Violent ups and downs in the stock market can make an investor feel like a surfer in choppy waters. When the market is up, investors want to hang on or get in even deeper. But when it drops, fear takes over and hordes of casual investors get out of the market.
Thankfully, there are general guidelines developed by studying the behavior of the stock market to help investors chart their way.
The first guideline to remember is “the trend is your friend.” In much the same way that a swimmer is wise to go with the tide, the investor must remember that the primary price trend will most likely reassert itself and smooth things out. One easy way for investors to define the direction of the market tide is by looking at the relation of the key market averages to their respective 200-day moving averages.
Currently, the three popular stock indices, the Dow Jones Industrial Average, the Standard and Poor’s 500 Index and the NASDAQ Composite Index are exhibiting rising 200-day moving averages, as in a bull market. “The trend is your friend” model tells investors to buy and remain in the stock market. Furthermore, this guideline says to remain bullish until key stock indices reverse direction.
When the moving averages of key market indices fall below and remain below declining 200-day moving averages, investors should get out of the market and consider U.S. Treasury Bills, high-grade money market funds or similar defensive investments.
<p>The second guideline reminds market players to invest in sympathy with Federal Reserve Bank policy. Historically, Fed tightening has been a reliable signal to start heading for dry ground. The recent Federal Reserve Discount Rate cut and the pumping of liquidity into financial systems are strongly bullish indications.
Two old Wall Street axioms are: “Don’t fight the tape,” and “don’t fight the Fed.” Both of them are currently charting a bullish course for the stock market.
One last thing — before entering either the water or the stock market — always remember, safety first. Just as the surfer should not enter the water without a life guard nearby, the investor should not be in choppy equity market without safety gear. In the stock market that safety device is typically a stop-loss order on each and all positions, usually about 10 percent away from the current price. That is, if the stock price drops 10 percent, there is an automatic order to sell the stock.
Dr. Henry Pruden, a professor at the Ageno School of Business at Golden Gate University, is a leading technical analyst with more than 20 years of active trading experience. He recently published “The Three Skills of Top Trading.” For more information, visit www.hankpruden.com.