V.6:5 (196-196): Trend detection by Arthur Merrill

Trend detection by Arthur Merrill

The trend of prices is itself an indicator of the future, since trends tend to continue. In a bull market, the major trend is upward. Since most stocks ride with the trend, it's a good idea to buy and hold stocks in a bull market. The reverse is true in a bear market.

But the movement in a bull or bear market certainly isn't a straight line. There are secondary reactions in bull markets when the intermediate trend is downward. There are rallies in bear markets when the intermediate trend is rising. Within these intermediate trends there are minor reversals, forming minor trends.

It pays to invest in the direction of a trend. But how do you determine this direction? Here are a few methods:

-The eyeball method: A glance at a chart can be revealing; the trend is sometimes obvious. As Yogi Berra put it, "You can observe a lot by watching." If the trend isn't obvious, one of the more objective methods is preferable.

-Filtered waves: This method is simple—minor reversals are ignored or filtered out. A trend is assumed to continue until an important reversal comes along. This is the method used in point-and-figure charts. Prices continue in a fixed direction until a reversal of a stated number of points occurs.

I prefer to use a percentage rather than a number of points. For example, my definition of a bull or bear market is any swing of more than 30% (Figure 1). All swings of less than 30% are ignored; what remains are bull and bear markets. This definition fits the financial histories quite well.