How to Define the SP-500 Trend

Define the macro trend and use it to your advantage.

The trend is your friend in the market.

Jason Pearce is a 25-year veteran of the futures industry. He's played the role of retail broker, managing director of a brokerage firm, newsletter writer/editor, trader, trading system/algorithm developer, and market analyst. You can find Jason at www.intermarketconnections.com.

Trend Simplicity

When trading and investing, the first question that one must answer is: What is the trend of the stock market?

If you don’t get this one right, every question and answer that follows is for naught.

William of Ockham, a fourteenth century philosopher, is credited with the principle that the simplest answer is the best one.  A modern version is the KISS principle.  This has nothing to do with the 1970s rock band, although Gene Simmons may own the trademark by now.  The acronym stands for Keep It Simple, Stupid.  Technical traders apply this principle by focusing on one thing only: Price.  It doesn’t get much simpler than that.

Macro View

When determining the trend, one has to decide which timeframe to focus on.  We believe that traders on all timeframes should be aware of the macro trend.  Being positioned in the same direction as the market increases your odds of success so it’s a no-brainer.  Even a contrarian trader should be cognizant of the macro trend to know how strong the tide is that he’s swimming against.

Drumroll, Please

Here’s a simple method to determine the macro trend: Compare the price of the cash S&P 500 to its monthly 10-bar moving average (MA).  An end-of-month close above the monthly 10-bar MA (by at least 15-pts) means the market is in an uptrend; an end-of-month close below the monthly 10-bar MA (by at least 15-pts) means it’s in a downtrend.

  Forget about the impact of China’s economy, quarterly earnings, the Fed’s interest rate policies, and the apocalyptic signs of the Blood Moon.  Price is the sole determinant of whether we say the market’s in an uptrend or a downtrend. 

Use the cash S&P 500 to identify the trend of the market in general.  Even if you’re not invested in the S&P or an index, knowing the overall market trend is still a valuable determinant for whether or not to be invested in individual stocks.  Your stock picks have a better chance of working out if the general market trend is bullish.

How to Use It

Here are three ways that a trader can use this signal:

1. On a month-end close above the monthly 10-bar MA, go long.  Exit on a month-end close below the monthly 10-bar MA. 

2. On a month-end close below the monthly 10-bar MA, go short.  Exit on a month-end close above the monthly 10-bar MA. 

Some say the short side is for traders with a stomach for risk and volatility.  This actually has more to do with leverage and position-sizing than market direction.  However, the short side is in opposition to the index’s nature to trend higher over the long haul.  Still, the signal proved worthwhile when it turned bearish after the major tops in 2000 and 2007.

 

A more conservative approach for using this signal is to go to cash when a downtrend signal materializes.  Better to be out wishing you were in, than to be in wishing you were out!

3. Use the monthly 10-bar MA as a price inflection point for trade setups during countertrend moves.  In an uptrend, a pullback below the monthly 10-bar MA may provide traders with a setup to go long if the market starts to recover.  Place a protective sell stop below the correction low and use a month-end close below the monthly 10-bar MA as the trailing exit.  The inverse applies when shorting the market.

The Current Trend

August ended with a month-end close below the monthly 10-bar MA for the first time since December 2011, indicating that the market switched to a downtrend.  Traders should now be short or in cash.

  Only a month-end close back above the monthly 10-bar MA will give us the ‘all clear’ to buy again. 

Although we’ve been in a bull market for over six years, bearish trend change signals still have merit.  The last bearish trend change signal occurred in August 2011 and the market dropped another 12%.  Prior to that, the bearish trend change signal in May 2010 kept the market hostage in a sideways range for three months.  The bearish trend change signal in December 2007 proved timely as it foreshadowed the financial collapse.

The Next Switcheroo

To reverse the downtrend, the cash S&P needs a month-end close back above the monthly 10-bar MA.  This would be good news!  Switch back to the long side of equities.  It means we survived the blood moons without a Zombie invasion.  Another uptrend signal would be in good company.  The four bullish trend change signals that occurred over the last twelve years were followed by multi-month/year rallies. 

The next few months should be interesting.  If you play your cards right, it may even be profitable.  Be sure to trade with the trend to increase your odds of success.

Photo Credit:    Paper Boat Creative/Digital Vision/ Getty Images