The Best Indicators to Identify the True Trend in the Stock Market
Stock Market indices are supposed to be used as tools to measure performance of a stock market. Standard and Poor’s 500 is probably the best known and commonly followed stock market index. It tracks the performance of 500 large companies listed on stock exchanges in the United States.
As you can see S&P 500 has been in uptrend since May 2020. Over the period of the last 19 months S&P produced three major pullbacks that found support at the first line of bulls’ defense produced by 21 Exponential Moving average on a weekly basis. On the picture you can see how my proprietary CAT Trade with Trend indicator for TradingView managed to recognize those pullbacks as favorable long setups (note the blue triangle with the word “Buy”).
Looking at that chart you may conclude that we deal with a very weak pullback into the blue support cloud that so far has lasted only two weeks (as of 3 Dec 2021). The S&P 500 index made a top at 4,743 and by the end of the first trading week of December 2021 it dropped to 4,538 losing less than 5%. That decline in S&P index looks like a normal shallow ordinary pullback.
However, that is a misleading picture. The problem is that there is a handful of stocks that used to lead that bull market but dropped hard over the last two weeks:
Stock of DocuSign ($DOCU) lost more than 50% since the beginning of November 2021.
Lending Club ($LC) Topped at 49.21 on Nov 1, 2021 and in the four following weeks its stock lost 40% of the value.
$AFRM used to be another darling of momentum traders. It topped at 176.65 on the first week of November but lost more than 40% of its value in the following three weeks.
$EYSY topped on the third week of November 2021 but then dropped hard and lost 25% of its value:
As you can see in the $ETSY chart a momentum trading strategy I teach in my new video course Trade with the Trend has been working nice for months. You can see numerous buy signals produced by that set of momentum trading rules when that trending stock dropped to the blue and green support clouds.
But momentum strategy works in a reliable way when the market in general is trending up. Jesse Livermore, a legendary trader, used to say:
“Trade only when the market is clearly bullish or bearish”.
In the past that would mean that you would add to your momentum strategy a general filter that would only allow you to take long trades in momentum stocks when all or some of major stock indices like S&P 500, Dow Jones Industrial Average, Nasdaq 100, Nasdaq Composite or Russell 2000 were trending up.
Nowadays those major indices can not serve as efficient market filters. As I showed you above, off the new all time high made in November 2021 S&P index lost 4.5% by the end of the first trading week of December 2021 while many stocks that used to lead the rally lost up to 50% of the value in a matter of three or four weeks.
Probably the main cause of disconnect between the major indices and average performance of hundreds of other stocks is rise of index investing.
As of December 31, 2020, more than $5.4 trillion was invested in assets tied to the performance of S&P index. That means investors tend to pour their money into a handful of stocks comprising S&P 500 index. That actually divided the stock market into two very different sub-markets: one is comprised of stocks that benefit from passive index investing being included into major stock indices, and another one, much more volatile comprised of speculative stocks whose prices are largely driven by risk takers, hedge funds and day traders.
As of December 4, 2021 there were only 10 stocks from S&P 500 index that lost 20% of the value over the preceding four weeks. But outside of that narrow basket of 500 stocks there were 270 more stocks with market capitalization of over $2 bln that lost 20% or more over the same period of time.
That exemplifies that performance of S&P 500 does not reflect performance of a broad stock market.
If you are a day trader or a swing trader who like to trade high beta volatile stocks you have to create a toolbox that will help you to measure the true measure of performance of the broad stock market.
If you are a part time investor you can save thousand of dollars by checking those indicators to know when its time to increase or decrease your market exposure. And you would need only two minutes a day to conduct an unbiased market analysis instead of watching self proclaimed gurus on CNBC.
Below I will share you indicators I personally use to identify the trend direction and prevailing market sentiment.
- Monthly Trend Indicator.
It is calculated as difference between number of stocks making a new one month highs and number of stocks making new one month lows.
As you can see, this indicator has been in bearish mode since November 16. When it flips back to positive readings that will be the time to buy stocks again.
2. Bullish Percent Indices.
The Bullish Percent Index (BPI) is a breadth indicator based on the number of stocks on Point & Figure Buy Signals within an index. It was developed by Abe Cohen in the mid-1950s and further refined by Earl Blumenthal in the mid 70’s and Mike Burke in the early 80’s.
Because a stock is either on a P&F Buy or Sell Signal, there is no ambiguity when it comes to P&F charts. This makes BPI a straightforward indicator with clearly defined signals.
Bullish Percent Index lets you quickly identify up and down swings that last from several days to several weeks. If you are a momentum trader then you should only take long trades when Bullish Percent Index goes up (green candles).
Bullish Percent Index calculated based upon a basket of stocks comprising Nasdaq Composite is much better tool to measure the true market trend because that stock market index includes almost all stocks listed on the Nasdaq stock exchange.
That gauge of the stock market sentiment turned into bearish mode on November 10. If you used that indicator as your market filter you would have avoided many bad trades during the second part of November 2021 and beginning of December 2021.
I explain how to fine tune that indicator and even share live charts of that and others breadth indicators with students of my brand new video course “Trade with the Trend”.
Do not expect those indicators to nail exact tops and bottoms in the market. The main advantage of using those indicators is that they provide you will early but relaible signals on changes in market trends.
Bellow allow me to show that Bullish Percent Indices are much less noisy trend indicators than the indices themselves and this is why they provide much more consistent reading of trend direction. They can help you to avoid trying to catch bottoms too early.
Another advantage of Bullish Percent Index is that you can track performance and market sentiment of a specific market sector:
Compare it to a daily chart of $XLF, Financial Select Sector SPDR Fund:
The price chart of $XLF was much slower in producing a sell signal in November 2021. Moreover, it was much more noisy and produced a failed buy signal on 23 Nov 2021 while the Bullish Percent Index correctly held the sell signal since 4 Nov 2021.
Let me show how Bullish Percent Index of the energy sector would do a great job keeping you on the right side of a trade:
Compare it to a daily chart of $XLE, Energy Select Sector SPDR Fund:
First we can see that price charts are mush more noisy and they can not provide clean buy and sell signals in the way Bullish Percent Index does.
Second, we can see that Bullish Percent Index provided early buy and sell signals at the vert first phase of a market turns. Not only it protects you from losing money in reversal trades but it lets you get on board on a new forming trend swing without missing a significant part of a new move.
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Good luck in your trading!
