It's PAYS to be Trendy

This post has three main parts:

I. Trends and Dow Theory- a primer on a very important subject
II. RSI- a little more on this and how it may be used for success
III. How to 'trade currency' without trading currency.

I. Trends and Dow Theory
Sometimes we all need to take a step back and look at some universal principles. We need to understand what is going on in the markets as a whole to make solid investing decisions on specifics.

In the post: In a picture and a word: why this market is so dangerous (see top posts) I went into detail about the fundamental reason that this market is in big, big trouble for at least the medium term. I provided my own informed thoughts and presented the views of Soros, Buffet, Mozilo, Das, and others. However, if the markets traded solely on fundamentals we all would have been short the market the last few months... and we would have paid for it. At least in the short term.

I have described, from a logical perspective, why the market may have been going up despite the underlying truth that every smart money manager understands (type in time to pretend in the blog search box at he upper left hand corner of the page). Yet there is a at least one piece that is missing here. What is it?

The way things really work is that the markets do not only trade based on fundamentals but also on technical and historical data. This is especially true today because of the prevalence of "programmed trading" and quantitative methods ("qaunt managers") that make trading decisions largely or entirely on technical factors and/or on historical precedence. One of the key components of technicals is trend analysis. It is critical that everyone who trades or invests, especially in a market like this, have at least a basic understanding of what trends are, how to spot them, and often most importantly some ways to identify trend reversals. The goal of this post is not to be the end all and be all of trend and technical analysis but a great place to start in understanding what the heck is going on and how to be successful, hopefully, in the market.

Some definitions: (investopedia.com).
Trend: The general direction of a market or of the price of an asset. Trends can vary in length from short, to intermediate, to long term. An uptrend is defined as one that has higher highs and higher lows. The opposite is true of a downtrend. If you can identify a trend, it can be highly profitable, because you will be able to trade with the trend.

Trend Analysis: An aspect of technical analysis that tries to predict the future movement of a stock based on past data. Trend analysis is based on the idea that what has happened in the past gives traders an idea of what will happen in the future.

There are three main types of trends: short-, intermediate- and long-term

Dow Theory: This is a centerpiece of technical analysis and should at least be familiar to all. Here is a good resource if you do not know about this.

Let's focus on a key concept of Dow Theory: the fact that in any trending market there are three major types of trends

1. Primary (long term) trend- lasts close to a year or longer (sometimes much longer). If up this is a bull market, if down we are in a bear market.

2. Secondary (intermediate) Trend- lasts three weeks to three months on average. It runs counter to the primary trend (hmmm... ring any bells?). Here is a picture of this:

3. Minor (short term) Trend: Lasts less than three weeks. These trends go counter to the secondary trend and hence in the same direction as the the primary trend. In a bear market the primary trend is down, the secondary trends are up, and the minor trends are down.

What this means in the context of the current market:
If we look at the chart of the SP since October we see clear down trend (lower highs and lower lows). Is this the start of a bear market or a secondary correction in the last bull market? Considering the fundamentals of this market, the length of time since the last bear market (according to this post about such markets by the Motley Fool a Bear market occurs, on average in the US, every five years), and the fact that we have not anywhere near run through the stages of a typical business cycle according to Dow theory, as well as other things, leads many to conclude that this chart demonstrates the onset of a bear market. The longer the overall trend continues the greater the confirmation of a long term primary downtrend. Assuming this is a bear market onset, in the middle of March, until the week before Memorial Day, we see an equally clear secondary counter trend (higher highs and higher lows).

Significantly, this was broken last week because for the first time we saw a lower low. This could very well represent the beginning of the second leg of the primary trend. Of course, this needs to be confirmed. Not all trends are upward or downward moving; there are also sideways movements. We may also get bounces off of key support areas like key moving averages. If these are broken the chances that we are in a second leg go up and short instruments may be good. Please note that it is not enough to look at one chart. Confirmation is a must for Dow theory. The more confirmation points the better. On the last post it was shown that not only the SPX but also the QLD and UYG (others too though not shown) have recently broken from the up trend. This is confirmation. While short instruments may need more confirmation (or not... a great time to short would have been off of the 200 SMA but that was then...) at the very least the break of the recent uptrend means that there is a lot of uncertainty on the long side right now which is why for many stocks reducing or eliminating long positions makes a lot of sense right now.

Until proven otherwise we are now back in a downtrend. As I mentioned I exited almost all of my long positions last week (biopharma is the exception) and have been considering short positions since.

One other point: trends occur not only in indexes but also in individual sectors and stocks. As investors we thus greatly empower ourselves by learning the ability to recognize and use trends. For example we can easily look at the longer term chart of POT and an index of food/fertilizer stocks such as MOO and see very clear trends. Identifying a trend is HUGE. Just as important is being able to identify a change in trend. Like every other dimension of the market trends are not infallible and should be used in conjunction with other data before being used for investment decisions. Also, as I mentioned before, not all charts show a trend. There are also ones that move in a range or a channel or a wedge... etc. Often the best investments though are the ones were a clear trend, either up or down, can be found. There is a ton more to learn here (that I need to learn also) but this may be a good starting point...

II. RSI
A discussion of RSI dovetails nicely with discussion of trends because RSI is a great way to identify potential changes in trend for a particular stock. As I mentioned in previous posts RSI is often misunderstood. Just because RSI hits 30 or even 20 does not mean that a stock is technically a good buy nor does an RSI of 70 or above mean the stock is for sure a sell. An RSI above 30 or over 70 often means "hey... watch this stock" It may have a price reversal soon. The RSI movement at these levels can tip a potential price reversal because it is a leading indicator.

There are three main ways to use RSI. Let's look at the oversold situation:
1. Divergence:
A hypothetical stock symbol ZZZ has an RSI of 30 or below. This RSI is starting to flatten out (is going from sharply down to more sideways). At the same time the stock continues to make new lows. This is an indicator that the stock pattern may reverse soon and go back up. This is the best most reliable use of RSI. Use this if you can first and foremost. The downside is that it can sometimes difficult to see if the RSI is really flattening out (need to take a close look at the chart and perhaps expand it or print it).

2. Crossing from under RSI 30 back over or from RSI over 70 back under:
Assume ZZZ has an RSI of 30 or below. The RSI is now moving up and crossed the 30 line. At this point it often means that the enormous selling pressure has dried up in the short term and now there are mostly buyers left. I've found that this works well in conjunction with other indicators. One example: in the charts of DUG last week the RSI turned quite nicely at a price of around 25.7. High volume always helps as one confirmation indicator,. In this case the volume was high. Generally this mehtod is less reliable than #1 (divergence), though easier to spot. Therefore as always use tight stops if for example the ZZZ starts to sharply turn down again. If you can, use #1 first and foremost. And always use in conjunction with other events/indicators. However, from personal experience I find that a turn of the RSI from 30 or below up, or from 70 or above down, tends to be a very powerful starting point for trend reversal analysis. When used in conjunction with a few other technical and/or fundamental indicators this can be a really good way to win, so to speak.

Here is the chart of DUG from last week that shows how the reversal in RSI, which ended up coming on the heels, apparently, of the Fed's comments, was a good indicator for taking a long position in DUG. Notice also that there was healthy volume as a confirming indicator.

Since the RSI is a short-term indicator, and after going above RSI 30 the stock may reverse quickly in some cases, it is important to place trailing stops as the new trend moves in your favor. If the new upward trend continues the profits run. If not the position is stopped out and a gain or at least a break even is obtained.

Just as a note of caution: below shows a chart where RSI rises above 30 and then the stock immediately drops more, sending the RSI back below 30.

In those cases if you would have gone long SIGM in middle March just as the RSI emerged from 30 you would have gone into the red. However, if you played it smart you would have put a tight stop down at a calculated point just below entry so that the losses would be small. This would be more than made up for by other cases where the profits run. If a particular chart causes you to stop out on several occasions (or the chart shows you would have stopped out several times using this method) then using the crossing the 30 or 70 RSI line method may not be good for this company at this time... which means move on... there's thousands of others plays out there.

3. Confirmation of charting patterns.
If other technical and/or fundamental indicators point to a buy or a sell of a stock it always helps to take a look at RSI to confirm the moves. This is the reverse of an attractive RSI, then confirmation.

Here is an excellent link that describes the points mentioned here regarding RSI in more detail.

A great way to use RSI is to form a watch list of stocks that may be ready to reverse pattern. Stock Charts allows you to find such stocks for free and is a great, great resource. Just go to stock scans (on the left menu) then look for stocks with an RSI below 30 that are reversing, or an RSI over 70 reversing etc. MACD crossing patterns, breadth indicators (advancing/declining issues), and many other indicators(stocks forming a triple top, etc.) not discussed here can be found there as well. All of these tools can be used to confirm each other and get a sense of what is going on... take it from the Beastie Boys... Ch-Check it Out!


III. Finally a word on currency. On the post on Food stocks (see recent posts or top posts) I mentioned that ETNs can be used as a way to get into futures contracts indirectly. There is also a way to play the dollar decline/incline against other currencies in the world. Use currency ETFs. Here is a comprehensive list for your viewing pleasure.

One more thing I want to add: Thanks to all the veterans who have sacrificed themselves for this country. Wars, regardless of where they take place and for what reason, are horrible, horrible events. Some are truly necessary and some are not. Regardless, the men and women that soldier(ed) the front lines both now and throughout history have sewn together the fabric upon which everyone else stands. For that we all owe our deepest gratitude.

Best, and thanks especially to those who serve,
Jon

This blog is for informational purposes only. It does not give investment advice.