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The Mega-Trend is Your Friend


A simple tool for technical analysis.

As the equity markets set up for what I believe will be a short-term non-confirmation (see Making Divergences Work For You), it's advisable not to lose sight of the fact that the longer-term technical picture is decidedly less positive. To help understand how to view the longer-term market picture, a technical analysis tool that I have found to be most helpful is the Mega-Trend.

The Mega-Trend (as I define it) is a multi-year stock price trend analysis where price and two moving averages (50 day and 200 day) are measured. In well-established Mega-Trends, three conditions exist:

1) Price is above (or below) its moving averages.
2) The shorter term (50 day) Moving Average is above (or below) the longer term 200 day.
3) Both moving averages are pointing in the same direction, either up or down.

Using the S&P 500 (SPX) as an example, for most of the past 5 years price has been above both of its moving averages and the 50 day was above the 200 day and both moving averages have been headed in the same direction (which is this case is up).

Then, around the end of last year, the circumstances changed and a Mega-Trend reversal occurred. Price went below its moving averages, the 50 day crossed the 200 day and both moving averages turned down.

The same analysis applies to individual sectors. The second chart on Energy (XLE) shows the same Mega-Trend pattern, only the crossover takes place around mid 2008.

What is important to remember is that all three conditions must exist for the tool to work effectively. A closer examination will reveal frequent crossovers by price, to its moving averages: As an example, investors often hear comments regarding price in relation to its 200 day moving average. In my experience, I have found no consistent predictive value in this frequently occurring fact.

But such events have no longer-term significance and little predictive value.

Another point to keep in mind is that this tool is less effective when applied to individual stocks. Perhaps it's due to the fact that they are subject to more frequent violent moves whereas whole markets and sectors and styles are less so.

Investment Strategy Implications

The Mega-Trend tool is a simple, elegant, yet highly effective tool for investors (and traders) as it keeps the longer-term picture firmly into view and helps place in context the shorter term wiggles and squiggles.

That said, the expected rally that my shorter-term technical tools (momentum, MACD, and Slow Stochastics – all part of the Divergences group) are forecasting will take place within an overall bear market trend.

Only when the Mega-Trend reverses itself will rallies and corrections be treated differently.

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No positions in stocks mentioned.
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