S&P 500 Rainbow Chart of the "90s"
Always remember: Keep the market as stupid and simple as it can be...Developed by Mel Widner and originally described in the July 1997 issue of Technical Analysis of Stocks and Commodities magazine, the Rainbow Charts indicator is a trend-following one. The core of the Rainbow Charts is a 2-period Simple Moving Average, to which recursive smoothing is applied. This way nine other moving averages are created, with each new one being based on the previous moving average. Recursive smoothing creates a full spectrum of trends and if different colours are used, when visualized on a price chart, they appear in the form of a rainbow.
Interpretation of this indicator is quite simple! In case the market is in a bull trend, the moving average with the least smoothing (the red line) stays on the top of the Rainbow and the most smoothed moving average (the purple line) stays at the bottom of the Rainbow.
In case the market is in a bear trend, the most smoothed moving average stays on the top of the Rainbow and the moving average with the least smoothing stays at the bottom of the Rainbow.
While the market is moving to the upside or to the downside, the moving averages track it and cross in a sequential order, as the move goes on. In case the price distances from the Rainbow, this indicates a potential continuation of the underlying trend. This will usually cause the Rainbow width to increase.
In case the price approaches or goes into the Rainbow, this indicates a potential trend reversal. This will usually cause the Rainbow width to decrease. The way the price penetrates into the Rainbow signals how strong the move is. To get an idea how easy the market was in the 90s of the last century take a look at "my" Rainbow Chart below.
Well, ex-post this can easily be said - please read about the market turbulences during the Russia-crisis in 1998 and the marvellous disaster which occured to the Nobel Prize Winners and their LTCM-dream team...in that period (reminder: two of LTCM's academic superstars, Robert C. Merton and Myron S. Scholes, had been awarded the Nobel Prize in economics)...