Thursday, July 24, 2008

The (Mega) Trend is Your Friend

Bottom fishers, short term traders, and market timers aside, some investors might be tempted to conclude that the sell oil/buy bank stocks trade is a sustainable trend. If, however, an investor takes a step back and utilizes one of the most consistent longer term technical analysis tools a decidedly different conclusion would be reached.

To illustrate, take a look at the accompanying chart for Financials (XLF)*.

The technical analysis tool I am referring to is called the Mega Trend. The Mega Trend (as I define it) is a multi-year stock price trend analysis where price and two moving averages (50 day and 200 day) are measured. In well-established Mega Trends, price is above (or below) its moving averages, the shorter term (50 day) Moving Average is above (or below) the longer term 200 day, and both moving averages are pointing in the same direction, either up or down.

Using Financials as an example, price has been below both of its moving averages AND the 50 day has crossed the 200 day (to the downside) and both moving averages are headed in the same direction (which is this case is down). For Financials, a bearish Mega Trend is well established. Now, let’s consider a few related points.

When price has rallied and touches one of its moving averages (which will be the 50 day), a potential Mega Trend reversal may be in the works. In the case of Financials, price has rallied to its 50 day. However, for a Mega Trend reversal to be complete, price must cross both moving averages AND the 50 day must cross the 200 day AND both must point in the same direction with price leading the way. Looking at the accompanying chart, this is precisely what occurred to the downside in mid 2007 after Financials had been (for the most part) in a bullish Mega Trend since the spring of 2003.

Investment Strategy Implications

The recent bounce in Financials is justified due its deep oversold condition and a degree of pessimism that was (and largely still is) so thick you could cut it with a knife. Short term sector allocation warranted (and rewarded) investors who increased their weighting in anticipation of and during the recent Financials rally within its bearish Mega Trend. It should not be construed, however, that deep oversold bounces signal sustainable trend reversals.

The Mega Trend tool is a simple, elegant, yet highly effective tool for investors (and traders) as it keeps the longer term picture firmly into view and helps place in context the shorter term wiggles and squiggles.

*click image to enlarge.

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