Using a weight-of-evidence approach is valuable for making quality decisions on desired or current investment positions. As technicians, we have a wide variety of tools at our disposal to anticipate potential rough spots, corrections, or buying opportunities. But that is all they are – tools of warning or anticipation. They give us an edge in identifying when and where to take on risk with limited downside. Finding asymmetric risk/reward opportunities is the epitome of what we do at 360 Investment Research. We don’t care about being right. We only care about being on the right side of the trade.
Over the past 5 posts, we’ve identified some warning signs for the overall U.S. equity markets. All of the posts carry weight as we analyze our long exposure to U.S. stocks. But none is more important than what we write about today – price. Price is the most important evidence. It carries the most weight. We can have all the common and proprietary indicators in the world and they mean nothing without the confirmation of price. Below is a diagram so you can visualize what we’re saying.
As you can see, we like to look for evidence to support our investment decisions. The best piece of evidence is price. What is it doing? What’s its direction? If price is making higher highs and higher lows, the trend is up. If price is making lower highs and lower lows, the trend is down. By analyzing price itself, we can determine the general trend and the potential change thereof. Using the diagram above, which shows the current status of the market, we can see that price moving to the right side of the scale would cause it to tip dramatically to the right into a new and potentially strong downtrend. In the same light, if the evidence on the right shifted to the left side of the scale, the swiftness of the uptrend would increase. So at this point in time, we are watching price like a hawk. How do we do this in reality? Simple. Just look left. When we analyze price using charts, we find the current price and look left. See the daily price chart of the S&P 500 below. Notice that price has been steadily making higher highs and higher lows. It is a beautiful staircase upwards, hallmarking an uptrending market. The exceptions are back in early February (SPX made a lower low and tested the trendline from the 2007 top) and back in mid-October (SPX made a lower low and tested previous highs/lows near 1825). Each time, the market recovered by subsequently making new higher highs without recording a lower high. When we consider this most important piece of evidence, the scale is easily tipped towards an uptrending market. All the other evidence only provides perspective in the event price changes and makes lower lows and lower highs. All the other evidence indicates caution is warranted. But, that doesn’t mean we need to short or be out of the market. Right now, price is telling us to remain long this market. As for the future, we’ll let price dictate what we should do next.
Look for our series finale on game planning and risk management soon.