Last week, stocks sold off and the week ended with a popular indicator showing a "sell" signal.
To understand, let's look at a simple chart.
This is the kind of chart many market analysts ignore because it just seems too simple. The indicator at the bottom of the chart won't be enough to beat the market, but it does help reduce risk.
The indicator at the bottom of the chart is the popular MACD indicator. And as I just mentioned, it's on a "sell" signal right now.
In the past 10 years, owning the S&P 500 ETF (NYSE: SPY) only when MACD is on a "buy" signal would have delivered 83% of the gains of a buy-and-hold strategy. But it reduced risk by more than 10% since you would be out of the stock market for the largest declines. The chart shows it avoided most of the decline in the fourth quarter of last year.
The complete strategy is simple:
- Buy SPY when the MACD indicator on the weekly chart is on a "buy" signal.
- Sell SPY and hold cash when MACD is on a "sell" signal.
For those of you who are technically inclined, the MACD in the chart is found with the default values. The indicator is found by placing a nine-week moving average (MA) on the difference between the 12-week MA and the 26-week MA. I used exponential MAs in this chart.
You really could use this strategy. All it takes is looking at MACD once a week and acting on the signals. Now, I'm not recommending that you do that because this strategy doesn't beat the market in the long run. But it is worth thinking about these signals.
Signals like this can help determine whether investors should be aggressive or conservative. It is important to be aggressive in bull markets and conservative when the stock market is declining. Right now, the signal is advising caution. This confirms what we've seen in the market in the past few weeks.
Technicals, however, don't tell us everything about this market. Looking at that chart shows the overall price remains in an uptrend. Yes, prices pulled back last week, but an uptrend is a series of higher highs and higher lows. The S&P 500 remains in an uptrend based on that definition.
Last week's decline in the index was due to China's devaluation of its currency, the yuan. The next chart shows the currency's value.
The chart shows the number of yuan per dollar and last week it rose above 7 for the first time since 2007. In response to this, the United States designated China as a currency manipulator.
As investors, this news raises two questions. The first is derived from the chart. That question is what happened in the stock market in 2014 and at other times when the yuan was being devalued.
The next chart adds the S&P 500 to the chart of the yuan.
The S&P 500 Index, the blue line in the chart above, rose in the past when the yuan increased or decreased in value. It's almost as if the yuan has no impact on the S&P 500.
That leads to the second question about China's devaluation which is "does any of this matter?" That question is more difficult to answer.
This will sound glib, but currency fluctuations only matter when they matter. Currency moves have little impact on stocks most of the time. They only matter when investors are nervous and looking for a reason to justify their opinion.
Although my opinion on currency moves might sound glib, it really isn't. I believe that investor nervousness, or sentiment, is something we need to follow to understand what the reaction of the stock market is likely to be.
Sentiment Has Taken A Sharp Turn
Among the sentiment indicators I follow is a weekly survey by the American Association of Individual Investors. The most recent data shows a big shift in sentiment. In the most recent survey, the number of bulls dropped by almost 17% while the number of bears increased by 24%.
It seems as if a number of individual investors noticed that "sell" signal on MACD and other bearish indicators. This made them nervous.
All that nervousness resulted in a 41% shift in the number of bears. That is the tenth largest one-week shift in bearish sentiment since 1987 when the survey began.
The table below shows what happened after the other large shifts.
In the past, the S&P 500 gained an average of 4.4% in a month after the shift in sentiment. Bearish sentiment preceded gains 56% of the time. This is an indication that investors are as likely to buy as they are to sell right now.
Action To Take
In the coming week, I expect MACD to reverse as investors realize their concerns about China are overdone. Yes, there is a trade war. But stocks are still attractive compared to alternative investments and there are still trillions of dollars in cash on the sidelines. We saw that earlier when stocks rallied sharply after a pause in the trade war.
For now, I consider dips to be buying opportunities. And for my subscribers and I over at Income Trader, it means we should have plenty of chances to make high-income trades in the weeks ahead.