggerated reactions to bad news. Driver impact is especially pronounced during times of market stress, often signaling the future direction of the MRI.
An important feature of these drivers is that we can forecast them months in advance. The forecasts are described on the CPM Investing homepage. The forecasting processes are complex, and you can request a presentation about them at any time.
The drivers are shown relative to their neutral states (dashed lines) in the lower panel. The forecast period for the drivers is shown in the light green box on the right side of the figure. The drivers are:
- Long-Term Driver (purple): Forecasts long-term gradual shifts in sentiment that significantly affect the Macro MRI and longer cycle MRI. Low points signal periods of natural pessimism, making markets more vulnerable to declines, especially when investor views on economic factors are also pessimistic.
- Short-Term Driver (red): Predicts short-term gradual sentiment shifts that influence the Micro MRI and short-term price changes. Low points indicate greater market vulnerability. Above and below the Short-term Driver we show green lines, which we call confirmation lines. The confirmation lines indicate periods when market prices are most likely to be affected by the effects of the Short-Term Driver, which can help us discern it impact in real time. These lines indicate when components of this driver are moving in unison.
- Flash Driver (yellow): Identifies moments when gradual changes in investor sentiment and market resilience are disrupted, often resulting in sudden market movements. There is a strong negative correlation between the actual index price change and the multi-week disruptions identified by the Flash Driver.
- Minor Flash Driver (rose): Detects brief bursts of optimism or pessimism. Though statistically insignificant over our multi-decade test period, it is often associated with abrupt market moves when investor views on economic forces are neutral or negative. This driver is also useful when combined with other indicators such as the MRI or other resilience drivers.
The first three are most important in assessing the future resilience of the stock market. If all three indicate pessimism, the market is likely to be very vulnerable to price declines and slow to recover from declines that occur for economic reasons. The abrupt episodic sentiment shifts indicated by the Flash Driver often supersedes the first two. Forecasts of the Flash drivers tend to be more accurate than those of the Long- and Short-Term drivers.
3. Monitoring the Gap Between the MRI and The Drivers
To assess investor reactions to economic and market forces, we monitor the gap between actual and predicted metrics:
- A small gap indicates neutral sentiment related to economic and market factors.
- A large negative gap reflects pessimism related to economic and market factors.
- A large positive gap suggests optimism related to economic and market factors.
4. Early Warning: Convergence
Early signs of market stress emerge when a Market Resilience Index begins to converge with its main driver. An early warning occurs when two key conditions are met:
- A downward trend in a physics-based driver, signaling an upcoming period of naturally occurring vulnerability.
- Convergence between the Market Resilience Index and its driver, indicating minimal optimism beyond natural forces. This suggests heightened market vulnerability and the potential for overreaction to negative news.
The figure below shows this convergence, with the early warning point marked ‘A’. Monitoring such convergence can help identify crucial market inflection points in advance.
The figure below shows a market condition in which the economic forces are strong and positive. No convergence is apparent.
