Trading with the stock market trend is the best way to generate profits and beat the market. At least 60% of the gain or loss in a stock price is due to the stock market trend. If only we could determine which way the market is trending. Fortunately, the stock market does move in cycles, short term (also called cyclical), and long term (also called secular). Secular markets typically can last between 10 to 20 years, while cyclical markets usually last between 2 – 3 years on average. Think of a secular market as the primary long term trend, while a cyclical market is simply a shorter term cycle within the primary long term secular market.
This is the second part of a five part series on how to beat the stock market the Trading Online Markets way.
Stock Market Trends
Since 1900 we have had 27 bull markets with corresponding bear markets to make things interesting.
As investors and traders, we need to understand where we are within these stock market trends, so we can be on the right side of the cycle to enhance our success. For example, the market was in a secular bull market from 1982 – 2000, experiencing a strong primary uptrend where the S&P 500 increased over 15 fold from about 100 to 1553. Of course, there were short term bear markets such as in 1987, however the easy money was made on the long side as the primary trend was up.
However, here’s where the danger lies: The majority of investors today have only experienced a secular bull market, such as the one from 1982 – 2000. Most people have not experienced a long term secular bear market where the primary trend is mostly sideways to slightly down. The last secular bear market lasted 16 years from 1966 to 1982. Just to give you some perspective, the Dow Jones hit a high near 1000 in 1966, and hit a low in the 800s during 1982. In other words, the Dow essentially was flat for 16 years. During this time, the ‘easy money’ was not made on the long or short side, but by being being a good stock picker: identifying undervalued opportunities, special situation stocks, and sectors that are temporarily strong. Understanding whether we are in a cyclical bull or bear market greatly enhances our chances for success.
The problem is that the secular bull market that began in 1982 ended in 2000. While the stock brokers’ advice to hold for the long term was good advice for a secular bull market, it is the wrong strategy for a new secular bear market. As history shows, this new secular bear market will probably last at least until 2010 or longer. The market rally from early 2003 until now is simply a cyclical bull market within the new long term secular bear market.
Here is an example of why it is important to follow the trend and not just buy and hold. On January 2, 1998 let us say that an investor had purchased shares of companies in the S&P 500. On that day the S&P 500 closed at 975.00. On January 2, 2009 the S&P 500 closed at 931.80. During that time the S&P 500 rose to a high of 1,552.87 on March 24, 2000, fell to a low of 768.63 on October 10, 2002 and back to a high of 1,576.09 on October 11, 2007. No one can claim to identify the exact highs and lows of the market. However, if one could capture 70% of the move up and down, they would significantly out perform most every investor.
To learn more about market cycles please see my Market Cycles page that describes the major cycles the market has experienced over the last 100 years. I also encourage you to read two excellent books on this subject. They are Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis and Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling.
Trend Following Indicators
There are a number of trend following indicators that have proven useful to investors. The ones listed here are examples of what has worked in the past. I find it best to start with the big picture and then work down to the daily view of the market.
To help understand the current big picture of the market let’s look at the monthly chart of the S&P 500. What you see below is how the S&P 500 performed starting in 1991 through June 2006. Keep in mind that the secular bull market we were in since 1982 ended in 2000. Since that time we have been in a secular bear market that typically has several shorter term cyclical bull and bear markets lasting 2-3 years on average.
The two blue vertical lines identify the cyclical bear market. Notice the 20 month Moving Average (MA) that appears to act as support during bull markets and resistance during bear markets. Also notice that at the end of June 2006, the S&P 500 was very close to falling through the 20 month MA at 1227. Keep in mind that the S&P 500 can move below 20 MA temporarily and then move back above it and the current cyclical bull market remains intact as occurred in September and October 1998.
Also, notice that the 13 month Relative Strength Index (RSI) acts as another good indicator of cyclical bull and bear markets. When the RSI is above 50, we are in a cyclical bull market and when it is below 50 we are in a cyclical bear market. As of the end of June 2006, the RSI remains above 50 indicating that we have not yet entered a cyclical bear market. The RSI is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. By the way, it is important to have confirmation of several indicators before drawing any conclusions.
The next step in evaluating trends is to drill down and look at the weekly chart of the market. Let’s continue with the S&P 500 as shown below. The vertical blue lines represent the same period as depicted above in the monthly chart. In this chart notice how the 65 week Exponential Moving Average acts as support during cyclical bull markets and as resistance during cyclical bear markets. The 23 week RSI also acts as a good indicator of when we are in a cyclical bull market or cyclical bear market. Again, it is good to have confirmation of several indicators before drawing any conclusions. The green arrows are areas where support was tested and held. These represent good buying points for the market as a whole. The red arrows represent areas where resistance was tested and held. These represent good shorting or selling if one bought on a dip for the market as a whole.
Drilling down further we should look at the daily chart of the market. As you might expect there are trends that usually can be identified at each level of our drill down. Continuing with a one year chart of the S&P 500 below notice the nice up channel that began in late 2005. This channel was broken to the downside in May 2006, signaling and end to the six month bull market. However, the S&P 500 did not decisively break through the longer term support level at 1227 as mentioned above. While not in a bear market, the chart seems to be indicating an area of indecision until a more verifiable trend can be determined. This is normally the hardest time to generate profits from investing. Just keep in mind that the intermediate term cyclical bull market is still intact on this chart.
This analysis of trends establishes whether you should be long or short in the market. Each investor should set their own rules of when to be long and when to be short. For me, I will normally will only be long in a secular bull market, since cyclical bear markets within these longer term bull markets are rare and difficult to trade well. Beside any pullbacks within a secular bull market are buying opportunities. However, in secular bear markets, I will be long during cyclical bull markets and short during cyclical bear markets.
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Within the Trading Online Markets web site, I prepare monthly market trend analysis that is available to everyone. For our Premium Members I include a trend analysis in the weekly Market Commentary that provides a comprehensive analysis of the economy, the key market trends, an analysis of important sectors and a review of current stock and Exchange Traded Fund (ETF) positions for the Premium Portfolios.
Once you have decided what trend to follow, you should start the stock selection process. Next, comes the search for the best companies that meet our fundamental criteria. Please read Part 3 of Beat the Market, Stock Selection.