Trend followers aim to be invested in the marketplace when trends are bullish as represented by a rising uptrend. They tend to sit it out during downturns or when the market is declining. In general, trend following is a simple and effective investment strategy that works best during bullish market conditions.
An alternative but equally effective investment strategy is based on market breadth analysis. This is another form of trend-following and may be better at differentiating between small and large market corrections and most important, between oversold rallies and sustainable intermediate-to-longer term recoveries.
The natural bias of the U.S. stock market is a rising trend. Separating good markets and bad markets is hard because of this built-in upward bias in the marketplace. The ability to correctly differentiate between taking small losses versus larger losses sometimes makes the difference between good and bad performances.
The key to successful trend following remains the ability to differentiate between the bumps (modest corrections) and the risk-off sell-offs (bear declines). Trend following investment strategies can run amiss under extreme market conditions such as external/exogenous events (i.e., Covid-19 pandemic). Under this market environment when the primary trend is erratic or undecided trend followers will need to supplement basic trend analysis with other technical techniques such as moving averages and market breadth analysis. The objective is to better filter out the noise created by the increase in market volatility and to make the primary or prevailing trends easier to interpret.
Attached are the advancing issues minus declining issues market breadth (A/D line) charts and the respective 200-day ma for key U.S. stock indexes including S&P 500 Index (SPX), Dow Jones Industrial Average (INDU), NYSE Composite (NYA), NASDAQ Composite Index (COMPQ), NASDAQ NDX Index (NDX), S&P 400 Midcap (MID), and S&P 600 (SML).
Market breadth has begun to expand in SPX, INDU, NYA, NDX, and MID. This would imply that leadership may be concentrated within these markets. However, two important US indexes including COMPQ and SML require additional technical work before they can sustain intermediate-to-longer term recoveries.
Summarized below is a detailed review of the market breadth analysis on SPX:
In the past, the S&P 500 Index price (black dash line) has correlated closely to its Advancing minus Declining breadth indicator (black solid line). When market breadth (Advance/Decline line) corrects it leads to an SPX price correction. On the other hand, when market breadth begins to expand it leads to SPX recoveries or rallies.
Market breadth peaked recently on 2/14/20 (6,450) and plummeted to 6,031 (3/23/20 low). This has led to SPX suffering a bear decline (-35.41%). We find it interesting the magnitude of the market breadth decline today is similar in scope to the late-2018 market breadth contraction.
The major difference is the sharp contrast between the two declines (-19.78% vs -35.41%). The extreme volatility during Feb-Mar 2020 caused by the external/exogenous shock to the financial markets (i.e., Covid-19) may have turned a normal -20% correction into a -35% bear decline. Since the market breadth contractions between the two markets are similar, it bodes well for the current expansion in market breadth today supporting the basis for a sustainable intermediate-term SPX recovery. It may not be the same as the V-type recovery as before. Rather the recovery may be more of U-type recovery this time around.
A higher-low market breadth pattern (6,031 - 3/23/20 low and 6,057 - 4/3/20 low), as well as higher-high market breadth (6,144 - 3/26/20 and 6,186 - 4/9/20) coupled with a SPX higher-low pattern (2,237 - 3/23/20 and 2,447 - 4/1/20) and a SPX higher-high (2,630 - 3/26/20 and 2,790 - 4/9/20) are technical encouraging.
On another note, the ability of A/D line to maintain above its 200-day ma (6,080) also supports the basis of expanding market breadth. The next hurdle is for SPX to clear above its 50-day ma (6,234). Accomplishing this feat would further reaffirm the expansion of market breadth and hence a sustainable SPX price recovery.