Why The Trend Is Your Friend

You likely have heard the old Wall Street adage "the trend is your friend". While this is commonly spouted, human nature overrides this wisdom at any and every turn. While it makes simple and logical sense to buy stocks that are going up (because they are making money), we instinctually fight that thinking as being too easy, or that its bound to come to an end at any moment. We have this remarkable tendency to want to bet against the prevailing trend. However for long-term trading success, this instinctual "feeling" is EXACTLY THE OPPOSITE of what separates the winners from the losers. Losers continuously fight the trend and continually get themselves out of position against a major market move. This thinking often comes as a result of some predetermined bias.

Unfortunately for our more ancestral investors trading on emotions and narratives, the data simply does not support the idea that human instincts prevail over market forces. A simple market filter can prove that the concept of trading with the trend outperforms.

Something I do every week is tally up the combined returns of the 90 SP500 Sector stocks and calculate the performance using a basic trend filter. Here is my process:

1. Group the 90 SP500 sector stocks by whether or not they are in an uptrend or downtrend. This is filtered using the 20 WMA.

2. Stocks trading Above the rising 20 WMA are allocated to one group and those trading below are set into another group.

3. The stocks trading Above the rising 20 WMA are in uptrends and the stocks trading below are either moving sideways or trending lower.

The findings of this process over time are impressive. Each week as the markets move, new names begin to trend higher and some turn and trend lower. Each week those stocks are adjusted based on their relative positioning to the 20 WMA. After continuing this process for several weeks you begin to see established trends gain momentum. The most telling thing from tracking this is how quickly the stocks trading Above the 20 WMA begin to outperform vs the stocks that are below the 20 WMA. As time progresses the outperformance continues to rise in favor of the uptrending stocks.

*I highly recommend you do this exercise on your own as it helps with your emotions significantly during times of poor performance. The visual of the long-term probability helps reinforce the concept that you are doing the right thing.

How Has the Trend Performed in 2014?

As of Thursday's horrendous market close these are the stats from the 90 Sector stocks trading Above the rising 20 WMA and stocks trading Below. 2014, YTD

Stocks Above rising 20 WMA (55/90) 

Total running returns  +8.30%

46 Winners/ 9 Losers

Biggest running win  +39.83%

Biggest running loss  -4.07%

Stocks Below 20 WMA (35/90)

Total running returns  -2.18%

6 Winners/ 29 Losers

Biggest running win  +2.39%

Biggest running loss  -9.56%

Observations

The difference in average return is tremendously higher for the stocks trading Above. +8.3% vs -2.18%, a difference of +10.5%

You can also see how successful those trades tend to be. Having an 84% current win rate is remarkable. While the current win rate of stocks Below the 20 WMA is just 17%. 

The ability to sustain large winning trades is the key to success. Largest current winner +39.83%, compared with the current largest loser at only -4.07%. This means the system cuts losing trades quickly for small losses and lets large winning trends run.

--This is a very simplistic way of looking at trend systems, but shows how a basic filtering method for trend can make a tremendous difference to your trading success. 

Based on these findings it should be obvious that no one would ever want to be buying a downtrending stock. The odds of success increase dramatically by waiting for the downtrending stocks to stop trading lower and reverse higher BEFORE making an entry. 

Trends tend to persist. When you catch a big trend early in its cycle you can make a lot of money. This works both with uptrending and downtrending stocks. You want to be Long the strength and Short or sidelined in the weakness.