What is the “trend” and how do you determine if it’s up or down? That’s the topic for today’s NERDvember discussion. In short, there are many ways to define the prevailing trend in the stock market, so I’m going to teach you how to do it in three different ways.
Method 1: The Market Crossing Above/Below a Moving Average
A “moving average” (or MA for short) is the average movement of a stock, fund, or index over a period of time. There are virtually endless timeframes that one can use when analyzing their portfolio, and the timeframe you choose determines how long or short the trends are that you’re observing.
If you observe a daily chart of the S&P500 or Dow, which is what most people are used to seeing, what you’re looking at is the average movement of the market each day. You can “speed” things up, you can observe the price movement on an hourly basis, or you can “slow things down” and look at a weekly chart, were each change that occurs is the total price change over one week (you wouldn’t see the daily, let alone hourly price movements).
I tend to use daily and weekly MA’s because my chosen investment timeframe is intermediate in nature (not too short, and not too long). Below is the S&P500 since the beginning of 2018 with a 200-day MA. So in black, you see the market’s movement each and every day… and in red, the 200-day MA is showing us the average movement of the market (again, the market is the black line) over a 200-day period (again,the red line), thus smoothing out the price, making it easier to define the directional movement of the overall market (i.e. – the “trend”).
One way to determine the long-term trend is to observe whether the market is above or below its 200-day MA. One could say that, if the market is above its 200MA, then it’s in an uptrend, but if it’s below it, the market would then be in a downtrend. Below, I’ve placed a red arrow at every point where the market crossed below its 200MA, and as you can see, this took place seven times in the last 22 ½ months.
Of the seven times the market reversed into a downtrend, above, only one (the 6th) turned into a big loss after the market crossed below its 200MA. So one thing you could do if you’re looking to avoid these other six “whipsaws” is to add a waiting period to your exit strategy. So rather than selling the day after the market crosses below its 200MA, maybe you wait three days, five, or till the end of the week. Of course, anytime you wait, you’re also adding the possibility of a larger loss if the market continues downward. So keep this in mind!
Still, while some may not like this concept, using an “above/below the MA” strategy can be instrumental in protecting your portfolio against losses, all while participating in the upside. Here’s the above-mentioned strategy and how it would’ve looked during the Great Recession. Not bad, huh?!
But maybe this strategy isn’t fast enough for you? Perhaps you feel that the -10% loss realized by holding your investments from top-to-bottom, until the the market crossed below its 200MA (two times) in spring of 2018 was “too slow?” Maybe you want to speed your trends up and get out faster, so as not to lose as much?
If this is the case, you can easily speed up this process by simply changing the moving average to something faster. Below is an example of the same concept as above (remember, above the MA = uptrend and below the MA = downtrend), but this time, I’ve used the 50-day MA, and as you can see, it’s a lot faster. While it would get you out of the market quicker, it would also create a lot more activity in your account and performance could suffer as you repeatedly got in and out, over and over again. I like to call this “death by a thousand cuts.”
Method 2: Moving Average Crossovers
Maybe using the 200-day MA is right for you? Maybe it’s the 50? Or maybe it’s neither of these. A second way to determine the trend of the market is to ignore when the market crosses above or below a moving average… but to instead pay intention to when one moving average crosses above/below another moving average.
To keep things simple, I’m going to combine the two MA’s mentioned in our first example, above (the 50 and 200MA) and plot them on a chart together. Here, the trend signal occurs when the 50 crosses below the 200, indicating that we’re in a long-term downtrend. Conversely, when the opposite happens (and positive crossover), the market is deemed to be in a long-term uptrend.
While some might think this is too slow (again, you have to know your own time frame), this is another example of a great tool that can help determine the trend. Using the Great Recession as a visual test, you can see below how a strategy such as this one would greatly assist someone in avoiding a catastrophic market crash.
Method 3: Relative Strength (RS) Ranking System
I’m finishing with this strategy on purpose because it’s the lease “visual” in nature. Most people can look at a chart, add a few trendlines or moving averages, and understand the basic concept. Relative Strength (or “RS” for short) is also simple, but doesn’t provide for as much nerdy eye-candy.
Most of the studies that produce the best results involve the strength (i.e. – performance) of investments over a period of 6-to-12 months. What these studies suggest is that the investments that perform the best over the last 6-12 mo’s tend to continue performing well over the next 6-12 mo’s. Furthermore (and just for fun) many studies also suggest that the investments that perform the best over the last 2-3 years tend to underperform over the next 2-3 years. Interesting, isn’t it?
Most humans look for the investments that are down in value because:
The best way to get optimal results in your retirement portfolio is to invest with the trend, not against it. In other words, buy with strength, swim downstream, and only take risk when the wind is at your back (is that enough analogies in one sentence?!).
So another way one could determine if the trend is up is to observe the relative strength (RS) between all the major market indices. In other words, compare the performance of U.S. stocks, International stocks, bonds, commodities, and cash/money market, track it back 12 months, and rank them on a monthly basis (at the end of each month).
Now, I’m writing this article intra-month, so this isn’t normally when I’d observe a ranking system such as this, but as you can see below, the 12-month rate-of-change suggests that currently, bonds hold the highest strength while U.S. Stocks come in at the #2 spot. Aside from observing what holds the most strength, it pays to also observe what investments have the least strength, which today, happens to be short-term T-Bills (or cash/money market).
Does the picture above tell you that we’re in an uptrend or a downtrend? I think it’s pretty obvious… while bonds are the leader, they’ve been weakening as of late, but U.S. and International stocks are #2 and #3, while money market is in dead-last. In this type of situation, I don’t think we want to be sitting on the sidelines in cash now, do we?!
Like the tip of an iceberg, this is just a brief (I know… it probably didn’t seem brief!) scratch of the surface when it comes to all the different strategies that can be used to determine the direction or trend of the market.
In fact, these same strategies mentioned above (and more) can be used to track the trend of individual investments, and the last strategy in particular can be used to rank investments in a market, countries against one another, or individual stocks vs. each other within a strong sector. The possibilities are truly endless!
The details of a strategy that “works” is completely dependent upon your personal timeframe. For me, I utilize an intermediate-term timeframe (so, 6-12 months) and I have four investment models that span from aggressive to conservative. Doing so ensures I cover all risk profiles and retirement planning needs, all while having the ability to participate in sustainable market trends that are going up, all while avoiding life-changing, catastrophic market crashes when (not if) then inevitably arrive.
Granted, none of these strategies will get you out of the market at the top – just like they won’t get you into the market at the bottom. So, if you’re looking for a perfect investment strategy, I wish you the best of luck, because that’s what it would take to achieve success even remotely close to perfection. A lot of good luck!
Till next time…
Categories: Adam Koos, CFP®, CMT®, Market Commentary