Which Trend Do You Trade?

By Scott Redler  FEB 15, 2012 12:50 PM

Trading with the trend may not be the sexiest or quickest way to make a buck, but over the long term, it's the best way to be a successful trader or investor.


Editor's note: The following analysis was shared last night on Jim Cramer's Mad Money show. You can see the segment from CNBC here.

In today's stock market, there are too many trading/investing cliches thrown around. There are only a few you should pay attention to, in my opinion. The most important one for me is, the trend is your friend.

Human behavior, and market cycles, repeat themselves.  We all exhibit greed, fear, and complacency at different points of market cycles. While there are different styles of technical trading our there today, I have found in my own trading that I am most profitable when a trend is in place.

Trends build your confidence, giving you the belief to buy dips and stick with positions over longer time-frames. They also allow you the opportunity to identify relative strength. Using a tier system for entries and exits you can navigate trends of different slopes, and trends within trends. Trading with the trend may not be the sexiest or quickest way to make a buck, but over the long term I believe it is the best way to be a successful trader or investor.

As a trader or investor, the first -- and perhaps most important -- step is identifying your risk tolerance, investment objectives, and time frame. Are you a long-term investor looking to hold stocks over a long horizon? Are you a trend follower who likes to follow intermediate-term trends? Or are you a risk-averse momentum trader who sleeps better with no risk exposure overnight?

No matter what your time frame is, I believe you need to know basic principles of technical analysis as it pertains to following trends. No trader or investor should enter the market without a risk-management system, and understanding trends is the way to build that system.  Let me explain further using four different charts.

Multiple Trends Built Since March 2009

Three trends have developed since the market bottomed in 2009.  Everyone loves to complain about the market. If you are simply a technical trend follower, there is absolutely nothing to complain about at all.

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The above monthly chart shows the Bullish Outside Reversal from March 2009 that lead to the new macro uptrend. For this trend to continue we need to, at some point this year, take out the 1370 level.

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The second chart, above, shows a more recent trend that we have seen develop in the past few months. The candlestick that ignited the move is the same type of candlestick that ignited the market's macro uptrend in March 2009. Technical analysis can be applied on any time frame, and this is an example. Same pattern, different scope.

After a dramatic reversal bar like we saw on October 4 (and like we saw in March 2009) -- these are examples of areas where a pure technician would start to build a long position. An investor-type market participant with a longer timeframe would use something like a monthly chart to identify these technical signs, but he would still have to have knowledge of technical analysis in order to time such a trade.

It is true that hindsight is 20/20, but when explosive reversals like this occur you can start to put on longs with defined risk parameters. A couple days after the October 4 reversal in an appearance with Marge Brennan on Bloomberg, I put the odds at 75% that the market's low for the year, and foreseeable future, had been put in. It put an end to the wild downside the market experienced last Fall, and led to another uptrend that has been great to ride for the intermediate-term swing trader or investor.

Recently, the bulls have been a bit spoiled by the slope and resilience of the uptrend. Typically strong stocks follow their 10- to 20-day moving averages. It is fairly rare to see an index follow such short-term moving averages, but that is what we have seen lately. In fact, since the December 20 Gap and Go that created the "Accelerated Uptrend," we have not closed below the 10- or 20-day moving average in 30+ sessions. Momentum traders will follow this for speed and composure. If and when we do close below these moving averages we could see a healthy pull-in to buy.

We have not even had a healthy 2-4% pull-in since that uptrend began. Dips have been so shallow that it has been tough to buy back aggressively if you are a shorter-term technical swing trader, but if you are looking to swing multiple positions there has been no reason to jump out of positions, either. I have, on a few occasions, taken profits too aggressively and tried to add to shorts, but each of those times I got shaken out and got back to my multi-long position approach.

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On the above chart, I outline the three areas to look for support to buy the dip in the market as it currently stands. The 21 day is 1326, a spot for aggressive momentum buyers to buy the dip (this would be a pretty shallow dip).

1280-1290 is the 50-day moving average, which would be a very healthy area to buy the dip as well (this is a high percentage area to hold as we move forward, and a compelling spot to add to longs).

The line in the sand is the prior break out which stands around 1245-1255 for macro investors to buy. This is where long-term money should protect the uptrend.

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The last chart zooms all the way out to show the 12- to 14-year sideways trend that looks ready to be taken out. There are two major hurdles that, if overcome, would add a lot of technical fuel to the fire.

1. We must break above 1370 and close above! This will Create a higher high to continue this macro uptrend.

2. Then the next major obstacle is 1570-1580, which, if breached, would take out the major double top that has controlled this index for over a decade.

On a fundamental note, the S&P's P/E ratio is trading a discount to the five decade average of 16.43. If the P/E for the S&P reverted to the mean, with earnings projected of $104.50, that puts the S&P at 1700ish.

Stocks have been unloved for a long a time based on what has taken place to shake investor confidence. The tech bubble, the financial crisis of 2007-2008, the flash crash, and most recently the steep drop that followed the S&P cuts of US sovereign debt ratings.   

I truly think that the next decade will be much better than the previous for equities.

That doesn't mean you just throw money at the market and hope I am right; you must have a technical plan that hopefully allows you to enter at the best prices with risk management parameters in place. 

Follow this macro trend as long as it stays intact, and keep rotating money/adjusting asset allocation to best-acting sectors and stocks when they correct into moving averages. Never chase excitement and exuberance. Buy dips, look for breakouts that hold, and stay the course.

The target I spoke about in December for the first quarter of 2012 has been met and exceeded 1320-1340. My 2012 target is 1420-1440. My target by 2015 is 1700+, but it still should be an interesting ride to get there.

No positions in stocks mentioned.

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