Can We Really Predict the Stock Market's Direction? Absolutely!
by Stephen Swanson
The term "prediction" can conjure up a lot of hocus pocus with images of crystal balls, tarot cards, and wizards, but when it comes to predicting the stock market, it has nothing to do with the fantastic and mystical, but about the science of quantifying herd behavior in financial markets.
That behavior is easy to see when you watch stocks like Apple Computer explode upward on substantial volume as they report record growth through sales on products like their iPod and iPhone each quarter. But did you also notice what happened to the stock just after October 2007, when broader markets began to crash? The stock fell from a nearly $200 precipice, to nearly half its value in just two months!
What happened, did Apple's amazing products suddenly fail to deliver, were consumers abandoning those products in favor of some other new fad device? Not at all! What happened to them is what happens to the best of companies in bear markets, they were sold, plain and simple. It's the herd effect, the "get me out now!" mentality.
But it wasn't just AAPL. It happened to GOOG too, and to RIMM, HP, GE, AA, and about 90% of all stocks accross the board, with many also seeing their price halved in just a few short months!
That's the extreme of financial herding, but was quite predicted by several indicators I like to watch - such as the $NYHILO - which measure the number of new highs against the number of new lows being created. That ratio peaked in July 2007 and had been rolling over for several months prior to the precipitous drop that occurred by year's end.
But something I consider even more remarkable is the fact that there are other regular movements in the market that are also attributable to that same herding behavior, but these occur on a more regular, less dramatic, and still very tradeable basis.
Did you know for example, the every 7-10 days, the Dow and NASDAQ indices oscillate up then down, providing some amazing swing trade opportunities for those willing to follow it? That movement happens in both bull and bear markets, but most investors have probably never even noticed it. Too bad, because with the high volatility we have had in our markets, each swing is a very lucrative opportunity for those who know to play it.
For example, during the 30% market recovery we've had since March 6, 2009, there were several points along the way where you could have used that knowledge of these smaller counter-trend swings, to add to existing positions, or initially buy into that bullish trend.
Buying after a big up trend has started is one of the trickiest things investors have to contend with. They don't want to chase the move, but the also don't want to stay on the sidelines and miss it. These regular 7-10 dips are the perfect place to enter and still avoid chasing the stock.
Ten day's after that March 6th low for example, there was another buying opportunity when a short term low again formed on March 20th (just 10 trading days later).
Seven days later, the market dipped again on 3/30, once more offering an opportunity to re-enter or add to long positions following another 8% rise in the days preceding it. Again, seven days later, on 4/7, another dip. On 4/20, you guessed it, markets dipped again. Each dip was predictable and recognizable to those who have been taught to watch for it.
I use longer term trend to help determine whether to play the trough or peak that occurs each 7-10 days, and use it as an entry or an exit point. For example, in a rising medium term market (where a 10 day moving average is rising) I'll use those short term dips to buy. Alternately, I'll use the short term peaks which occur in a medium term down trend (where the 10 day moving average is declining) to sell short.
We had a short selling peak on 1/28, another on 2/6, a flat consolidation day on 2/18, another consolidation on 2/25, and a market low on 2/6. Each of those occurred in the regular 7-10 days cycle.
It is a very powerful way to trade, and if you watch the charts we post on our site that track that 10 day cycle, it's easy to see when that 7-10 day cycle is forming a peak or trough. In the current bullish rise, use the troughs to buy. But once the 10 day average starts to decline, use the 7-10 peaks to sell.
In future articles, I'll show you an easy way to ride those waves of profit without having to worrying about which stocks to use - we'll take a look at the new generation of exchange traded funds, or ETF's. The double and triple beta variety will provide 2:1 or 3:1 leverage in the market. Using the technique I described above, it can help you gain back what you might have lost in the recent bear market decline!