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Deciphering the Trend: It’s All a Matter of Perspective

by Richard Evans

Nearly every investor has heard of that venerable stock market saw, “The trend is your friend.”

It makes sense. The trouble is, though, for most investors, deciphering the trend is often an effort in futility.

However, it does not have to be so, as trends have identifiable characteristics, patterns that repeat time and time again.

The Characteristics of Trends

The first characteristic of trends is duration and extent: the minor or day-to-day trend; the intermediate or month-to-month trend; and the major trend, lasting a year or more. Although the intermediate and the major trends are most important, most investors seem to be mesmerized by the day-to-day trend.

A second characteristic of trends is that they have three phases: An uptrend shows accumulation, mark-up, and speculative phases; a downtrend shows distribution, mark-down, and distress selling phases.

Running concurrent with the phases of trends is momentum. Accumulation (in the uptrend) and distribution (in the downtrend) usually proceeds at a steady pace, whereas most of the price movement occurs quickly during the mark-up or mark-down phases.

One final principle is that the trend is shaped by support and resistance levels. Support and resistance levels are levels of actual trading areas, and the greater the volume, the greater the support and resistance. Put simply, a downtrend is determined by a breakdown below support, and an uptrend is determined by a breakout above resistance.

These concepts of trend are so basic as to how stock prices behave that I simply cannot fathom how any investor can buy or sell stock without some knowledge of where a stock stands within its trend. Not developing an awareness of trend is akin to taking a cross-country auto trip without a roadmap. The comparison may seem extreme, but that is how many investors still choose to buy and sell stocks.

The Dow Jones Utilities

As an example of trend analysis, I’ll follow up an earlier column of mine in the July 1994 AAII Journal [“Technical Clues From an Uncommon Source: The Dow Jones Utilities,” page 19], which discussed a trend of much importance to all investors, the interest-sensitive utilities. Since the 1994 stock market reaction was largely due to rising interest rates, a correct analysis of the trend of the utilities would be paramount in deciphering the trend of the overall market.

At the time of last July’s column, the Dow Jones utilities average was in a steep downtrend, the mark-down phase, having fallen from a high of over 255 in September 1993 to a low of about 175 in June 1994. Technically, I highlighted the channels and pointed out 190 as being a significant resistance level.

Subsequent to the July article, the downtrend was broken and the utilities average began to advance. I’ll describe the change in trend and what it implied for the overall market.

But first, consider what it means to affect a change in trend. When I am asked what to look for in a change of trend, I always reply that investors should look for a trend that has been in a long decline, but is beginning to flatten out.

The concept of a trend beginning to “flatten out” after a long decline does not sound too technical, and it is not. But it is highly useful in identifying opportunities. This trend analysis is not applicable to all stocks, but by definition works quite well in spotlighting opportunities in low-priced and depressed stocks, as well as groups of stocks, such as the utilities.

So, technical analysis at this juncture is how to measure when a trend is beginning to flatten out and turn up. Since the best buying opportunities are when a trend is in the process of moving from distribution to accumulation, investors don’t want to wait too long to buy and, invariably, analysts do not turn bullish on these turnaround situations until the trend has long advanced from the lows. We’ll see if we can provide some insights to allow investors to get a jump on the crowd.

One bullish definition of a change in trend is a series of lower lows reversing into a series of higher highs, or a series of rising zigzags following a period of lower zigzags. A change in trend is also often thought of as breaking a trendline. Breaking a descending trendline, for instance, is considered bullish. However, these zigzag and trendline patterns develop due to interacting support and resistance levels.

For instance, throughout the February-May 1994 decline, the utilities just kept dropping through support levels. Support failure is obviously bearish. Each time a support level was broken, that level in turn would become resistance for the next advance. Support and resistance levels are just concentrations of trading associated with reversal areas. Whether one particular level of trading acts as support or resistance depends on which side the stock (or index) is trading.

Consider the 190 level. On the decline into early April last year, 190 acted as support. However, after the utilities broke under 190 in May during the decline to 175, 190 would then act as resistance. The 190 resistance level explains why and where the rally in late May and early June would top out at 189, it explains what shape the utilities “zigzag” takes, and it explains why and where the trendline is drawn.

In any case, through June the utilities average was acting in a perfectly orderly downtrend. However, in the decline following the June highs, support at 175 held. Hence, the trend began to change.

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During the following rally into July, the utilities advanced until it hit resistance as it approached 185. The resistance at 185, of course, was due to the immediately preceding late May-early June reversal level, where the utilities traded between 185 and 188 for about three weeks. After hesitating for a couple of weeks, the utilities moved up past that earlier resistance level to a new high. In doing so, the utilities had now traced out a bullish zigzag and had broken a down trendline. The advance would be short-lived, as the rally took the utilities right up to the 190 resistance level and a larger declining trendline. The utilities dropped back to 175 by September, where it would trade between support at 175 and resistance at 185 for four months.

Now, a valid question here would be: How do you know when such a zigzag advance will be the start of a sustained uptrend, and when it will be a dud?

Well, my experience is that when a stock, or a group of stocks like the utilities, has been down and depressed for an extensive time, the first rally off the lows will be more of a rebound from oversold conditions, and maybe some short covering, rather than the start of a sustained uptrend. Quite simply, the length of time a stock takes to “base” after a decline is directly correlated with the extent of the decline.

If a stock rebounds off the lows in a “v,” it is more likely the preceding decline was more intermediate in nature, and there are not that many investors hoping to “get out.” When the preceding decline has been extensive, and, therefore, more investors are holding issues at a loss, the bottoming out process will be more of a sideways drag as it takes more time to absorb resistance. As it was, the utilities would trade at support for the next three months. Mid-November would be the turning point.

During the week of November 21, the stock market was in a mini-panic. “Stocks Plunge 91.52 on Worries Over Rates” was the Section C lead headline in the November 23, 1994, Wall Street Journal. In the panic, the utilities average likewise edged lower, and closed slightly below 175, for three straight sessions. However, on November 23, the utilities reversed sharply and closed up 3.56 on the day to 177.50. Sellers had attempted to send the utilities lower, but there was a bullish reversal instead. In the days and weeks following that reversal, the utilities continued to edge higher, while the rest of the market moved lower.

One reason I had written the column last July on the utilities average was to relate how the utilities had operated in similar interest-rate tightening conditions in 1984, and to alert readers to look for similarities in 1994 as to how the overall market decline might end. And here it was: Déjà vu all over again.

Following the late November reversal, the utilities began to trace out the most bullish of patterns—the minor trend zigzag pattern, just like walking up a flight of stairs. When a sustainable trend begins, the accumulation phase typically is characterized with just a very quiet and orderly bullish minor trend pattern. In the process, the utilities had quietly broken above a long-term down trendline.

After the first of the year activity began to pick up, and the utilities began to gather momentum as analysts turned favorable. However, right when investors turned very bullish on the utilities, in late February, on positive interpretations of comments made by Federal Reserve Board Chairman Alan Greenspan, the resistance levels associated with April 1994 trading levels took the wind out of the utilities’ sails once again. The utilities declined to support at 185. Note that the top of the March trading range was 190.

In early April the utilities advanced smartly, but fell back at resistance at 195. Nonetheless, the advance did absorb considerable resistance at those levels, and the next move will set the tone for the market.

Conclusion

Time changes, but trend patterns remain the same.

A little knowledge of trends and their characteristics can significantly enhance the individual investor’s buy and sell decisions.


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