Nervous About Stocks? Wake Up and Smell the Surge

Jan.19.11 | About: SPDR Dow (DIA)

Ask almost any investor these days what they think of the market and they will likely mention something about stocks being overbought or that sentiment is too optimistic or that a correction is likely close at hand. To which I’d like to say, “Wake up and smell the surge!”

But before we go any farther, let me say the current trend in the stock market, while impressive, is indeed extended and could very easily pull back a couple of percent for just about any reason at all. However, it has become clear that the bears are going to need a catalyst in order to convince the current batch of dip-buyers that it is time to take a break.

With the requisite caveat that Ms. Market can and will do whatever she darn well pleases – and whenever she darn well pleases – out of the way, let me say that I’m not referring to the outlook for the next wiggle or giggle in stock prices here (that’s what Technical Talk is for). No, I want to focus on the bigger picture of the market this afternoon.

To be sure, there are any number of successful trading strategies that can be applied to the stock market. And in my experience, there are a great many that can make traders a boatload of money. But the key to the general public making money in this game is simple: Make hay while the sun shines and then move it to the barn when the storm comes.

In English, I’m suggesting that for the average investor the trick to being successful is to get the “big picture” right. Forget about the little blips of 3% - 5% in the market (heck, even the Daily Decision doesn’t usually concern itself with such moves). Instead, stay focused on the major trend. For if you can stay mostly invested when the bulls are running and then avoid being mauled when the bears take over, you will likely be a happy camper in the long run.

I know, I know, this is easier said than done. And this is especially true these days with all the high-frequency trading, the news and quotes on your phone, the flash crashes, and the T.V. commentators screaming at the top of their lungs about, well, just about everything.

However, there ARE a handful of indicators that can help keep you on the right side of the major trend. And one of them is the overall breadth of the market. In short, when we see a surge in the breadth statistics (advances swamping declines and/or up volume trouncing down volume) it usually means that there is more where that came from.

One example of successful breadth indicators would be the relatively well-known “10-to-1 up day” buy signals (and, of course, the “9-to-1 down day” sell signals). For many years, buying when up volume exceeded down volume by a measure of 10-to-1 was a good indication that stocks were likely heading higher over the next 1, 3, and 6 months. According to Ned Davis Research, the S&P 500’s mean gain after up volume exceeded down volume by a measure of at least 10-to-1 over the following three months has been +4.1% since 1950. This compares quite favorably to the average return of +2.0% for all three month periods.

And when a second 10-to-1 signal has been given without an intervening sell signal, the returns are even better. Over the next three months, the S&P averaged gains of +4.5% vs. +2.0% for all three month periods. And over the next six months, the S&P showed cumulative returns of +11.4%, which is more than double the average of +4.1% for all six-month periods.

Unfortunately however, a change in the market’s environment has hurt this reliable indicator. The bottom line is the recent advent of high frequency trading has caused this indicator to lose some of its value. The problem is the frequency of the signals has increased dramatically over the past few years. Consider that from 10/1/80 through 12/31/07 – a period of 28 years – there were a total of just 40 buy signals given by the indicator (an average of 1.4 buy signals per year). But from the end of 2007 through 10/28/2010 (a period of less than three years), there were approximately 42 signals – or an average of nearly 15 per year!

So, does the fact that there are now nearly 10 times as many buy signals as there were just three years ago mean that we should abandon this tried and true concept? Dan Sullivan of The Chartist doesn’t think so.

Mr. Sullivan decided that while a 10-to-1 up day was impressive, he’d like to see the market really show him something before making a long-term commitment. Therefore, after what was likely a fair amount of testing, The Chartist decided that in addition to a 10-to-1 up day, he wanted to see the following day “follow through” with up volume exceeding down volume by at least 4-to-1.

Since 1947, there have been just 40 such buy signals. Three months later, the market was higher 31 out of 40 times, with the DJIA sporting an average gain of +5.8% (which is significantly better than the 1.9% average gain over all three month periods). It is also worth noting that of the nine losing trades, six of them occurred before 1950. As such, three months after the Sullivan buy signal, there have only been three losing trades in more than 60 years.

Six months after a buy signal, the DJIA produced an average gain of nearly +10%, which, again is significantly above the average return of +3.9% for all six month periods. One year after the signal was given; the Dow was higher 35 out of 40 times (with 3 of the bad signals occurring before 1949). And what is perhaps most impressive is the fact that there hasn’t been a losing trade one year after the signal was given since 1957!

The most recent signals have certainly worth paying attention to as well. Grab yourself a chart and check out how these buys would have worked out: 3/18/2009, 7/8/2010, and 9/2/2010. Not bad, eh?

Oh, and by the way, the most recent buy signal was given on December 2, 2010. As such, the odds would appear to be pretty good that stocks will be higher three, six, nine, and twelve months from now. Well, according to the “surge” that is.

Disclosure: No position