3 Reasons to Love and Hate Stock Market Trends
Written by David Fabian, November 20th, 2014
Nearly everyone in investing has heard the axiom: “the trend is your friend”. This popular rhyme is generally used to convey confidence in an investment theme, and underscore a historical penchant for price direction.
As a believer in trend following, I am drawn to moving averages and statistical evidence supporting my investment thesis. In my experience, these technical indicators can help serve as guideposts for making prudent investment decisions rather than ill-timed trades.
However, the reality of stock market trends is that they aren’t perfect. They are prone to error when too much emphasis is placed in perfect timing and can be unreliable during periods of extreme volatility.
By examining the pros and cons of trend following, we can be better prepared to capitalize on its strengths and avoid its weaknesses.
Reasons to Love Trends
1. Trends are persistent animals that often represent long-term periods of consistent price action. This can provide confidence in a particular segment of the market based on knowledge of past performance with the expectation that it will carry forward into the future. For example, an upward sloping trend line, such as the 200-day moving average on the SPDR S&P 500 ETF (SPY), tells you that this basket of large-cap stocks has been moving higher for a considerable period of time. This can be considered a positive sign of strength.
2. A stock or sector that isn’t showing a trend due to sideways or indecisive price action can be viewed as a warning sign. Avoiding areas of the market that aren’t showing relative strength (or weakness if you are shorting) can be helpful when examining new opportunities. Waiting for an more established trend to develop or breakout to occur may provide enhanced confidence in a successful outcome.
3. Trends can help you avoid major corrections and bear markets. By implementing a sell discipline using the long-term trends of the market, you can avoid seeing a big chunk of your money disappear like many investors experienced in 2008. Managing risk is one of the primary reasons for the adoption of a trend following approach as a trigger for exiting stocks, bonds, or commodities.
Reasons to Hate Trends
1. Trends aren’t perfect and can be frustrating. If the volatility in October 2014 taught us anything, it’s that the market can often ignore trends in the process of price discovery. That leads to sharp volatility and whipsaws that leave you in the dust if you sell near the bottom and then watch the market rise once again while you are hiding out in cash. There is always the risk when you sell an investment that it will continue on a different path than you had anticipated.
2. Trends won’t get you out at the top or in at the bottom. Moving averages and other technical trend following tools are based on a calculation of historical price metrics. That means they trail above or below the current market price and won’t provide useful for picking inflection points. Those that like to purchase or sell their investments after a sharp move won’t find solace in a trend following methodology.
3. Following the trends of the market requires time, tools, and discipline to implement successfully. You have to be aware of your holdings from a situational perspective and make portfolio decisions based on changes in the prevailing market environment. This can be prohibitive for investors that prefer a more passive or laid-back approach to their investing endeavors.
The Bottom Line
It doesn’t matter if you love or hate trend following. There is no perfect recipe for investing success, as there are strengths and weaknesses to every method. The point is to have a plan or strategy that you are comfortable with and understand its limitations when they arise. That way you implement it on a consistent basis and avoid big mistakes that can cost you money or opportunity along the way.
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