August 4, 2015
Trades & Tutorials
By Geoff Bysshe
Last week the major U.S. stock indexes pulled back to some important areas that traders will bet on being reversal areas. In the SPY and IWM these levels are the 200-day or 40-week moving average. In the QQQ the 50-day moving average was the focus.
Here’s an easy to way to anticipate when a bounce off these key levels is a good time to buy the dip versus waiting for further declines to play out.
A Time Tested Way To Measure The Health Of A Trend
Many traders look at market breadth numbers to determine how healthy the market is, and whether up trends will continue or declines will reverse.
Market breadth can be measured in a number of different ways, but they all basically look at the number of advancing stocks verses declining stocks. In a healthy uptrend the number of advancing stocks should outnumber those declining.
In healthy uptrends buying dips makes sense, but as trends age and fewer stocks continue to rise, buying dips becomes more risky.
A New Way To Identify A Healthy Trend Worth Buying
Professional traders pay a lot of attention to how market sectors are performing to help assess the health of the markets’ trend, but I’ve never seen anyone make determining the opportunity to buy the dip this straight forward…
Similar to the time tested method of looking at market breadth over time to determine the trend’s health, I look at the number of market sectors that are positive versus negative to determine if a pullback is temporary or the start of a bigger down turn.
When the market corrects to a major, institutionally watched, support level like the 200-day or 40-week moving average. The number of strong market sectors should be sufficient to support the market. If it’s not, then it’s not a good time to buy the dip!
Likewise if the market has been in a down trend and is trying to get back over the 40-week moving average the same analysis applies. Wait until you have enough market sector strength before you anticipate a bull trend to continue.
So how many sectors does it take to support a bull market?
There may be dozens of ways you could define your list of ‘market sectors’ to be considered. I don’t believe that more is necessarily better. The idea is to have good coverage of the different areas of the market that will move in the various stages of the business cycle.
At MarketGauge we have a simple list of 14 ETFs that determine a good universe of market sectors to be considered for this indicator.
And as you’ll see by the charts below, bull markets continue when you have more than 3 of these 14 market sectors that are positive. To be counted as positive the sectors must have a positive percent change over 6 months or 130 weeks.
Chart 1: The green histogram represents the number of ‘positive’ market sectors.
So when markets pull back to the 40-week moving average make sure there are at least 4 positive sectors before you buy the dip. In this case more is better! When markets are trying to get back over this key average after a down trend the same rule applies.
Should The Recent Market Decline Be Bought or Avoided?
Last week the SPY and IWM both traded under their 40-week moving averages. Currently 7 market sectors are positive so it’s still a trend healthy enough to look for the market to bounce.
Chart 2: The current condition of the market sector indicator (as of 7/31/15)
From a trading perspective which must also consider risk management, however, the number of positive sectors is an indicator not the final trading decision.
Trading risk management would suggest that if the market breaks the moving average significantly it should not be assumed that it will recover simply because there are more than 3 positive sectors.
This indicator should be viewed as one that confirms that a market over the 40-week average is one worth buying vs. one that should be avoided. Similarly, if the SPY is breaking the 40-week moving average and there are less than 4 positive market sectors expect further declines.
So with the markets hovering around their key moving averages, now is an important time to watch the performance of the market sectors! It’s simple and as you can see in the charts, very powerful.
You can see the current condition of the 14 ETFs that we use for free at https://www.marketauge.com/sectors/
