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October 22, 2005

Mental Momentum

Market & Sector Review
This Week's Economic Reports

Member Update --> This past week we began publishing a new Relative Strength Report that includes new data. The daily reports are now split into two reports one a relative strength table and the other a technical indicators table (this will be added to in the future). I have been working closely with one of our members over the last month or two to come up with these tables. He has graciously written a step-by-step approach on how he uses this data to make money in the markets. Read it closely and over and over if you need, this work is outstanding. The new data is updated daily for all stocks and is included when you search through groups. Waveslider (as he prefers to be known) uses the Dow Jones Total Market indices as opposed to the Media General Groups, we are working towards not only including more indices but also to be able to list stock components by index as well as by group. This may take awhile to accomplish, so patience please. Relative Strength is one of the most important concepts for analyzing sectors and stocks as you have probably learned since we have been publishing this data. This additional data dramatically inhances what you have had in the past. It is in my humble opinion more important than almost all other technical data. A big thank you to- Waveslider!

Mental Momentum

When you're under a great deal of pressure, it is easy, even common, to choke. The stress being on edge, make it extremely difficult to make decisions or to look at your current trading predicament objectively. When you have a drawdown, you can feel a little disappointed, a little stunned. After you've made a series of successful trades, you feel much more powerful, as if you can relax a little bit, and when you feel relaxed, you are more creative in approaching your trading strategies. Everything seems to click and you start trading effortlessly and profitably. It is extremely difficult to feel such empowerment when you are falling behind, or stuck in a rut, not making any headway. There are two types of momentum in trading. There is profit momentum and mental momentum. Mental momentum can be just as important as profit momentum.

We feel mental momentum when we believe we have made our best effort, when we feel that we have done everything we possibly could have done. At these times, we should pat ourselves on the back for a job well done. While trading, we usually forget to give ourselves credit when we have put in a good effort. We become so focused on profits and those efforts that produce profits. In order words, we focus exclusively on performance goals, while completely forgetting about learning goals, which are equally important.

Instead of focusing only on a performance goal, focus, also on other goals that are equally important, but may not always directly produce a profit. There are many modest goals that can be achieved easily and deserve a reward upon completion. Break down the goal of making a huge profit from a few good trades into specific steps that are doable, and should be rewarded. For example, studying for 10 or 20 hours a week or learning a new trading technique is important and worthy of reward, even if the reward is just a personal sense of accomplishment. The specific goal may not immediately lead to your larger goal but it is easy to achieve, and will lead to personal satisfaction upon completion. In the long run, this alone will contribute to the attainment of your larger longer term goal of becoming a seasoned, profitable trader. The more you complete these modest goals, the more mental momentum you achieve.

Give yourself credit for all the effort you put into trading. It is tempting to feel good about your efforts only when they pay off, but you put in just as much effort putting on a losing trade as a winning trade. Regardless of whether you win or lose, you'll feel better if you reward yourself for all the work you do, regardless of the outcome. The more you reward yourself for all the work you do, the more mental momentum you will feel. This, in turn, will make you feel strong and empowered, allowing you to trade more effortlessly and profitably.

Market & Sector Review

I am keeping my comments extremely short this week in order to introduce you to something that in my humble opinion is a very exciting addition to this site. This addition and the explanation below should help just about everyone out there make more money once you learn how to use it. As always is the case the explanations are from the long side of the market but utilizing the data in reverse manner should help you on the short side as well, if you are inclined in that arena. Relative Strength analysis is perhaps not only the most overlooked technical tool, but the most important one of all.

As stated last week, in my opinion, the odds are currently favoring a transition from a cyclical bull market to a cyclical bear market. You may have noticed over the last few months that indicators that have worked so well since the beginning of the cyclical bull are no longer working - first sign of a change going on. In transition phases as I believe this to be those favorite indicators of yours must go to further extremes to generate signals. A few weeks ago I was bullish almost exclusively because of sentiment and I stated at that time there was a lesson for me here and I was looking forward to learning from it. I think the lesson here is that sentiment data must go to more of an extreme before we can consider it bullish or bearish, and a valid indicator, especially so at probable market turning points. As you saw this week with the markets up sharply on Wednesday and giving it all back on Thursday, volatility is picking up, usually a sign that something big is going on, although it could have been at least partially due to unwinding of derivative spreads. Transition phases and bear markets are extremely difficult, even for the most experienced traders to navigate, novices take note. Expect both sharp rallies and sharp declines without much notice. All this being said, I have a target on the S&P, as stated last week, of approximately 1140, if we get there relatively quickly it could be the springboard for a substantial and trade able rally. The NASDAQ is outperforming the S&P and the NYSE, see explanations below, and that is usually a good sign for stocks in the near term. Note: Google's earnings on Thursday evening and the explosive rally on Friday should underline the simple cliché "It is a market of Stocks", all this makes the presentation below even more timely.

You have probably noticed the daily postings of the Trading Reports have been split in two, first a relative strength table which will be explained below and secondly the technical indicators that were in the old reports now have a separate table which will be added to later. You should also note that the new data is also included for each stock, so when you look through stocks within groups this data is displayed for each stock and is updated nightly. The dissertation below is by a one of our members with whom over the last month or two I have come to know well. He chooses to be known by the moniker Waveslider, which he probably uses on some message boards. Personally I have gained the utmost respect for Waveslider and although our time frames are not the same I have learned much from him recently and I sure hope you read and learn from the following. Wavelider's preference is to use the indices and then search for component stocks within those indices as opposed to the Media General Industry Groups, it is not better, it is not worse, just a matter of preference, probably from personal experience. We are working on bringing those index component stocks on site as searchable by the index just as you search through groups now.

Below this explanation is our Weekend Most Improved Report on the ETF's and Groups. A short note: since Waveslider and I have been working on this project I have casually noticed that this report blends very nicely with the methodology to which you are about to be exposed. Enjoy what you learn, it may be a good idea to print it out, keep it by your computer for future reference. To my knowledge this is the only site on the Internet that provides you with this data, learn it, combine it with Rankings over 6 and 12 months, and the Changes Report each weekend, use it, and be a step ahead of the crowd!

Using Relative Strength Readings for Stock and Index Selection
October 2005 by Waveslider

Whether you trade mechanically or discretionarily, if you are a small time trader or investor you are often riding the coattails of the big players. It is no secret that mutual funds, brokerage firms and large shareholders have the ability to move markets. In order for "the rest of us" to carve out some profit, we depend on fundamental and/or technical data to direct us to opportunities. The purpose of this article is to demonstrate one method of locating where the major players are putting their money, and thus increase the odds not only for a profitable trade, but for a potentially larger than average trade.

Are you smarter than the pros? You may be, but unless you have the information the pros have, they will likely run you over. Simple truth is that unless you have some type of inside information, you don't have the information the pros do. On the bright side, the big players leave tracks - you just have to know how to be a tracker. Using relative strength readings (comparing inter-market relationships) is a very powerful method. Being aware of these readings is likely more valuable than most, if not all technical tools that analyze price and volume. This is the tool to use to track the big players.

In the context of this article, relative strength refers to the relationship between two price sequences. It has nothing to do with RSI (Relative Strength Index), a technical tool developed by Welles Wilder many years ago. To calculate relative strength is as easy as dividing the price of the secondary market, or group, or stock by the price of the primary market. If the line is rising, the secondary market (stock, group, ETF) is outperforming and vice versa.

The method I am going to demonstrate is a top-down method for selecting stocks, ETFs, indices, whatever. In order to keep this discussion easy I will address all trades from the long side, although the method works equally well in either direction. You've heard of the saying "the rising tide floats all boats"? It's true of the markets, and this method places the trader/investor in the indices and stocks that are the strongest, with the idea that since there is massive accumulation in these areas, the prices will likely continue higher.

Where to begin? At the top! Use the broadest markets and then narrow down to the indices and then individual stocks, or whatever you choose to trade. The 3 major markets I look at I call "the Generals". They are the Russell 2000, the S&P 500, and the Nasdaq. These are all broad indices with many components, giving a better overall perspective of the market. Since the Dow Jones Industrials Index is comprised of so few stocks, one stock that experiences some event can throw the reading off. That said, you could use any index you want, as long as it is broad and represents a wide portion of the stock market.

You will need to choose one of these broad markets to get your entry signals from. Use one and stick with it, otherwise you will start second-guessing yourself and suffer from information overload. Whatever signal you use, try to find one that fires often. You want a lot of opportunities to get involved. Keep in mind that the actual entry signal is not as important as how you manage your trade. While that topic is outside of the scope of this article, by using this powerful method of selection, no matter where you enter you will know that the big players are here lurking. They want it, and when the broader market turns in the right direction, they will be there "participating".

OK so you have your General, you have your signal (moving average cross, range breakout, trend lines, whatever), now what? Here is where your homework begins. There are powerful tools on the Prudent Trader website which will help you in narrowing down where you want to be. Additionally, it is VERY helpful to have some type of charting program which will allow you to visually analyze the TREND of the relative strength calculation. We will discuss this concept later. [Editors Note: All indices, ETF's, and stocks in the various market scans and reports have links to charts at stockcharts.com. if you do not have a charting program of your own]

Step one: look at your General for the short-term analysis, specifically the last five days. Have we had strength over this period or weakness? Strength can breed more strength, but unless you have a quick trigger finger, waiting for a day of range contraction or a period of pullback is much safer. Also you will know sooner when you are wrong. These decisions should be made based on your holding period.

Now we have determined what the market has done over the past few days, what do we do with Prudent Trader's powerful scans? Look for the indices that are outperforming the market! First we are looking for corroboration between longer-term readings and mid-term readings. These are "windows" in the time which tell you the persistence of the index's relative strength. Prudent Trader's site allows you to see how the index was performing a month ago relative to the broader market. We use the proximity to a moving average of the relative strength in percentage terms to make an analysis. Whoa! What is that? Simply, the moving average of the relative strength is a "moving anchor" which gives a good idea of the longer term trend of the relationship between two markets. When expressed in percentage terms, we can compare indices to find where the most strength lies.

The longer-term scan is your first list. Go to the website and select "Relative Strength Tables" next to the "Market Indices" tab. There is a lot to do here, but let's stay focused. Select "RS Value as a % of 21-Day MA 21-Days (Month) Ago". Once you are on the page, look at the column titled "MA % of 21-Days" and the "MA Dir". Is the moving average trending up or down? Throw out the ones that are trending down. Which has the strongest reading? Those go to the top of the list. Take a look at the ones that have an up trending moving average, even if they have a negative % reading. The index may be starting a comeback. While this is a powerful tool, you are still going to have to look at some charts to see the trend of the relative strength VISUALLY. We will examine why next.

Markets fluctuate and anything that measure markets fluctuates as well. The question is whether there is a trend in the fluctuation or whether a range exists. This is a very important concept for relative strength analysis. This is because we don't just want to find an index that is outperforming the market; we want to find one that is CONSISTENTLY outperforming in the time frame that is being traded. For this reason we want to see our relative strength line trending in the proper direction - even if the market is not trending. This is our edge, because it tells us that even if the price is not moving, there is some type of accumulation that is supporting and buoying this market. When the added fuel of a broad market move comes it is like a child letting go of a helium balloon. There is no holding back. If the line is moving sideways in a tight or wide pattern, there is no information to be gleaned. The market being examined is performing in sync with the market and we are not interested.

So we have the list of what was going on a month ago, and we compare it to the next reading in the column to the left, readings taken from a week ago. Is the moving average still moving up? Is there still a strong reading? If so we have a possible persistence of trend. Next column. Here's where we start looking for aberrations. If there is persistence of trend, and our short-term column is giving a negative reading, we may have an opportunity. An important piece of knowledge is that stocks or indices undergoing accumulation will have high volatility, sudden sell-offs. During this period the market will under perform the General. This is shakeout of weak hands is typical of an up trend, and it offers "smart money" an opportunity.

Now that we have the knowledge of this opportunity, should we rush out and get involved? NO! Not yet… There is always a chance that this was a blow-off top or other type of capitulation. We need to wait for a signal from the index. This signal will likely occur about the time your General is giving a signal. When the General gives a signal, there is a good chance the tide has turned. If you jump the gun, you will get taken out. But if the entry signal comes, you should take it! This trade has a higher than normal profit potential, because you are in an index that is consistently outperforming the market, and will likely continue. So if you are blessed with a winner, it will likely run further than an under performing index. Take this same strategy and apply it to the components of the index you have located and you will be involved in the strongest stocks in the entire market!

Let's look at an example to illustrate this concept. The following chart is a recent chart of the AMEX semiconductor index. The lines on the bottom are the Relative Strength reading compared to the S&P 500, and a 21-day moving average of this line.

Index is in a wide range bound pattern and has recently failed to continue lower after testing a horizontal support level. Notice that after trading in harmony with its relative strength line, the relative strength line made a higher low while the index made a lower low. This is commonly known as “divergence”, a clue of what is to come. If you were watching this market closely, you would probably take the trade when the trend lines broke. However this would not have shown up in our scans since the relative strength line has been trending down.
The Relative strength line breaks out of its pattern and we know we should be looking for an entrance. Intermediate and short-term scans are showing this index as a potential, but the reading from a month ago is still down.
Now our scans show that on the longer and intermediate term basis, this index is outperforming the S&P. The short-term reading is below the average line. Notice how there was an abrupt shakeout just before the #3 mark, but the line held steady instead of following price. Just before the #3 mark is a small range “inside” bar that indicated that volatility had dropped off. This is our opportunity – when volatility resumes, we want to be involved in our chosen direction.
After hitting new year highs, the index once again sells off hard. However, while the price is about at the same level as #3, the relative strength line is higher than where it was at #3. This market continues to outperform the market on a longer-term basis, and as you can see the relative strength line is still in an up trend. The proper move currently is to do nothing. Once the General has once again resumed its trend, you would want to take buy signals in this market.

The Prudent Trader scan site can be used for all sorts of scans, and this is just one approach. I hope it has sparked some ideas for you to investigate. The important concept to understand here is that the market is moved by the big players, and by seeing where the big players are putting their money keeps you swimming in the direction of the tide, not against it. This is not a sure fire approach, nothing is, but it places odds in your favor. Read the wealth of information on the Prudent trader site for tips on proper trade management and trading psychology, as these factors are likely the variables which can make or break you.
Good trading!
Waveslider (I can be contacted with questions via Bill at the Prudent Trader website Click Here! )

I certainly hoped everyone enjoyed this dissertation. I know I did! It takes a bit of practice and getting used to but if you spend the time, do the work, your efforts will be handsomely rewarded, we promise!

This Week's Economic Reports

Have A Great Week!

Bill

Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.