The Trend Is Your Friend
Until It Ends
Market timers, swing-traders, momentum players, and long term equity investors, all have a common goal: they expect to gain capital appreciation over time. The principal difference between these classes of investors is the time frame for investment or trade is different.
Realizing a profit through capital appreciation requires price gains which result from participating in an uptrend. This is the case regardless of time frame or investor type, whether the time frame they operate in be measured in minutes, days or years. Understanding the mechanics of a trend, how to detect an emerging trend and most importantly how to determine when a trend has ended, can help any investor class improve their performance.
The following chart is going to serve more than one purpose however first we shall use it to establish a few basic definitions and principles, some of which will already be familiar.
Figure 1: US Transportation Index, Monthly time frame
What is a trend
? Put simply a rising trend is a series of higher highs and higher lows. We can be somewhat more precise and state that a time series chart of an equity (or bond or household prices or any price-based object or commodity) which shows a set of higher *swing* highs and higher *swing* lows is in an uptrend
. Naturally a set of lower swing highs and lower swing lows is a down trend. Importantly we must note that what is trending in one time frame may not be trending, or may be trending in an opposite direction, in smaller or larger time frames.
What we will not look at
. Among the technical analysis community there is a wide variety of techniques used to locate trending markets and entry or exit points within each. We are not going to discuss at any time the many and varied indicators commonly in use - most all of which are re-interpretations of price. An enormous amount of effort is invested in the development of these "tools" in the search for the holy grail--my opinion is that most of this work is wasted effort. The techniques that I use and will share are based on simple price observation and work whether one is charting on the latest computer hardware or doing it by hand as they did back in the days of Dow.
. How to we locate trends already in progress?
Figure 2, constructing a proper trend line
Remembering that an uptrend is a series of higher swing highs and lows, we can mark up our chart to highlight a uptrend
using a simple trend line drawing technique. We draw a line starting at the lowest swing low, passing the line through and beyond the bottom of the highest swing low present in the series prior to the current highest swing high. The one proviso we must follow as a rule is that the line shall not be intersected by any price until after the highest high in the series has been made.
Essentially we are looking to delineate the easy to spot trend, and as the trend progresses, it will become obvious that redrawing the line will become necessary. More on that later.
Detecting the start and end of a trend
. How can we detect when a trend has ended, as opposed to having merely stalled? Conversely, how can we detect when a trend has started?
Eventually price will make a significant move below our evolving trend line. The simple rule to remember is that until a higher high has been set, our line remains rooted at the lowest swing low immediately prior to the highest high on the chart.
Anatomy of a trend change: Step 1, the uppermost trading range
Figure 3 - the development of a trading range
Corrections such as shown in Figure 3 occur frequently over the course of a bull market. How can we identify whether the bull is merely pausing as opposed to reversing? The patient trader or investor will need to wait. Generally a correcting market will attempt some sort of rally and at that moment we can use the points of reference laid out on the chart to mechanically determine if the market is reversing or carrying on following its correction or "pause" phase.
Two more lines are in order.
Figure 4 - identifying the uppermost range
Here we are marking out the current known limits of the uppermost trading range which has developed following the perhaps as yet intact long term uptrend in the Transportation Index.
All we know at this point is that price is moving net sideways - the overall trend - at this point almost five years old - has not yet reversed. Long periods of consolidation are not abnormal but a deep correction such as portrayed is an indication that we really need to be paying attention to the aging bull run.
While price remains in the trading range we can't venture an opinion as to whether it is likely to continue or reverse, but certain milestones will help us make that determination eventually.
Anatomy of a trend change: Step 2, the failed test of top
Figure 5 - a "2B" test of top
Of all the events which we can observe from price in an uptrend, none carries more significance than a retest of a prior trading range high. A failure of price to carry on is a signal which many market participants regardless of their style will take note. Price is something we all understand and such tests are part of the lexicon of investing life whether you look at charts or not. 52 week high lists in the news paper. TV faces inform us that the market is "Trading near the highs of the day".
Figure five shows the current chart of the US Transportation Index. We see that - so far this month - price has made an attempt to break the prior range highs and has immediately reversed. This marginal new high and reversal
is known by some technical analysts as a "2B test of top", classified as such by Victor Sperandeo in his book Methods of a Wall Street Master
. Incidentally he is the first I've ever seen to outline a sane methodology for drawing trendlines and his method is what I have adopted and illustrate in this article.
At some future point I'd like to discuss emotional response to price but a short note on this chart is warranted. When price makes a marginal new high there are a range of emotional responses felt by various market participants. Previous highs are frequently the location of buy and sell stops, for those who want to get long, or want to end a long trade, as well as those who were short but need to bail, or those who want to start a short trade. When price reverses you can be sure that most participants are going to be off-side, and this creates some initial thrust or fuel for the move down.
Such it is and has always been in the market. Ratios and expectations mean something, but do not mean as much as losing or gaining money, and certainly ratios and logic are less important when price is at extremes. Emotional response is at its highest when markets are rocketing or reaching new highs, and at its lowest when hitting new lows with increasing speed.
Is the failed test of top a sign of reversal in the market?
No, and yes. No, the failed test of top does not in fact reverse our long term uptrend, because no series of lower swing highs and lower swing lows is yet in place. Thankfully we have a completely reliable totally mechanical way of identifying trends.
But yes, it is a big red flag, particularly when looking at charts in larger time frames (weekly or monthly charts).
What signals the end of the trend?
Refer back to Figure 4 and consider the following statement:
A trend will have reversed from up to down when the following occur:
1. Price moves below the uppermost trading range lows
2. Price initiates a series of lower swing lows and lower swing highs.
Clearly by the time a new downtrend is in place on the monthly chart, a significant portion of the gains from the prior uptrend will have been lost. Our solution? At key inflection points (tests of tops and especially at the point of departure (not shown yet on any chart) of the range lows, dial down the analysis by at least one if not two time frames to either the weekly or daily charts.
Myself, I use the test of top as a presumptive change of trend in the works, and take a failure of a test of top in larger time frames (weekly or monthly charts) as an instruction to lighten up my long positions or perhaps exit the market entirely or add short exposure. When reviewing markets off the larger time frames there are fewer false alarms and if the market should manage to find its footing, there will be ample time to change stance and rebuild long positions.
Others with very long time horizons might wish to wait for the return to the range lows before taking decisive action. After all, it may be that the market decides to move sideways for many months or perhaps even years, rather than initiate a new downtrend on the monthly chart. While that sounds like a reasonable position to take, bear in mind that a sideways moving market on the monthly chart may have 20 - 30% swings in price movement for many years with no guarantees as to ultimate outcome.
Finally the double top on a monthly chart is not something which comes along very frequently. With regard to the transportation index we've been reviewing, the last such case was the range which was defined first by the sharp price declines in the 1998 financial crisis; the Transportation index rallied to a marginal new high in June 1999; the index fell over subsequent years to a decline of 49.5%.