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There is nothing that gets an individual investor's attention quite like an enthusiastic "market expert" pounding the table with some bold prediction regarding what will happen next in the stock market or some previously unknown stock that is "due to double or triple in price." What confidence! What bravado! What chutzpa! Oh yes, and what BS!

I am going now to make a statement that I absolutely cannot quantify, yet which I believe to be 100% true and with which I believe virtually anyone would agree - that is, if you had acted on all of the "red hot" advice you've ever heard by some stock market "guru," you would be far worse off financially than you are today. Anyone disagree? And still, I must admit that even I get mesmerized when I hear some talking head confidently and forcefully making a case for this investment or that. Ah, human nature. Can't live with it, can't live without it.

Fortunately for me, long ago I adopted the notion that I don't know a thing, particularly when it comes to trying to "predict" what is going to happen next. Yet ironically, this has served me well. If I had to sum up my own personal overall approach to the financial markets in one word, that word would be, well, two words actually - "trend follower." Go with the flow, baby, that's what I'm all about. Now on the one hand, trend following is kind of a bummer because it involves resigning oneself to the notion that you will never pick a top or a bottom. In fact, you will never even come close to doing so. And let's be honest, that's what we really all want to do, right? Ah, there's that pesky human nature again rearing its ugly head again. Still, I can't help but think back to the second half of the 1990s when the stock market went up double-digit year after year. And two primary recollections come to mind:

1) From 1995 into 2000 there was a never-ending stream of pundits proclaiming that each given pullback in the market was "the end" of the bull market and that there was "no way it could keep going" the way it was. The good news for them was that they were ultimately right in the end. The bad news is that they missed about four or five thousand Dow points on the way up. Oops.

Lesson #1: The trend is your friend.

2) The other recollection was that every week Investor's Business Daily would present an interview with some "random" investor - typically a housewife, a college student or a blue collar guy named Vinny. And in the interview - which always included a picture of said individual, invariably with their arms folded across their chest and a smug look on their face - would detail their "investment strategy." Please do not think I am being condescending because I am a true believer that anyone can do well in the markets if they are willing to learn and work at it (and if you are a housewife, a college student or a blue collar guy, please do not contact a guy named Vinny and encourage him to come and break my legs), I am simply reporting the facts. In the end, the sum total of these various strategies could be boiled down to the following pearl of wisdom: In a bull market, buy stocks (pretty much any stocks).

Lesson #2: Never mistake wisdom for a bull market.

Of course we have not had to worry too much about bull market wisdom in the past several years. And even though the market has rallied gangbusters since March there remains a noticeable dearth of folded arms and smug looks.

GETTING A HANDLE ON "THE FLOW"

Once you give up the notion of "calling tops and bottoms with uncanny accuracy" (but God, I love the way that sounds), you can start to focus more on the overall trend of the market rather than on the exact next moment when it will reverse. As we saw in the aforementioned late 1990s this can be quite useful. For the stock market there are essentially two key trend elements:

1. Price
2. Internal Market Action

Now even neophytes get the part about "price". Price up, good. Price down, bad. Pretty straight forward. So if we compare a given stock market index to a given moving average of that index's closing prices we can quantify the current trend as either "up" (if the current price is above the MA), or "down" (if the current price is below the MA). Internal market action is another matter. There are advances versus declines, new highs, new lows and so on and so forth. So let's take a look at one potentially useful method for combining these two key elements to help identify good times to be in the stock market as well as good times to be out.

Price Action

First let's compare the Nasdaq Composite Index (COMPQ) to its own 200-day moving average. If the latest closing price is above the 200-day moving average then we will designate the price trend as "up." Otherwise, the price trend is designated as "down."

Figure 1 - OTC Composite versus 200-day moving average

Internal Market Action

Next let's look at daily (52-week) new highs and new lows on the Nasdaq. Intuitively it makes sense that the market is "healthier" if more stocks are making new highs than new lows. As it turns out, because there is a longer-term upside bias to the stock market, the ratio of new highs to new lows does not necessarily have to be above 50% to portend good things for the market. So here's the formula:

A = Daily Nasdaq new highs
B = Daily Nasdaq new lows
C = A/B
D = 10-day moving average of C

In plain English, each day we divide today's Nasdaq new highs by today's Nasdaq new lows and then look at the average of these daily readings over the past 10 trading days. A reading above 0.41 is considered "up" and anything less is considered "down."

Figure 2 - OTC New Highs/New Lows (10-day average; 1988-2009)

Putting the Two Together

Our ultimate goal in this exercise is to be in the market when the odds are greatest that the stock market will move higher. In theory the probability of the stock market rising should be much better if both of these trend indicators are bullish than if one or both of them are not. So let's put this theory to the test.

Figure 3 displays the growth of $1,000 invested in COMPQ when only zero or one of our model indicators is bullish. As you can see, the results are not too good.

Figure 3 - $1,000 invested in COMPQ when zero or one indicator is bullish (1988-2009)

Despite riding some of the bull market in 1999-2000 despite weakening internal market action, this approach quite obviously bore the brunt of the 2000-2002 and 2007-2009 bear markets.

Now how about when both indicators are bullish? Figure 4 displays the growth of $1,000 invested in the COMP only when both of our indicators are bullish. As you can see, there appears to be something to our theory.

Figure 4 - $1,000 invested in COMPQ when both indicators are bullish (1988-2009)

For the record, since 1988:

1. $1,000 invested in COMPQ only when zero or one of the indicators is bullish shrank to $472 (or -53%).
2. $1,000 invested in COMPQ only when both indicators are bullish grew to $13,223 (+1,222%).

Go with the flow, anyone?

SUMMARY

Investing doesn't have to be rocket science. I learned a long time ago that simple ideas are the best. If price is moving up and the internal market action is decent, it is best to give the bullish case the benefit of the doubt. There is no prediction going forward involved in any of this, and the downside is that the market could turn around tomorrow and it would take awhile for indicators such as the ones I've detailed here to turn bearish. In fact, with the market up roughly 50% over the last six months, this is a significant possibility.

Welcome to the "exciting" world of trend-following.

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

NOTE: To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.

Look for the interview with Jay Kaeppel in the upcoming November 2009 issue of Technical Analysis of Stocks and Commodities magazine.

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