This is a special post from Jay Delaworth who is a trend following investor and founder of IntelligentTrendFollower.com
It’s finally happened! After a couple years of sideways action, near the end of 2016, the S&P-500 index broke out to new highs. And I think it might just be getting started. So in this blog post, I’m going to show you why a variety of fundamental and technical factors indicate 2017 could be a great year for trend following strategies.
Plus, by the time you’re done reading, you will know how to put all of this information into action for yourself!
To get started, let me show you that SPY chart:
And keep in mind, this breakout in the S&P-500 isn’t in isolation. The Dow Jones Industrial Average and tech-heavy Nasdaq index also finished the year at prices higher than where they started.
Perhaps most encouraging of all, the MSCI all-country world-index is also pushing higher for the first time in years. All of this bodes well for trend following strategies.
In fact, for trend following investors in the stock market, this breakout is a BIG relief.
That’s because trend followers have had it hard recently. While option traders and mean reversion traders can profit in a sideways market, it’s a money-losing strategy to keep buying breakout stocks that fail to launch.
On the other hand, when global markets are starting to trend higher, I become more confident in trend following strategies. When trying to look for the trend on the index charts above, one thing you should notice are the aligned and smoothly-upsloping moving averages. Even though these are lagging indicators, they confirm the markets are in an uptrend across a variety of timeframes.
And the reason this is so interesting is because research suggests, uptrends beget uptrends.That’s why I encourage you to keep reading to see how you might be able to profit from trend following trading and investing strategies in 2017.
Although 2017 is shaping up to be a great year for trend following the stock market, you might not know it due to the fevered political news coverage this year. And nothing scares traders away from their process like a fear-inducing news headline.
MSo while I admit these alarmist articles might drive page views, they’re of zero value to process-driven trend followers who stick to their system.
But the main reason I mention all of this is to support the bullish case for trend-following strategies. Because simply from a contrarian point of view, it’s hard to believe we’ll see an enormous market crash in 2017 if that’s what all the pundits are predicting. After all, everybody can’t be right, right?
For that reason alone, it’s hard to foresee a market meltdown. Because based on the fear in the air, you’d think everyone is waiting in cash for the chance to jump-in at the first sign of a pullback.
In today’s case though, I also think the trends in the underlying economy have also been better than most care to admit. This positive economic momentum might not sell newspapers as well as fear-driven news stories, but it does further bolster the bull case for the year ahead. But you don’t have to take my word for it.
Getting a read on the economy isn’t always easy. But understanding this business backdrop can provide valuable context for investors and traders trying to stick to their system. The day-to-day fluctuations are much more manageable when you have a sense of the bigger picture. Plus, if you know where to look, it’s actually pretty straightforward.
Personally, in order to avoid being pulled off course by flippant bearish claims, there are a couple data sources I consult regularly. I’ll share them here because you might find them helpful as well. And as you’ll see, not only are stock prices trending up, but the economy seems to be as well.
So the first place I like to look for balanced economic updates is the Fat Pitch Blog. Their weekly recaps of economic data present an unbiased look at the most popular numbers, and how they’ve been trending over the last few years. This valuable context alone is enough to put most of your Zerohedge-induced fears to rest and help you better stick to your process.
Another great source I like to lean-on is the periodic commentary from “Davidson” via ValuePlays.net. He often references a unique metric called the chemical activity barometer, which provides compelling insights into economic activity I don’t see quoted elsewhere.
Here’s a recent graph (source):
To supplement this view, I also review the weekly updates from Jeff Miller at DashofInsight.com. He provides a fact-based analysis with updated recession forecasts each weekend. And in case you’re curious, he’s currently giving the green light to equity bulls.
Finally, I do my best to tune out the noise by reminding myself to focus on trendlines and not headlines. I encourage you to consult the sources above, as well as looking at the primary data yourself. The St. Louis Fed FRED database has a ton of great information that’s available free. For instance, instead of worrying how the economy is doing, you can start looking up numbers like retail sales. Here’s the graph:
I hope you can see the trend, for now at least, seems to be higher. Now this is but one example. So if you’re still unsure about how current economic activity aligns with your investing or trading outlook, I strongly encourage you to dig deeper and consult the trends in these types of data sources.
By no means is this data a cure-all for market uncertainty. But it provides objectivity and contrast to the doom and gloom headlines we see daily. This approach helps me stick to my trading process and capitalize when market conditions are in my favour. It might also do the same for you.
So I hope you can start to see why, from both a fundamental and technical point of view, I am bullish on trend following in 2017. Let me tell you a little more about how I’m planning to profit from it, and how you can too.
As the name suggests, trend following is pretty self-explanatory. The idea is to look for price trends, and then invest alongside them. So just as you saw the trends in the economic data above, so it is for stocks, ETFs and other asset class prices.
One of the simplest trend following strategies is based on the 200-day moving average. Paul Tudor Jones put it this way, (source):
“You always want to be with whatever the predominant trend is. My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.”
Now, while the 200-day simple moving average strategy is an easy one to get started with, I like to take it a step further.
Specifically, I spend most of my time using weekly charts looking back 3-5 years. And the main thing I like to try and find is a series of smoothly aligned and upsloping 25-week, 50-week and 200-week moving averages.
Let me show you what I mean:
As you can see, when all of the moving averages are aligned like this, the stock is definitively in an uptrend! This presents opportunity. See how the stock is trending across multiple time frames (as indicated by the different moving-average-lookback-windows)?
Great. So with this simple definition of trend following in mind, let’s look at how we could use this framework to find Trading and investing ideas in the stock market.
I hope you’re starting to understand how trend following works, and why 2017 is shaping up to be a good year for it. But to help you take this a step further, I’d like to show you where I find potential trend following stock picks. The good news is, it’s quite easy.
First, my favourite place to go looking for stock picks like this is FinViz.com. I really like their screener, and the ability to display results in charts is super convenient.
Now, once you’re at the FinViz screener, the easiest way to find strong stocks is to look at the new 52-week high list. By definition, if shares of a company are hitting new highs, there’s a good chance we have an uptrend on our hands
While this is a good starting point, we can whittle it down a little further to help us find the stocks in the strongest uptrends. How do we do that?
Well, it’s actually quite easy. Back on FinViz, you can easily update your technical stock screen to ensure that all the moving averages are firmly aligned and sloping up. To do this, just make the adjustments shown below to the moving average fields on your screen.
Now, we have some potential stock picka. Feel free to add any of your own preferred technical criteria as well, to further refine this list.
Then, once you’re happy with your shortlist of stocks in an uptrend, you can start looking at those trend following ideas that align with your other investment criteria (depending on your individual goals).
Now although this simple strategy is a good starting point, we can go one step further to tilt the odds in our favour even more. You’ll just need to head back to FinViz.
In the world of stock trading, you can get great results using technical analysis alone. But why stop there?
With so many great trading tools and resources available for free online, it’s easy to augment your opportunity set with some fundamental data. And conveniently enough, FinViz is a free one-stop shop that lets us do this.
To help you see for yourself, let’s walk through another example. Going back to the prior screen, we can use our prior short list and add a few more filters.
For me, I like to work with profitable companies without too much debt. In my experience, this helps isolate stocks that really have room to run.
Here’s how I’d update my FinViz screen to accommodate this: first just flip to the “fundamental” tab and then make the updates shown below.
Now with these adjustments, not only have we tried to find the best companies with uptrending stocks, but it’s also eliminated some risk of permanent capital loss. That’s because by focusing on profitable companies, we can usually avoid being diluted by additional debt or equity offerings.
Personally, I hate waking up to a press release announcing new capital raises. So by trying to find companies that are able to finance their growth with operating cash flow, we can reduce this risk. While no system is perfect, this is a step in the right direction.
That said, there are a few more important things we can do to help reduce risk.
Just like dessert, I like to leave the best for last. And in my opinion, risk management is the most important part of any trading strategy. Trend following is no exception. So what does this downside protection look like?
Well, the main thing is to decide how much you’re willing to lose. Assuming your trade idea goes 100% wrong (which WILL happen at some point), how will you deal with it? Plan for when to sell your stocks. With trend following in particular, you can expect to have many small losses and a few big winners that will more than pay for your losses. This is why modest position sizes are so important.
For stock traders, I recommend using a volatility-based stop loss that uses average true range to inform where you should exit your position. I’ve previously written in-depth about the topic of when to sell your stocks. So you may want to study up, if this is unfamiliar territory for you.
In every case, we can summarize risk management best practice as:
For me, this defined downside and clear contingency plans not only protects my capital. But it also helps me sleep at night (even when I’m fully invested).
The truth is, anything can happen in the markets. So it pays to be prepared. And while I know I came out with a strong forecast for 2017, nobody can predict the future. That’s why you need a clear risk management plan.
So whether you are a trend follower or not, with your bottom-line protected you can feel much safer swinging for the fences in 2017. Good luck this year!
By the way, if you are still hungry for more information on how to find breakout trend-following stocks, I’ve put together a detailed post. You may want to check it out because it has even more free stock screens for finding breakouts.