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Technical Tuesday - Special Edition

By Chris Rowe October 18, 2011 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

This article is mostly educational, but it leads up to a point about what the CURRENT market is telling us it wants to do.

To gain a true understanding of what the current market is telling us, it will definitely pay to run through the educational part of this article...

Studies show that trading off of the faster "signals" can generate higher absolute returns, as they get you in or out of a trend early on.  But the indicators that give the faster or earlier signals tend to give "false signals" more frequently. 

Most traders and investors absolutely love a trending market, whether on an intermediate-term basis (weeks to months) or a long-term basis (months to years).  But lately they've been starving for a solid trend that hasn't been served.

When you're confused about which way the market is headed, you're often best served to just sit on the sidelines until you gain some clarity. 

In the mean time, you absolutely MUST identify what kind of trader or investor you are, and respect the signals you see when those signals speak to your personal parameters in terms of trading time frame.

I'll explain by giving you a small taste of what subscribers are learning in my "Technical Analysis Millionaire" live online course…

The course benefits traders and investors that trade ANY time frame. 

But personally, I prefer to trade the intermediate-term trend, which means I also have to focus on the next larger trend -- the long-term trend. 

I use several tools for my decision making process but, as you may know, I use the NYSE BPI and the 20 & 40-week moving averages for clarity on the intermediate and long-term trend, respectively. 

First I'll show you how easily anyone can beat the long-term performance of the S&P 500 just by using the 20-week moving average (blue) & 40-week moving average (brown).

I had to break down the time frame from 1992 - 2011 into two charts for clarity. 

But in the two charts below, you can see how effective and simple of a long-term strategy it has been to just have bullish positions when the 20-week moving average is above the 40-week moving average, and to be bearish when the 20-week moving average is below the 40-week moving average. 

To make it easy to see, I highlighted in green times when the first was true and in red when the latter was true.  (As always, just click on the images to make it a little easier to see the detail.)

S&P 500 1992 - Late 2001

S&P 500 Late 2001 - Today

Note, above, how the market advanced strongly off the 2003 and 2009 lows before the 20/40wk MAs gave the buy signal, and how the market lost quite a bit before the 20/40wk MAs gave the sell signal.

So you can see that you never get in at the absolute bottom and never get out at the absolute top.  But you sure do save a lot of money on Aspirin over the years.  Don't forget: if you have bearish positions on when the charts are red, you're making a lot of money as the market declines.

The strategy certainly does tend to pay off, even if we don't eat all the meat on the bone.  In fact, there was only one real misstep in this long-term strategy, and that happened in 1994 for a very short period of time.

No big deal.

S&P 500 April 1993 - August 1995

Here's a close up of the 20 & 40-wk MA situation today...
When the 20-wk is below the 40-wk, what typically happens is the market advances back up to those key moving averages and then breaks new lows, then advances back up to the key moving averages (which are then lower) and then breaks new lows.  The process repeats itself until the market bottoms out... typically. 

The 20-week MA is below the 40-week MA, which is a long-term SELL signal.  BUT, the market is in an intermediate-term up trend within that long-term down trend.

It looks like we are back up to the key moving averages -- and so, what should we expect next?  (Just want to see if you're following along.)

Within those very long-term up trends and down trends, there are huge profit opportunities in the staircase patterns.
I like to profit from those intermediate-term ups and downs within the long term trend, but the other reason to track those changes closely is to get into the long-term directional changes much earlier in the game.

I see those signals MUCH earlier with the NYSE BPI.  But I use the two indicators in conjunction with one another for maximum results.

Let's look at the NYSE BPI...

Maybe you understand Point and Figure charting (tic-tac-toe looking charts), or the NYSE BPI, and maybe you don't.  But I'll make the chart below a bit more clear without having to teach the lesson in this article.

First, understand that the NYSE BPI gives intermediate-term indications and long-term indications.

The column changes are intermediate-term, and the signals are long-term in nature.  Since longer-term trends tend to dominate those that are shorter-term in nature, we would be more biased toward the longer-term signals.

(If the intermediate-term signal says "buy" while the longer-term signal says "sell", we give that intermediate-term "buy signal" less respect.)

BPI Columns

When the most recent column (far right) is in Xs, the intermediate-term trend is showing DEMAND in control (which is usually a set up for higher prices), and the opposite is true for O columns.  When the supply/demand relationship changes (from Xs to Os) a new column is added. 

First, I want to highlight the 20/40-week signal long-term strategy within the BPI chart below.

So what I did below is I shaded, in red, times when the S&P 500 chart (that we just discussed, above) had the 20-wk MA BELOW the 40-wk MA.  That's when the S&P 500 was on that long-term "20/40 SELL" Signal.

When the 20-wk MA was above the 40-wk MA, it's either shaded in green or yellow.  There is a green box around those time frames. 

So you can see the comparison between the S&P 500 charts above and the BPI chart below.  But there is more to discuss.  Why did I highlight parts in yellow?  Ah-HA!

That's to show the "earlier" signals that we get from the BPI.  (If you're not getting this, it's okay, read on and it becomes more clear.)

On the left, you can see the green shaded area where the 20/40-wk MA was on the long-term buy signal, but you can see the "OVERBOUGHT BPI sell signal" happened in the first few days of July.  That was the true top for most stocks, although some larger names pushed the averages higher in October.

It wasn't until January 2008 when the 20-wk MA crossed below the 40-wk MA, generating that long-term sell signal.  So if you used the NYSE BPI, you were bearish for 6 months before the long-term 20/40 technique investor was. 

It worked out well this time, but keep in mind the indicators that are shorter-term in nature are more prone to false signals.  They therefore have caveats that any trader using them must know about.

You can see from January 08 to August 09 the 20-wk was below the 40-wk.  But you can also see that there were three BPI oversold buy signals.  The caveats are two fold:

1.  The 20/40 week long-term signal shows we are in the declining stage of the stock market cycle.  Therefore we know the buy signals seen in ANY indicator are less reliable, while the sell signals are much more reliable.  So we might play the buy signals, but we have much less risk on the table at that point and we are quicker to exit any bullish positions.  That's why it pays to understand when you are in the early stages of a new bear or bull market (covered in TAM).

The truth is, the "buy signals" that are found in a down trend are best used as a signal to EXIT BEARISH positions, as opposed to ENTERING BULLISH positions.  We are bearish biased when the next bigger trend (in this case, long-term trend) is DOWN.  That's what we are seeing today.

2.  When a trend is a newer trend, as opposed to a more mature trend, the opposite signals are less reliable.  For example, buy signals in the early part of a NEW long-term decline can almost be completely ignored.  The next buy signals are suspect.  The later ones (after the bear has run its course) get much more respect. 

The first sell signals off of a bear market bottom are to be ignored, etc...

Therefore, the "buy signals" in the fist part of that red January 08 - August 09 time frame just told us to get out of bearish positions for the time being, and re-enter them at more attractive prices.

Finally, below is a chart of the S&P 500 that starts with the end of 2006.  In green or yellow is when the 20-wk MA was above the 40-wk MA.  In darker red or lighter red is when the 20-wk was below the 40-wk. 

In yellow is times when the 20/40 signal was a long-term buy, but the NYSE BPI had moved to an "overbought sell signal".  The NYSE overbought sell signal is one of the most important and powerful bearish signals.

The lighter shaded red area is when the 20/40 was still on a long-term sell signal, but the NYSE BPI had put in an extremely oversold buy signal and did so when the bear market was quite mature.  

S&P 500 Q4, 2006 - today

The longer-term trends are almost always more reliable than the shorter-term trends.  This is not to be confused with "short-term" trends.  The NYSE BPI is intermediate/long-term in nature.  

So What Does The TAM Approach Say Now?

The TAM approach goes deeper than this for those subscribers who want to take it there.  Others just use the approach for long-term, comfortable investing that's more passive than the more "involved" trader, without being ignorant to major trend changes. 

Considering some of the action in the other indicators I have in the "Tools" section of the TAM website, we are seeing shorter-term strength in the general stock market, even though we are in the long-term declining stage.  

We have to consider the fact that this is very early on in the declining stage.  It's not a "mature" bear market.  So even though we are seeing strength that we would see if the S&P 500 were going to push ahead to the next resistance level of 1,255, we have to respect the time tested rules that have made us wealthier.

Scroll back up to the first two charts and think about the following:  It is possible that the 20/40-wk MA signal is doing something that we saw happen in 1994, where the 20/40wk MA signal went long-term bearish but the market charged ahead.  We are seeing HUGE strength in the short-term, which is what is seen as markets reverse back up with the long-term trend following suit.  

The 20/40-week MA strategy could possibly have given us what some may refer to as a "false signal", sure.  But we must also consider the fact that something like that happens about once in a decade or two, and the rest of the time the long-term signal keeps us on the right side of the trade. 

The conclusion is that it makes sense to view the intermediate-term bullish advances as opportunities to get into our bearish positions again (but only when we get the next bearish signals from our internal indicators).  This market DOES look strong to the upside right now, and of course it can be a bit of a grind to sit and watch that happen.

Based on the last 20 years that we just studied using the 20 & 40-wk moving average signals, we have to feel comfortable with the possibility that this may be that very rare occasion where our long-term stance is bearish while the market is forming a long-term bottom.

We can jump right back into the bullish side of the long-term if the market tells us to.  In the meantime, we'll keep on studying and licking our chops and waiting for the next bearish signal.  

After all, that's the strategy that has made many, MANY people very wealthy over time.