Wouldn’t it be great to be able to discern a change in the market’s trend and make money off of it? And wouldn’t you like to be able to accomplish this feat yourself without having to rely on the advice of gurus, advisors, newsletters, or “talking heads” on Wall Street? Well, believe it or not, you can determine when a change in direction is taking place if you know what to look for and where to look. The market signals its intention to those who know how to read its vital signs.
This chapter will help you to become a skillful trend follower. Whether or not you plan to use the specific timing strategies that will be provided in later chapters, this chapter will provide guidance in determining the market’s existing and changing trend so that you can make smarter investment decisions with your regular and retirement accounts. This ability will be very useful information no matter which investment vehicles you are investing in— stocks, equity mutual funds, or equity exchange-traded funds (ETFs). Remember that about 70 percent of the price changes of those investments depend on the market’s direction. So knowing, watching, and obeying the trend ultimately will lead to more profitable investments with less risk than guessing whether the market will advance or decline.
To determine the market’s current trend, you need to analyze specific market internals using charts with specific indicators. I suggest that you pick up a basic book on charting, such as John Murphy’s Visual Investor or others listed in the Bibliography and get a handle on the basics when you have time. There are a number of technical indicators that have proven useful over a long time horizon in their ability to discern the current trend. There are hundreds of stock market indicators and methods that can be used to monitor the stock market. However, the vast majority of them either fail to provide the information that we are looking for, they duplicate the information from other indicators, or they do not have a high degree of historical reliability. I have selected four wellknown, free and easy-to-use indicators that I’ve been using for decades that provide reliable market signals.
WHAT THE INDICATORS NEED TO SHOW
Our objective is, first, to determine whether the market is in a major trend (an uptrend with increasing prices or a downtrend with decreasing prices) or in a trading range, where the price is essentially going nowhere. In a trading range, technicians call the lower price level support and the upper price level resistance. Prices will tend to bounce off support, hit the resistance level, and then bounce down to support again. However, once resistance is broken to the upside by increasing prices or support is broken to the downside, the new trend will be established, assuming that it is not a false breakout. We will use two moving averages to assess the intermediate- and long-term market trend.
Second, we want to know whether the market is in an extremely overbought or oversold condition. An overbought market is one in which the market indices are at a relatively high price level, where individual investors and market professionals are exuberantly bullish and some technical indicators are in overbought territory. This condition can go on for an extended period of time, as indicated by the market’s huge run-up into March 2000 and into December 2010. On the other hand, when the market is oversold, it is at a relatively low price level and individual investors and market professionals are excessively bearish; for example, this was the case in October 2002, March 2003, October 2008, and March 2009. This condition also can go on for some time before a change in trend occurs. It is critical that you invest with the major trend and not against it. This is why you have to stay alert to an impending change in the market’s overbought/ oversold condition.
No one can accurately forecast when the market will change direction, but you can be on the lookout for extreme readings on certain indicators because when such a reading occurs, the market usually reverses direction. If we, as investors, can take advantage of such a situation, then we are well on our way to investing profitably. This is what this chapter is all about—taking the pulse of the market. Either an overbought or oversold condition can be turned to your advantage if you put yourself on the right side of the market’s new direction.
First, I will focus on simple moving-average indicators to show you how to detect the overall market trend. Second, I will cover the New York Stock Exchange (NYSE) bullish percentage to show you how to measure the market’s overbought or oversold condition. And third, I will cover the percentage of stocks above their 200-day moving average (200-dma) to allow you to detect the strength of the trend. I will not be covering the use of basic trend lines and support and resistance, which you can learn easily by going to the “Chart School” on www.stockcharts.com or reading a basic charting book. These two basic tools should be drawn on all charts as an added visual aid.
These market indicators normally should be checked weekly. However, during periods of market extremes and high volatility (e.g., October 2002, September 2008, and March 2009), they should be checked daily so that you can ascertain a better entry/exit point for your investments.
INTERNAL MARKET INDICATORS
The key to profitable investing is to be on the right side of the market. This is when market timing strategies excel. Too many investors do not pay attention to what the market is saying. Instead, they pre fer to read financial and investment magazines, newspapers, and newsletters and watch financial shows that transmit the market hype instead of the objective facts they need. These spin stories are misleading because all the information they impart is just “noise.” It has no value to the average person in terms of what he or she needs to know to be a more informed investor.
Instead, every investor should use a more systematic analytical approach and learn to understand what the market itself is telling him or her to determine if it is time to buy or sell. This goal can be accomplished easily by “putting your ear to the ground” and “listening carefully” to what the market is telling you. The market speaks loudly and clearly, not softly and surreptitiously. After reading about the market indicators in this chapter, you will come away with solid information to judge whether the market trend is changing. This information alone is very useful in making your investment decisions.
No one indicator should be used alone to make your buy and sell decisions. They should be used as a group. When you find that a majority of the indicators line up in a bullish or bearish direction, then that is the time to carefully consider making your move. Remember that an extreme reading on an indicator (except the moving average, which has no extreme points) first must reverse direction before you invest your money.
Indicators 1 and 2: 200-Day and 50-Day Simple Moving Averages
Moving averages are one of the most well-known and time-tested tools used by investors and professionals to determine the market’s overall long-term trend. This tool shows you where you’ve been; thus it is a lagging indicator, but it is still a very useful one. Market technicians use various moving averages, but the ones used most often to determine the market’s intermediate- to long-term trend, respectively, are the 50- and 200-day moving averages (50-dma and 200-dma).
Figure 4-1 shows a 200-dma (the line that begins in February 2009 at that top left of the chart) and a 50-dma (the lower line that is tighter to the index line) on the Standard & Poor’s (S&P) 500 Index from November 2008 through October 20, 2010. In simple terms, the 200-dma depicts the average price of that index over the last 200 days. This moving average is plotted as a line on the daily price chart of the index in this example. Each day, the last 200 days of prices are added together and divided by 200 to calculate today’s moving-average price point. In our example, the last price for the 200-dma is 1181.73 compared with the last closing index price of 1181.23, so this means that the trend is positive because the price of the index is above the moving-average line. The moving average smoothes out the daily prices, so the trend is easily discernible.
How is the moving average used? Looking at Figure 4-1, if the price of the S&P 500 Index is above its 200-dma, then the market is considered in an uptrend. This was the case from August 2009 through May 2010. As you can see, there were a number of
crossovers of the index and the moving-average line in June, July, August, and September because the index was in a trading range.
If the S&P 500 Index price is below the 200-dma, and if the moving-average line is slanting downward, then that is a declining trend, as was the case from December 2007 (not on chart) through late May 2009—a downtrend lasting 18 months. Being out of the stock market during that frightful period saved astute investors a great deal of financial and emotional pain because the market dropped 50 percent from top to bottom. There are rare occasions when the index price fluctuates by as much as 20 to 30 percent above or below the 200-dma. Consider that level to be an extreme reading, and look for the index to most likely reverse its direction because such a strong trend is never sustainable.
The faster-moving 50-dma provides a quicker way of gauging the market’s direction than the 200-dma because it provides earlier signals as to the market’s direction on both the buy and sell sides. Figure 4-1 also includes the 50-dma, which is the line directly underneath the index beginning in late March 2009. There are more crossovers of the index with the 50-dma, as you will notice, between December 2008 and February 2009, as well as in July through September 2010. You will note that the 50-dma had a crossover in middle to late March 2009 for a buy signal compared with the 200- dma crossover that occurred much later in early July. You would have about 10 percent more money in your pocket had you acted on this earlier signal.
Intelligent investors should not necessarily wait for any of the market averages (such as that of the DJIA, the S&P 500, or the Nasdaq Composite Index) to penetrate its 200-dma on the downside before deciding to sell their investments or make new purchases. Such an approach can be financially ruinous because by the time the moving average gets penetrated to the downside, for example, the portfolio already could be down 10 to 20 percent from the highs, especially if high-flying issues are held in the portfolio.
Price penetration of the moving averages in either direction should not by itself warrant a buy or sell decision on your investments. Rather, it needs to be used in conjunction with the other indicators mentioned in this chapter to obtain a consensus reading on the market.
Indicator 3: New York Stock Exchange Bullish Percentage
Investor’s Intelligence, a well-known and long-standing newsletter, developed a unique market sentiment indicator called the NYSE Bullish Percentage ($BPNYA symbol on StockCharts.com) in the 1950s. The firm uses point-and-figure charts instead of the more traditional bar charts to track the $BPNYA percentage changes. Point-and-figure charts are used by the firm to monitor indi vidual stocks, mutual funds, sectors, industries, and ETFs. In addition, the charts are also used to measure a stock’s relative strength and other market measurements. A simple point-and-figure chart is provided in Figure 4-2. A point-and-figure chart is composed of columns of X’s and O’s corresponding to increasing and decreasing prices, respectively. Neither a security’s daily volume nor its daily prices are shown on the chart. You can find more information about these unique charts from the Web sites and books listed in the Bibliography.
The $BPNYA measures the percentage of NYSE stocks that have bullish point-and-figure chart patterns. This is comparable with looking at regular bar charts that have just formed bullish patterns (e.g., breaking through double and triple tops). Figure 4- 2 contains over seven years of data from January 2003 through October 20, 2010. The numbers in the chart represent the months of the year in each year’s data (October through December are represented by the letters A, B, and C, respectively). As you can see, low-percentage $BPNYA readings below 30 that then turned up into a column of X’s turned out to be excellent times to get into the market. The high-percentage readings of 70 or over were excellent times to get out of the market, after they’d turned down into a column of O’s from 70. The lowest readings occurred in October 2008 at an unbelievable reading of 4 percent. Interestingly, at the bear market low of March 2009, the $BPNYA reading was higher at 14 percent.
Conversely, the high readings of the bullish percentage occurred in January 2004, April 2007, May 2009, September 2009, and April 2010, all at relative market highs. Remember to wait for extreme $BPNYA readings to reverse direction before investing, as well as waiting for a consensus from the other indicators in this chapter.
Indicator 4: Percentage of Stocks above Their 200-dma ($NYA200R)
Figure 4-3 is a chart from StockCharts.com of the NYSE Composite Index on the upper graph and the percentage of those stocks above their 200-dma on the larger lower graph. As we know from our prior discussion, the 200-dma is a long-term moving average, and stocks tend to stay above or below it for extended periods during bull or bear runs. When the market is in a strong rally mode, it is
common to find that an increasing percentage or more of all stocks on the NYSE trade above their own 200-dma. An unusual and rare situation occurred from July 2009 through early May 2010, when the market was in a strong uptrend. During that entire 11-month period, the percent of stocks above their 200-dma stayed well above 75 percent or higher as the market kept rising. Only in May did the market begin to drop, and it finally bottomed at 32 percent in early July 2010. When the $NYA200R begins to turn down from its peak and drops below 70 percent, that is usually a potential market top and is considered a sell signal on this indicator.
Likewise, when the stock market bottoms or becomes very oversold, you will find that only about 20 percent or fewer of all stocks are trading above their 200-dma. This situation occurred in mid-January 2008, twice in March 2008, and in early October 2008. Astoundingly, from September 2008 through late April 2009, the $NYA200R stayed below 20 percent, bottoming at 1.5 percent in October 2008 and 3.75 percent in March 2009, levels not seen before on this indicator. In comparison, at the market bottom on October 9, 2002, only about 20 percent of stocks were trading above their 200-dma. Therefore, when the $NYA200R reaches 20 percent or lower and then advances above 20 percent in the opposite direction, that is typically a buy signal on this indicator.
By tracking the four market indicators covered in this chapter, you will be able to determine the market’s trend and be able to observe an impending trend change. It is only when three out of four indicators have a signal in the same direction that you can assume with a high probability that a trend change is occurring. Therefore, it is important to view all the indicators (daily data are used) weekly and especially daily during potential turning points based on how close the index is piercing its two moving averages (200-dma and 50-dma) and the extreme readings on the other two indicators. If you want to go long the market or short the market with a basket of stocks, mutual funds, or ETFs, make sure that the trend has been confirmed; otherwise, you are risking losses if you try to go against the trend. Never fight the trend, or you may not have any principal left to invest in the future. Do not assume that you are smarter than the market because you nor anyone else has ever been that lucky.
Table 4-1 is a summary of the four indicators with their key buy and sell readings. By reviewing all the indicator readings, you will ascertain the market’s trend. When three or four indicators are positive, that would indicate a buy signal. When three or more indicators are negative, that would indicate a sell signal. Any readings less than three in either direction are ignored. Keep in mind that this is just an example of how to view the indicators and not an exact science. You may personally want to weight the indicators differently than I have done and come up with your own scoring system. Remember that being on the right side of a trending market and minimizing your risk are both critical elements in building wealth.
Make sure that once the indicators change to a market buy signal that you make your investment, and remember to place stoplimit orders in the range of 7 to 10 percent, for example, to protect your principal from a market reversal. Once the price starts
advancing, you should consider using trailing stop-limit orders for the same reason. The first indication of a market that may be changing direction is if the S&P 500 Index falls below its 50-dma, so be aware of such an occurrence, and be ready to take the necessary action if two other indicators also deteriorate. The penetration of the 200-dma will take a longer time to occur.