It’s Not About Calling the Top or the Bottom

As a technical analyst, I am often asked some version of these questions “Is this the top?” or “Is this bottom?” I always respond the same way, “I don’t know.” That is not a phrase that you often here. Many people think that analysts and investors always have an answer but the simple fact of the matter is, we don’t. 

I adhere to the trend following and momentum discipline when it comes to investing. Technical analysis is rooted in the concept that markets trend. Technical analysts look at various indicators to determine if a trend is beginning, continuing or ending. We are interested in identifying new trends as early as possible and positioning ourselves or our clients in the direction of that trend. 

The concept itself, trend following tells you that we are not even thinking about calling tops and bottoms In order to follow a trend, there has to be a trend to follow. This implies that we are not going to catch the top or the bottom in a repeatable way. Markets will almost always be moving higher when we become bullish and will almost always be moving lower when we change that bullish view. We are not even trying to call tops and bottoms, we are trying to identify the change in the trend as early as possible.

The better question is “Has the trend started to change?” To answer this question, there are data points that we can use to tell us if there is a high likelihood that the trend is changing.

The chart of the iShares Expanded Tech – Software Sector ETF provides a great example of spotting trend changes as early as possible. 

For the majority of 2019, we have been bullish on the software industry group. After bottoming in December 2018, the group staged a sharp reversal moving from an underperforming industry to an outperforming industry. This was the first datapoint to alert us that the weak trend may be reversing. We can clearly see that in December 2018, IGV went from having weak relative strength vs the SPY to having strong relative strength. 

We receive further proof that the trend was possibly changing when the Chaikin Power Gauge ETF Rating shifted from Neutral (yellow) to Bullish (green) in late December. The rating is a powerful combination of fundamental and technical attributes that point to an ETF’s potential to outperform or underperform the market. What’s interesting about the ETF rating is that it uses our 20-factor model to look inside the ETF, at the ratings for the individual holdings of the fund, to give us an indication if the fund is likely to lead or lag.

Next we can use moving averages to tell us if the trend is potentially changing. In the main section of the chart, we can see that IGV crossed above our long-term trend line (which is a moving average) and the line began to turn higher. This was another datapoint that told us that the trend was transitioning from bearish to bullish. 

The combination of these three data points told us that IGV was likely shifting to a bullish trend with the potential to outperform the market over the intermediate term. And that was the case until recently. Notice that we did not call the low in December but were still able to participate in a strong move to the upside.

Taking a holistic view of the chart more recently, the key data points point to the potential for the trend now shifting from bullish to bearish. Reading from the bottom up, we can see that the Power Gauge ETF rating has moved to a Neutral position, strike one. In early August, the fund began to underperform the SPY and continues to do so, strike two. Finally, IGV has moved below the long-term trend line, which itself has shifted from rising to flat, strike three. 

Finally, as a point of confirmation that IGV is likely to continue to underperform the broader market, we can look at the individual holdings within the fund. Here we can see that as of September 11th, there are 15 stocks in the fund which are rated Very Bullish or Bullish in our model and 39 which are rated Very Bearish or Bearish.

Was July 2019 the top in software? I don’t know! But the weight of the evidence certainly increases the odds that it was. Which in turn alters our bullish view on the space.

Spotting trend changes early is one of the keys to long-term success in the market. It helps investors enter the parts of the market that are likely to outperform in order to capture the majority of an advance. It also helps us exit those positions before we surrender our hard-earned gains.

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