The S&P 500 and other indices are turning bull market doubters into bull market buyers as they’ve just climbed back above key technical levels.
The most recent “pullback” — a mere 4% — is all but a memory now.
Just last week, the S&P 500 and Russell 2000 were acting like boxers that were headed down for the count. Both carved through technical support with volume increasing — a classic technical sell. On Monday, though, the market proved that light-volume summer trading can favor the bulls one day then the bears the next.
The market’s volatility has followed a path drawn very clearly by a few key technical trendlines. While the return of volatility has some investors scratching their heads as they try to squeeze profits from the ever-shifting market, those willing to follow a few “rules of engagement” are rewarded for their discipline.
With that in mind, we offer the three rules to trading a technically influenced market:
Rule 1: The Trend is Your Friend
Likely to be the most-repeated phrase when investors talk about technical analysis, the overly simple rule that “the trend is your friend” is also one of the more effective.
Unfortunately, it comes with little description for what “the trend” really is … so we’ll fill you in a little more.
First, the “trend” for 99.9% of the professional traders is the 50-day moving average. This is by far the most-watched trendline out there, which means that Wall Street is more sensitive to how the market (we typically use the S&P 500 as the proxy for “the market”) is trading relative to its 50-day MA.
Click to Enlarge According to our historical testing, since 1990, the S&P 500 Index is twice as likely to move higher on any day that the 50-day MA is trending higher (the “friendly trend”). The reverse is true in that the index goes down twice as often when the 50-day is trending lower.
Buy-and-hold investors can beat most of Wall Street’s pros by buying when the 50-day trendline starts to trend higher and selling when it starts to trend lower.
That’s it! This rule alone would have kept you in the bull market this entire year.
Rule #2: Buy That Dip
The market has now gone more than two years since experiencing a correction of 10% or more. Remember, corrections are healthy for stocks because they shake nervous investors out and provide opportunity to those willing to step in and take advantage of the lower prices.
Click to Enlarge At its current mark, we would expect to see a move to the S&P 500’s 1830-1850 zone to signal that the healthy correction has taken place. If you don’t feel comfortable trying to buy on lows like that, just refer to Rule No. 1 and buy as soon as the 50-day starts trending higher again, it really can be that easy.
Rule #3: Don’t Be Afraid to Stick With the Leaders
Markets are always led higher by a few groups of stocks, and these are the sectors or ETFs that you should expose your portfolio to for two reasons.
First the obvious: They outperform the broader market.
Second: These are the sectors that investors will usually rush to when the “healthy correction” does come, which means these stocks typically work back to their highs and above in short order.
In today’s market, the ETFs that represent the leadership are the Health Care SPDR (XLV), iShares Dow Jones Transportation Average ETF (IYT) and PowerShares QQQ Trust (QQQ) — basically, healthcare, transportation and broader tech. And those are the ETFs we favor right now.
As of this writing, Johnson Research Group did not hold a position in any of the aforementioned securities.