Trend Analysis

How many times have you heard the phrase “ the trend is your friend ”? Ad nausea I'm sure. However, even a saying as hokey as this must have merit if so many established technicians regurgitate it in their seminars. The problem lies in that it's not always easy to identify the trend of a sector or market. However, simple trend analysis can be a very effective tool at recognizing sectors rolling in and out of favor. Short-, intermediate-, long-term and secular trends are the time frames that we see each day in our study of technical analysis. The time frame you utilize in your trading will be directly determined by your individual discipline (i.e. swing trading, position trading, etc…). Finally, if you believe that the psychology of the markets actually moves the indexes, we can agree that psychology develops and ends the trends we observe.

Learning how to identify the trend should be the first order of business for any investor. It stands to reason that, if you're invested in a stock whose group trend is against you, you're chances of success decrease dramatically. Did you know that as much as 65% of a reason a stock goes up is because of the group it's in? That's a staggering number which proves the point that top-down research on the group or market you're considering is the absolute first step. Abraham Lincoln once said, "Give me six hours to chop down a tree and I will spend the first four sharpening the axe." The same preparation should be applied to trend analysis by investors. We all want to buy stocks that go in our favor. However, you have to lay the groundwork, via trend analysis, to be successful.

To begin, a secular trend is defined as one that can last for one to three decades, holds within its parameters many long-term trends, and, for the most part, is easy to recognize because of the time frame. The price-action chart, for a period of twenty five years or so would appear to be nothing more than a number of straight lines moving gradually up or down when discerning the secular trend. Have a look for a moment at the chart of the S & P 500 below. I've taken the chart back to the mid-80's to show you the rise of the market leading up to the turn of the century. Many technicians believe we were in a secular bull market from 1982 to 2000. It's hard to argue that we weren't looking at the chart below. Keep in mind that a secular trend will encompass numerous long-term trends and an exponential number of intermediate- and short-term trends. I'm sure you all remember the “Crash of '87”. Well, in the context of this secular bull market, that long-term bear market was simply a blip.

 

Bull and bear markets are also known as primary markets trends or long-term trends , and history has shown us that the length of these markets generally last from one to three years in duration. If we consider recent history, the current markets have given the signs of making the turn from a three-year bear market to the makings of an early bull market. Keep in mind that, even if you were only able to trade the longer-term trends in the markets as they appear below (blue lines being bull markets and red being bear markets), you could be a VERY successful investor.

 

Within all primary trends are intermediate-term trends or movements. These are the trends you consistently hear about on CNBC and the ones which keep the journalists and market analysts constantly searching. Sudden rallies and directional turnarounds make up the intermediate trends and, for the most part, are the results of some kind of economic or political action and its subsequent reaction. In duration terms, these movements typically last three months to a year. Take a look at the chart below for the Semiconductor HOLDRS (SMH). This is a closed-end fund that invests strictly in stocks within the semiconductor sector such as Intel and Applied Materials. What you're seeing in this chart is that the SMH is in a long-term positive trend (blue line) but it's being interrupted by an intermediate-term correction or down trend (red line). As a trader, you may look at this intermediate-term corrective phase as a buying opportunity if you felt the longer-term trend was still in tact.

Last, let's take a quick look at a short-term trend . As you can imagine, short-term trends are brief in nature and can be found imbedded in intermediate-term movements. That said, short-term trends don't lack significance because of their brief existence. In fact, many long-term market changes can be traced first back to significant breaks within the short-term action. Short-term trends are mostly used by day and swing traders. However, long-term traders should also pay heed. Take a look at the chart below for an example of what a short-term trend looks like. It's a chart for the Internet HOLDRS (HHH). As you can see, the group was in a long- and intermediate-term trend. But, along the way, the group went through short-term corrections along the way (red lines).

Now that we've determined what trends to look for and how they should be viewed in different trading styles, let's take a look at the best tool for uncovering the trend: trend lines. An evaluation of any chart will quickly reveal that prices usually move in trends. Often, a series of ascending bottoms in a rising market can be joined together by a straight line, and so can the tops off a descending series of rally peaks. These lines, known as trend lines, are a simple but very useful way to discover sector/market rotations. In fact, trend lines are the foundation to our investment approach. A proper trend line has to connect two or more peaks or troughs. Frequently, we see people constructing lines that only touch one point. This is a fundamentally important flaw because whenever you draw or interpret a trend line, you can't forget that a true trend line is a graphic way of representing the underlying trend. Consequently, if it only touches one point, it is not a true trend line. Let's go back and take a look at the chart for the Semiconductor HOLDRS (SMH). This is an important chart as it shows two very clean trends (long-term bull and intermediate-term bear) that are well defined by their trend lines. The first line (bull line in blue) was set up four different times. Thus, when the SMH finally broke this trend line to the downside, we knew it was an important leadership change in the markets from the March, 2003 lows. Up to this break, Semiconductor stocks had not only led technology stocks but also the overall market. This was a clear sector rotation out of the Semiconductor issues and it proved to be the precursor to a rotation out of technology as a whole. The breaking of this long-term bull trend line told us, at a minimum, the short- to intermediate-term trend had changed to the downside.

Next, take a look at the intermediate-term bear trend that ensued on the SMH. This trend line was also very “clean” and was defined by three different points. As traders, you can easily see the two trends we've discussed and both proved to be significant changes.

As traders, it's imperative that we always have an opinion of the macro market or sector trend. It's not to say you're always going to be correct. However, if you attempt to fight the trend by picking individual stocks before laying the groundwork of trend analysis, you'll continually find yourself on the short end of the stick. This isn't to say that identifying the trend is always easy. But, after years of research, I can honestly tell you that the great investors of our time (whether technical or fundamental investors) all had one thing in common; they were masters at identifying the trend. The system we've laid out for you is not fool proof. However, it gives you a foundation for identifying trends. Remember, in trading, it's not about who you are but “where you are”.

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