Trend Architect Blog

Trend Following Journeys

The Edge of Trend Following and Why Day Traders Lose

An ubiquitous urge, particularly among beginners, is to predict how markets are going to evolve in a given course of time. Having predictions subconsciously leads to trading them instead of actual market conditions. They become so inextricably enmeshed with a trader’s bias that objective judgments are not possible anymore.

Trading with the trend is easily the simplest and arguably the best trading metastrategy, but is not an actual strategy. The reason why so many traders have difficulty implementing it is a lack of details. It is a challenge: coming up with a detailed plan for trading with the trend that is consistently profitable. While the market wiggles and the inexperienced trader takes one loss after another, an experienced trend follower has been staying in his position during the whole time. No action was taken at all, but yet the trend follower ends up with a more advantageous position than the one who is trying to be assertive. Why is that so?

The trend follower listened to the market and is convinced of his edge and aware of his risk. He is also aware of the typical patterns that make up a trend. To avoid closing positions fearfully, you have to know why you are opening one in the first place. What is your rationale for going long or short? Every single trade of yours must be planned out with great care. It also includes having proper risk management in place, for example, with a stop-loss order.

The majority of traders who begin trading, choose to scalp out of fear and are so focused on the tiny wiggles that everything looks like an opportunity. We witness this behavior in various trading forums and online chats. What’s happening is subjective trading out of gut feel and fooling oneself with regards to progress made. This getting in-and-out every minute never seemed to me a paradigm for success in the long run. The market is a master in tricking the average person.

Since one cannot predict markets – or turnarounds for that matter – another plausible explanation for hyperactivity (besides prediction) is that a trader tries to catch up with the market. He missed out on the easy move down and is now at a disadvantage. Consequently, the only solution that he can think of is to buy into every spike, hoping to participate in a big rally. While the anticipated move fails to materialize, he is taking one pounding after another.

This show turns into real comedy when the market actually turns around. Now the trader is feeling left out all over again. He subconsciously reverses his habit, and keeps shorting on the way higher. He is playing cat and mouse with the market all day long, only to lick his wounds in the end.

What is a Trend?

We need to acknowledge that markets do not move like elevators, but like waves within a current. Uptrends are always interrupted by frequent reactions, whereas downtrends will witness just as many rallies. What we focus on, is the overall current in the shape of trends because this tells us the path of least resistance.

According to the Dow Theory, an uptrend is defined by a sequence of higher highs and higher lows. A downtrend is a sequence of lower lows and lower highs. Look at the SPY in the 1H time frame, for example, and you will surely get a clear picture of trends that you can take advantage of.

If a market is still showing a series of lower lows and lower highs, one simply does not go long in this environment. Buying is a much more challenging proposition because a long position will most likely fail sooner or later. This is due to the strong underlying market forces that are able to break support areas sooner or later.

At some point you may be lucky enough to have caught the bottom, but is it worth it? Let’s be realistic. Even if you did catch the perfect bottom, you have most likely exited prematurely out of fear of another sell-off anyway. So much energy is expended on catching turnarounds, resulting in so little proceeds while you could have it much easier.

Trends take time to shift from bearish to bullish. You will notice a shift soon enough once sellers stop selling where they are supposed to and buyers are cracking a significant resistance area. This all becomes visible in the aforementioned time frames.

Alternatively, regard price action from a psychological standpoint: Imagine yourself in the position of the buyer, then in the position of a seller. What would you be thinking in each case? Would you be contented with what’s happening in the market? What would you like to see to stick with your bias? It is a power game. This thought process is very powerful because it gives you a more objective view on the market and makes you reflect on the price action.

Listen to the Market

Beginners focus too much on the random moves intraday, than the actual trend in the broader perspective. Trade those, and you will witness far greater success. It is evident that a trader gets confused every single trading day anew.

Randomness has no logic, so do not seek logic in randomness. Random profits also create the illusion of progress in your trading. You get random rewards playing craps, too. But that does not mean that you know what the dice are going to do at the next roll.

To escape randomness, you must feel comfortable with holding your position over night, even several nights. It is a common misconception communicated among beginners that you need to close your trade within the same day. Anything can happen, they typically say. Trends last more than a single day. They last multiple days, sometimes months. Why? Because public sentiment does not shift from one moment to the next but takes a long time.

To trade such multi-day trends, you will need to figure out which support and resistance area is of real importance, and observe the price closely at those areas. They will stand out visibly as a trend unfolds and your eye will be trained to spot them by the time. A break of such zone is a potential entry for a new trade. By trading longer term time frames, you will not trade randomness, but trends that sustain themselves over multiple days. A welcome side-effect is that your broker commissions sink drastically.

Only take action if you observe clear evidence for a reversal. Otherwise you are better off doing nothing and letting the stop-loss order work for you. A stopout should happen where the original reason for your entry is no longer given due to objective observation of price action – not your gut feel.

Why the S&P 500 is Heading to 10,000

The S&P 500 is on its best way to reaching its next target, 10,000. Before we get too excited about this ambitious milestone, let me clarify one small fact: This target is only due in 18 years time.

Historical Evidence

If geometric averages of historical stock market returns are any indicator, you will be surprised to find out that equities appreciate by 9.5% per year on average. After witnessing two of the most devastating stock market crises in recent years, this sounds like a far-fetched theory. Allow me to put these events into perspective, though.

Both the Dow Jones Industrial Average and the S&P 500 have evolved in a predictable super-cycle: While the overall direction of the super-cycle has been upward, it was regularly interrupted by phases of tumultuous standstill and uncertainty. Take the mid-1960’s until end of the 1970’s for example. Some of you may still remember the energy crisis, the Great Stagflation, and high interest rates. It was a phase of roughly 15 years in which we were seemingly unable to do any progress. Where was the S&P 500 at that time? It stood at a shy 100.

Despite these difficulties, markets had found their way back to growth and innovation: Computer technologies emerged and soon after the world-wide web. Today, we are emerging out of two shocking financial crises yet again. After the dot-com bubble burst and the Great Recession made us hold our breath, the market is finally ripe for its next wave of innovators. The super-cycle is rolling again.

Relentless Progress

My view is that we have a number of waves of change getting ready to erupt on the world stage. A whole new industry is getting ready to be born and, with it, new jobs and investment opportunities. Are we running out of oil? My bet is that in less than 20 years we won’t care. We will be driving electric cars that are far superior to what we have today in every way, from power sources that are not oil-based.

Artificial intelligence? Virtual reality? There are whole new industries that are waiting to be born. In 1980 there were few who saw the rise of personal computers, and even fewer who envisioned the internet. There are hundreds of new businesses that couldn’t even exist just 20 years ago. I am not sure where the new jobs will come from, but they will. Just as they did in 1975.

Twenty years ago, China was seen as a huge military threat. Now we are worried about them not buying our bonds and becoming an economic power. We are on the verge of remarkable changes in so many areas of our world and we better be invested while that happens. I do not know which industries will dominate, let alone individual companies. So my best bet is to go with the broad S&P 500 directly.

With the S&P 500 flirting with the 2,000 mark, the time it takes to reach 10,000 from today onwards is exactly 17.73 years. That’s right, we need less than 18 years to reach this huge milestone, and those who have missed out, will be wondering why they had not invested despite the bad times here and there. Try out the calculation yourself with this compound interest calculator. It is unlikely going to be a straight run up because we are dealing with emotions on a large scale.

Nevertheless, do not allow these emotions to distract you for the greater happening. The world is progressing, and so should your portfolio.

Interrupted with Fear

Stock market gyrations will continue to offer tremendous buying opportunities during downturns (the time to invest even more). During these phases of uncertainty and sell-offs, pundits will undoubtedly raise their voices and talk you out of your position. They will reason out how manipulated the current recovery was, or that a crises of colossal magnitude was still upon us. It will sound very convincing to you indeed. Let them be.

I ask you. What value, besides a little evening entertainment, have they provided you? I assume that these people have talked you out of potentially very rewarding investments which you would be enjoying right now, had you not listened to their preaching. You should critically think about this and take consequences.

Even Larger Returns

I believe that your returns can be amplified even further if you are exploiting both the ups and downs. Trend Architect does precisely that: Sending you trading signals at significant turning points in the market to help you stay out of adverse moves and yet capture strong and sustained trends.

I have been actively navigating the volatility in a way that very few professionally managed strategies can compete with. This is because I adhere to a few core rules of trend following and ensure that my strategy provides above-average returns in any market condition.

Why the Global Economic Cycle is Deflating

I found a chart that is titled Global Stock Market Cap. It is the market capitalization of all stock markets in the world. You add up the United States’ stock market, the Chinese, the European, the Japanese, and numerous other stock markets around the globe. It is an assembly of all the prices for all the different stocks combined in a single, solitary chart. What you can see is a massive credit cycle in action. And here is how it looks like:

At the end of May 2015, the global stock market peaked with a total market cap of $75 trillion.

At the end of May 2015, the global stock market peaked with a total market cap of $75 trillion.

When you look at this chart, you can see how valuations grew by around $30 trillion from 2011 to the summer of 2015. $30 trillion. In four years.

We have already lost half of that in the past 6 to 9 months. One of the key things of credit cycles is that they are self-reinforcing. I find it important for regular market participants to understand. Whenever markets are going up, it is self-reinforcing because the general public will have more money to spend.

Self-reinforcing Processes

There can be good and bad examples of self-reinforcing processes. A bad one is the self-reinforcing cycle of debt. A person borrows in order to consume beyond his current income and is unable to pay the bill, so he borrows again to make the payment and gets deeper and deeper into debt. We usually call this a vicious cycle. A virtuous cycle (a good example) is a favorable self-reinforcing process. If a person spends less than his income, he can add the residual amount to savings or investments which collect interest. If he spends less than the income in the next period again, he can increase savings and thus collect even more interest.

It has been thoroughly explained in Ray Dalio’s video How The Economic Machine Works. A very educational watch.

These cycles tend to feed on themselves unless there is an outside factor such as a central bank that has the fire-power to change their direction. As the Global Stock Market Cap shows, we are already in a contracting stage on a global scale. The contraction is even faster than market participants in the United States may realize. As a matter of fact, the Federal Reserve added fuel to the fire last year and began increasing its interest rates.

Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 0.25-0.5%.

Although it plans to raise them four more times in 2016, it could barely bring itself to squeeze a 25-basis-point hike out of its tightly clenched loins after seven years. It is since in a wait-and-see stance and further rate hikes appear unlikely given the bleak economic conditions since the beginning of 2016.

The market may even be at the early stages of unwinding the largest credit bubble in history and is overdue for a recession. A painful stock correction is likely even if we avoid slipping into recession. In fact, it may have already started. Investors need to learn to ignore what they are told by the establishment and think for themselves. My expectation going forward is that it is going to get worse because you are seeing this contraction happening globally and there is not enough fire-power coming from central banks that could at least subside this downturn. Let alone help bring markets back to its highs.

We can consider ourselves lucky because as trend followers, there is little interest in what economists have to say. In the short term, it will be interesting to see how long the current bounce will last. The medium term may appear bleak but this will fade, and we will rise back to new highs after we have overcome the contemporary troubles and negativity. I continue to be excessively bullish in the long term perspective, so let me end on a positive note.

Even with all our economic and geopolitical troubles, the progress of humanity in overcoming problems has been persistent and impressive. Technology is advancing on dozens of different fronts. There is good reason to believe that we are living in the upswing of an exponential curve of progress unlike any that life has ever experienced.

Look no further than the revolution of sustainable energy and becoming independent from oil, scientific breakthroughs in decoding the human genome and reversing the cause of biological age, the excessive automation of everything under the sky up until we no longer need to own an automobile or stress about parking lots because we can simply call a driverless and battery-powered Uber anytime and anywhere, the rise of artificial intelligence after understanding how our minds work (something that could progress to artificial superintelligence entirely surpassing our human capabilities), space exploration and becoming an interplanetary species. After what happened during the Industrial Revolution since 1815, I believe that we are transitioning into a new phase of Technological Revolution (or whatever it will be called) while computers were merely the prequel to the unbelievable opportunities that lie in front of us. Extremely exciting times ahead.

Will the Downtrend Resume After the Bounce?

The bounce off 182 in the SPY as outlined in my previous post materialized as expected and the S&P 500 has been cautiously moving upwards in recent days. It was a crucial support area and marked as one of a triggering level to watch in the member’s dashboard.

SPY-20160129

Perhaps one of the most pressing questions in everyone’s head is whether we have seen the bottom and can ride on a sustainable uptrend going forward. I assert that we have not. Let me explain why we are most likely trapped in a counter-move against a bigger downtrend.

 

Markets will recover enough to work off the oversold conditions and to revert back to the mean until evidence of a slowing economy and worries about the inability of institutional counter-measures overwhelm public sentiment again. An intermediate upside target looks to be around 200 in the SPY. Thus, we have yet to endure a second wave down until prices realistically reflect the primary fundamental factors such as earnings. Let me remind you that we are still looking at an average P/E ratio of 20 in the S&P 500, a far cry from the mean of around 15. We need to work off this excessive optimism because there is no big wave of technological progress that captures the mainstream.

Quite the opposite. Smartphone technology has peaked and the market is saturated as clearly observed in Apple’s iPhone sales. We take it for granted already, and yearn for the next big thing. Yes, there are small innovations here and there, but what I’m talking about is a breakthrough technology that fundamentally changes how humans live and work and get mainstream adoption. Until we see that coming in the distant horizon, we will have to patiently wait and prepare our cash to invest in disruptive companies at bargain prices.

I will prepare a chart that illustrates what I’m seeing for the coming 12 to 18 months in next week’s post. Meanwhile, enjoy the uptrend. If you missed our signal, become a member today and reap its benefits.

How to Become a Trend Follower

During my trading journey, I regularly encounter very interesting people from various fields. Aspiring traders who are just starting out are unable to reap consistent profits off the financial market, some even having been involved for many years and having tried various approaches. I assert that this is due to the lack of a fundamental understanding of trends, which is why I’m attempting to demonstrate how price action is interpreted correctly.

The nature of trends is the first thing an aspiring trader needs to fully comprehend. Trends do not stop from one moment to the other but last for a significant amount of time. A trend evolves in a sequence of support and resistance levels along its way, and reversals always take place after breaking an aforementioned level.

There is always enough time to spot a reversal and to adjust your position accordingly.

How to Recognize Trends

Take the 1-hour chart of the SPY for example. You will notice a repeated pattern of uptrends (higher highs and higher lows), downtrends (lower highs and lower lows), and trading ranges where the price moves up or down forcefully but without a resolution.

Uptrend

Steady uptrend pattern in SPY.

Downtrend followed by a trading range.

Downtrend followed by a trading range.

A break of any of the aforementioned pattern is taken as an entry opportunity to catch a reversal and follow a newly established trend. The specific method for trading reversals has been elucidated here and here. Consistently great opportunities are reversals to the opposite direction after trading ranges.

You never do anything prematurely and always wait for the market to tell you what to do. By doing so, you will avoid entering and exiting positions based on gut feel.

Let us think back to our childhood when we got our first bike. Our parents might not be particularly good cyclers but they knew one thing: to ride the bike we must be able to balance. Consequently, they do not bother teaching us how to shift gears, or how to do dirt jumping. They leave it at the basics. But this is what aspiring traders fail to understand. They start off with the most challenging stunts like scalping and picking tops without knowing anything about price action. Seeking answers in indicators is one of the mistakes they succumb to.

Back to the Basics

Whenever an aspiring trader comes to me, I will ask him to turn off all indicators, then give him the basic understanding he needs to start trading profitably. This includes price action, understanding the battle between bulls and bears, and trends. After that we go into more details such as risk management by using stop-loss orders properly.

To my surprise, many are able to find entries and manage positions with a bit of assistance within a few weeks, or have developed a totally new strategy with the help of the basics I provide. Most importantly, they do this without looking at any indicators that they used to love so much.

S&P 500 Could Easily Drop Another 20%

The market is tumbling since the beginning of 2016, and I thought it is appropriate to share the assessment from my perspective.

As bad as it sounds, we are most likely at the beginning of a very adverse move and have yet to await a moment of balance before sentiment can establish a turnaround. Thankfully, members have been largely unscathed by this fast move down. If you wish to stay on the right side of the trend and never be caught up in such an adverse move, check out the advantages you receive by being an informed member.

What is Ahead?

In my previous post, I pointed out the 1820 support area which also happens to be one of our triggering levels. Touching that base would shape up a triple bottom (troughs of October 15, 2014 and August 24, 2015) and a bounce is likely. However, I don’t think that this will be the bounce from which the market can ultimately recover. It is going to be a mere counter-move against the predominant downtrend.

If you look at the S&P 500 valuation, the average P/E ratio currently stands at almost 20. This is not a sustainable valuation. In fact, 20 has been an extremely premium valuation historically.

Average S&P 500 Valuation

Considering the possibility that we could revert back to the mean of around 15, we still have another 20% downswing ahead of us. This gives us an S&P 500 near 1500 given that earnings do not falter. With the negative sentiment spreading across the world and people becoming aware of a new bearish market, they will. In turn, we may have to anticipate an even lower mark.

20160114

I do not expect it to turn out to be another 2007/2008 financial crisis. This is just letting air out of a hot balloon without significant fundamental flaws.

Stronghold Support

With that said, a possible low is the all time highs made in the years 2000 and 2007 at around 1560 which is near the aforementioned fair valuation if everything else stays the same. It is going to be a stronghold of support and I do not expect prices to slip through it like a hot knife through butter. We would have merely reverted back to fair valuation, though. If we reach it, I will be posting a follow-up assessment.

Any thoughts? Discuss your view on the market in the comment section below. I’m always excited to hear your perspective.

Trading Strategies and Psychology

One strategy I have heard people discuss from time to time is using the 200-day moving average as a timing indicator. Stocks are purchased when a broad market benchmark is above its 200-day moving average, and stocks are sold when the market benchmark falls below its 200-day moving average. Though there are variations in the type of the moving average used, the basic premise is the same: Own stocks when the market is above the indicator and sell stocks when the market is below it.

In his fifth edition of Stocks for the Long Run, Jeremy Siegel analyzed whether this strategy is beneficial. He ran the numbers from 1886 through 2012 using the Dow Jones Industrial Average. He applied a 1% band, meaning the DJIA had to be at least 1% above its 200-day moving average to trigger a buy signal or at least 1% below its 200-day moving average to trigger a sell signal. The band is important because it reduced the number of transactions. Without it, an investor would be frequently jumping in and out, driving up transaction costs in the process. Siegel also assumed end-of-day prices were used.

Keeping You Out of Trouble

Following the 200-day moving average timing strategy would have kept an investor out of the worst market downturns. Specifically, the investor would have avoided the large losses endured during both Black Tuesday (October 29, 1929) and Black Monday (October 19, 1987). The strategy would have also helped the investor avoid the 2007-2009 bear market.

Commenting on the results, Siegel observed, “The timing strategist participates in most bull markets and avoids bear markets, but the losses suffered when the market fluctuates with little trend are significant.” He added, “The timing strategy involves a large number of small losses that come from moving in and out of the market.”

Mind the Transaction Fees

Jeremy’s calculations show the 1886-2012 annualized return from the timing strategy dropping from 9.73% to 8.11% once transaction costs are factored in. In contrast, the buy and hold strategy realized a 9.39% return. If the 1929-1932 crash is excluded, the buy and hold strategy looks even better: A 10.6% annualized return versus annualized returns of 9.92% and 8.38% for the timing strategy (without and with transaction costs, respectively).

One advantage the 200-day moving average timing strategy did have was reduced risk. With the exception of 1990-2012, the timing strategy incurred less risk than the buy and hold strategy for every period and subperiod studied. This is due to the avoidance of the market’s big downward drops.

Depending on Your Discipline

There is one consideration not factored into Siegel’s analysis: investor psychology. If an investor lacked cold-as-steel nerves and either failed to sell or buy stocks when triggered, the timing strategy’s performance would be much worse. This is because by not acting appropriately, the investor would have missed out on the benefits the strategy was designed to provide.

This is the inherent problem with all trading strategies. An investor who is psychologically unable to stick with them during turbulent market conditions is always better off with a buy and hold strategy. It does not matter how well a trading strategy has performed in the past; if an investor cannot stick to it in all market conditions, his portfolio will suffer. A simple formula to remember is portfolio return equals strategy performance less transaction costs and behavioral errors. A sound strategy that incurs the lowest combination of transaction costs and behavioral errors is the one that will allow you personally to realize the largest long-term gains.

What Overbought and Oversold Means

In the trading universe, you often hear from people who claim that a particular market was overbought or oversold according to their magical indicator – sometimes even gut feeling.

Oftentimes this message implies to be cautious with new commitments and to expect a dirty reversal anytime soon. Unfortunately, the inexperienced trader all too often interprets an oversold condition as a signal to buy into a falling market. If you cannot expect to earn much with the current downtrend anymore, the reward must be waiting on the opposite side, mustn’t it?

Not quite. The general wisdom among trend followers is that as long as a market is falling, support areas are going to give way to the sellers eventually. What appears to be support for a moment will henceforth break for new lows because of an underlying bearish force in the market. This indicates that optimistic market participants are not going to succeed in the long run. It is simply the nature of downtrends that buying into them is a very challenging proposition.

How do we recognize a falling market, you ask? You can characterize downtrends as a sequence of lower highs and lower lows in a daily time frame. An uptrend is consequently defined by a sequence of higher highs and higher lows.

Take a Closer Look at Trends

Take a daily chart of the S&P 500, for example, and look out for decisive lows created during an uptrend. As long as visibly striking intermediary lows have not been taken out by the bears, the trend is still regarded positive. Shorting in an uptrend is a fool’s game.

Daily chart showing an intact uptrend.

Daily chart showing an intact uptrend.

How can we trade an “overbought” market then? If you are in a position already, the easiest answer is to evaluate whether a tighter stop-loss makes sense. Set it to the most recent low that was formed on the way up to protect your profits, and continue to participate in the current trend. We will never know whether the next reversal is for good, so trailing the stop-loss order would yield the most desirable outcome.

If you have no position, be on the lookout for promising entry opportunities during reversals. You want to make sure that you are entering during a turnaround at a trough. Use the daily time frame as a reference for the bigger picture, and use the 1-hour time frame to trade an actual reversal pattern therein.

Identify visually striking support or resistance areas and observe the price when it is smashing through them with momentum. An example would be the break of an intermediate horizontal resistance. That is your potential buy entry to participate in an uptrend.

How to buy a low in an uptrend.

How to buy a low in an uptrend.

Conclusion

You should not jump into the market or close out a good long position in panic just because some random trader shouts “overbought”. Stick to your trade as long as there is not enough evidence for a turnaround. What can be more painful than a loss is to close out and bitterly see how everyone else continues to profit from the trend you used to be in.

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