|The financial market sector is one of the leading market sectors of the stock market. When the financial sector trends higher, the rest of the market usually follows, and when it turns lower, so does the overall stock market. By analyzing the trend of the financial market, we can determine the trend of the overall market. Recently, I wrote two articles using the momentum indicator to determine both the trend and momentum of a security or index, "Momentum Indicator Measures Trend" (published June 29) and "Momentum Indicator Measures Momentum" (July 7). This article serves as an example of the methods used in these two articles to determine the trend and momentum of the financial market sector.|
|Figure 1 shows the price chart of the Financial Select SPDR exchange traded fund (ETF) (XLF) in the bottom pane. Above the price chart are three momentum indicators in three different time frames. The 200-day rate of change (ROC) indicator measures the long-term trend and momentum, the 50-day ROC indicator measures the intermediate-term trend and momentum, and the 20-day ROC indicator measures the short-term trend and momentum.|
|FIGURE 1: XLF, DAILY. This chart shows the rate of change momentum indicator in three time periods. The 200-day ROC represents the long-term trend, the 50-day ROC the intermediate-term trend, and the 20-day ROC represents the short-term trend.|
|Graphic provided by: MetaStock.|
|Looking at the 200-day ROC indicator, note that it first broke down below its zero line on June 9. The last time this indicator broke down below its zero line was three years ago on July 27, 2007. The breakdown below the zero line of the 200-day ROC serves as a long-term trend reversal signal. A move below the zero line signals that price is lower than it was 200 days ago. When price is lower than it has been, it is an indication that price is in a downtrend. Thus, with the price of XLF now lower than it was 200 days ago, it is a signal that price entered into a long-term downtrend in June. |
Price continues to make lower high peaks and lower low valleys, indicating that the ROC line continues to move lower, signaling that the momentum of price continues to accelerate in the downward direction. As a result, the long-term trend of XLF remains in a healthy downtrend (that is, a trend identified by the market trending in a certain direction with price continuing to accelerate in that direction). Since the first move below its zero line, the 200-day ROC indicator has moved back and forth around the zero line, creating whipsaw signals whether the long-term trend is up or down.
To minimize these whipsaws, a filter is used. The filter I use is as follows: As long as the market continues to make lower highs and lower lows after having first moved below the zero line of the 200-day ROC, the market remains in a downtrend until proven otherwise.
|Looking at the 50-day ROC indicator, note that it first broke down below its zero line on May 18. A move below the zero line of the ROC signals that price is lower than it was 50 days ago, indicating that XLF has entered into an intermediate-term downtrend. After breaking down below its zero line, the ROC continued to make lower highs and lower lows until early July, signaling that the momentum of the intermediate-term downtrend was accelerating during this period in a healthy downtrend.|
However, in early July the ROC broke out above its downtrend and formed a higher high, putting an end to the downtrend of accelerating prices. This does not end the intermediate-term downward price trend itself but only the trend of downward accelerating prices. The price trend can continue, even though price is no longer accelerating.
To reiterate, while still in an intermediate-term downward price trend, the breaking of the downtrend indicates that price is no longer accelerating in the downward direction and has started a period of deceleration or a slowing-down of the downward price trend. The deceleration of a price trend normally occurs before the trend actually reverses direction. This deceleration period serves as an early warning of a possible future intermediate-term trend reversal.
|Looking at the 20-day ROC indicator, note that it broke out above its zero line on June 18, indicating that price is now higher than it was 20 days ago, signaling the beginning of a short-term uptrend. Since then, price has moved back and forth above and below the zero line, creating whipsaw signals as to whether the short-term trend is up or down. By using the filter mentioned, these whipsaw signals are minimized. As long as price continues to make higher highs and higher lows, the uptrend remains in play. However, since the beginning of the short-term uptrend, price has made a higher low but looks to be in the process of forming a lower high. This could indicate that the short-term uptrend is in trouble. While this may be an early warning that the uptrend is in trouble, price acceleration in the upward direction continues until the ROC makes a lower low.|
In conclusion, the long-term trend of the Financial Select SPDR ETF is in a healthy downtrend. The intermediate-term downtrend has entered into a period of price deceleration, which could eventually lead to a reversal in the intermediate-term downtrend. Since the long-term trend is in the downward direction, the period of price deceleration of the intermediate-term trend is identified as a market correction until proven otherwise.
The short-term trend, on the other hand, is in an uptrend. If this short-term uptrend continues to move higher, it will eventually reverse the intermediate-term downtrend, which could then ultimately reverse the long-term trend. However, while price continues to accelerate upward on a short-term basis, it does appear that the short-term uptrend could be in the process of turning back down. This example has served to show that by using a simple momentum indicator, it is possible to determine the trend of a security such as XLF and the price momentum of that trend.
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