Making the trend your friend

If you’ve been in the stock market for more than a minute, I’m sure you’re familiar with the phrase “the trend is your friend.” What this means is that when the market rises, so do the majority of stocks, and when it sinks, stocks go down with it. There seems to be some debate about the exact definition of “majority.” The dictionary definition is anything more than 50%, but I’ve heard estimates that at least two-thirds of all stocks go with the market flow.

Being the naturally curious type, I thought I’d do my own test and see what would come up. I had an ulterior motive, though, and that was to see how the stocks that I picked in my daily *Blue Plate Specials* would measure up—would they fare better or worse than the overall market?

The set-up
Time Frame:
I decided to look at the market rally between 12/18/09 – 1/11/10 in which the S&P 500 gained just over 4%. So as not to compare apples to oranges, I choose the 1/20/10 – 1/22/10 decline for my bear market analysis. Sure, it lasted only a few days, but when markets fall, they tend to fall fast and furiously. During this time the S&P lost 4%, an amount comparable to its recent gain.

Stock Selection:
Using my *Blue Plate Specials* list from 12/18/09 and from 1/20/10, I selected all of the stocks from the “Breaking out to new highs” list for my bullish candidates and used all those from the “New Lows” and “Breaking Down” lists for my bearish candidates. (The exact stocks are listed at the bottom.) The bullish candidates were all bought at the closing price of the day while the bearish candidates were all shorted at the closing price. No margin, commissions, or fees were used (although you need to have a margin account to short stocks).

Results
The bullish portfolio was closed out at the end of the day on 1/11/10, and the bearish one was closed out on 1/22/10. I’m not claiming that this is a highly rigorous study, but you can see from the tables below that even this ad hoc test does show a significant correlation between the market and stocks.

Bull Market Stats Table 2-11-10
Bear market stats table 2-11-10

It’s interesting that the percentage of winners in both markets is roughly equal (85% vs 88%). The percentages here might be higher than are typically reported because of the fact that these stocks are specifically selected to outperform their peers. For example, stocks breaking out to new highs on greater than normal volume show a strong tendency to keep climbing as long as the market rallies. The table shows these stocks beating the market 5.7% to 4.1%, a significant difference in only a few weeks. Similarly, stocks breaking down as well as those hitting new lows tend to underperform their peers during market declines.

The tables also show that it’s no picnic being long in a down market but it’s even worse to be short in a rising one. Noteworthy, too, is the fact that stop/losses wouldn’t have helped you except if you were caught short in a bull market.

Summary
The take-aways from this little test are two-fold. The first is that the trend is indeed your friend. The second is that you can potentially increase your total returns by judiciously selecting your stocks according to the prevailing market climate and being quick to exit when the wind changes.  Isn’t that exactly what trading (not investing) is all about?

Stocks used to generate the table stats:
1: ACAT, AHC, AIRV, AME, ARE, CAVM, CSKI, EPE, HVT, ITWO, LGCY, LPL, LPSN, NFBK, NOG, NPO, OCNW, ORCL, PODD, PRM, RBCN, RDWR, RDY, SBUX, SENO, SMOD, SNDK

2: AGU, BBY, BEC, BT, CTCM, EM, NCTY, PTR, PTRY, SUSS, TUP, WLBC

3: ALD, APL, CBRL, COF, COV, CPTS, IIT, LHO, MTB, PFCB, PNC, PONE, SLA, TMRK, VSH, YUII

4: ANV, CAJ, CDE, CRIC, IDI, SUPX, TNDM, TOWN

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