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Monday, September 17, 2012 - 06:30
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Monday, September 17, 2012 - 10:03
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Monday, September 17, 2012 - 06:30

An Indicator With 82% Accuracy is Signaling a Possible Market Surprise

Monday, September 17, 2012 6:30 AM

Most technical indicators are designed to predict trend changes or confirm the direction of the trend. Standard indicators, like MACD or RSI, all tend to offer trading signals at the same time, and that is one of the reasons that trading is so difficult. It is not possible to use any of the well-known indicators with the same default parameters everyone else is using to beat the market. To outperform the market, you need to use tools that are not as widely followed.

My 26-week rate of change (ROC) system does that. I use a trend following strategy and try to identify the best ETFs to own at any given time. By best I mean the ones that are likely to go up the most. The ROC system also has risk indicators built into it that will move to a cash position during those times when there is nothing to buy, like we experienced in the 2008 bear market.

Before we get to the time when cash is the best investment to hold, we generally start seeing some warnings signs that a market decline is possible, and that is where we are now.

While reviewing the system results for this week, the amount of risk in the stock market seemed noteworthy. The strongest sectors in the market right now are the more defensive stocks, the kind that traders buy when they are looking for a decline. Telephone companies, drug stocks and utilities are near the top of the rankings. In a healthy bull market, we generally see technology stocks and other speculative sectors leading the way. Tech sectors are now in the bottom half of the 50 U.S. stock market sector ETFs that I monitor, and they have been falling sharply in the rankings during the past month.

After noticing this, I looked through some charts of ETFs and was very surprised to find relative strength (RS) buy signals in place for some inverse ETFs. RS shows how strong any individual stock or ETF is relative to the rest of the market. An RS rank of 70 indicates the ETF has outperformed 70% of the alternative investments during the past six months. It is possible to see a high RS rank even when an ETF is down if it losing less than the average stock or ETF over that time.

Using a simple strategy of buying when RS is above 70 would have delivered profits for traders who bought ProShares UltraShort S&P 500 (NYSE: SDS) at that time in every single year since SDS started trading. Short-term stock market declines have followed nine of the eleven trading signals (82%). This is a warning signal that the stock market might be setting up for a pullback.

SDS is just now signaling a buy. The chart shows how SDS has done a fairly good job delivering on its objective to move opposite to the S&P 500 index, shown in the chart above with SDPR S&P 500 (NYSE: SPY). Based solely on this chart, the odds favor a short-term pullback in the stock market. This is a trade for very short-term traders at this point, although it could also become a trade for long-term traders if a bear market does develop.

Aggressive traders should consider buying SDS as protection against a short-term decline.

Action to Take --> Buy SDS at the market price. Exit position after three weeks unless additional bearish signals develop.

Within the 26-week ROC system, there are no changes to the portfolio this week. The system continues to hold the following:

This article originally appeared on TradingAuthority.com:

Indicator With 82% Accuracy Signaling Possible Market Surprise

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.