Most investors have little trouble riding a bull market, and those with some experience can typically navigate their way around a bear market. But what about those instances (like now!) when the market outlook is murky and the trend of the major averages is choppy or directionless?
Obviously, such market environments make it extremely difficult to get a “read” on which way stocks are likely to move next. That’s why it’s critical for investors to have a discipline, or system, to help in making the right investment choices in uncertain markets.
Thankfully, there are a number of proven systems that can aid you in avoiding the pitfalls that attend directionless or trading range-type markets. One of them is the time-tested Cabot Momentum System that was developed decades ago by Cabot’s founder, Carlton Lutts. Like virtually all systems that actually work, it’s based on the tried-and-true principle, “Keep it Simple!”
This system was designed to answer the question, “When is it time to buy a stock?” It’s based on some basic observations, including a stock’s relative performance to the S&P 500, the use of key trend lines (i.e., moving averages) to determine the market’s strength/weakness, market sentiment (i.e., investor psychology) and the market’s internal condition as measured by the new 52-week highs and lows.
Of these principles, there are three that are particularly useful for determining whether it’s safe to “go fishing” and commit to buying stocks in general. The first is the Cabot rule regarding trend lines. There are three trend lines we most often use here at Cabot, as advocated by Lutts. The first one, which is referred to as the Cabot Trend Line, is a 35-week moving average.
This is a decidedly easy rule to use and involves the use of just a single trend line. The rule is that as long as the major indexes (including the S&P 500, the Dow 30 Industrials, the NYSE Composite and the Nasdaq Composite) are above the 35-week moving average, the market is considered to be favorable for buying and holding equities from a longer-term perspective (provided, of course, you have done your homework and bought stocks that are fundamentally sound).
By using this principle, you can never be on the wrong side of the market’s long-term trend for very long, Lutts noted. “And once the new trend forces us into the correct side of the market,” he said, “the probabilities favor a continuation of the new market trend.”
The second set of trend lines Lutts advocated are the 25-day and 50-day moving averages, which he called the Cabot Tides indicators. Collectively, these two averages are especially useful for determining the equity market’s intermediate-term trend.
The best way to apply the Cabot Tides is to look at a number of widely used broad market indexes like the ones mentioned above. If most of these indexes are standing above the lower of these two moving averages, and the lower moving average itself is advancing, then it can be assumed the market’s intermediate-term trend is bullish. Otherwise, it’s safe to assume the intermediate-term trend is down. (Note: violations of both the 25-day and 50-day moving averages should be considered as especially valid for a trend change when it occurs on a weekly closing basis.)
While using this approach is not without cost in terms of opportunity lost in the first couple of weeks of an advance, it’s a small price to pay for getting into stocks when a bull market becomes established (in lieu of trying to “catch a falling knife” in an uncertain market)—and getting out of them quickly when the trend reverses. Or as Lutts put it, “Probably the most important advantage of using this moving average approach in timing the market is that you are guaranteed to catch every intermediate market advance while avoiding every intermediate market decline.”
An ancillary indicator to complement the Cabot Tides trend lines—and one used by many Cabot analysts over the years—is the Two-Second Indicator. This involves nothing more than a simple glance each day at the number of NYSE stocks making new 52-week lows. When that number exceeds 40 for several days running, it’s normally a sign that internal selling pressure in some segment(s) of the market is increasing—and could spill over into the broader market. For that reason, when the new lows are consistently above 40, it’s usually a safe bet to avoid taking on too many new commitments.
By regularly looking at all three Cabot indicators discussed here, investors can increase their odds of staying on the correct side of a market trend most, if not all, of the time. The most important takeaway from the Cabot trend-following approach—or any stock market system for that matter—is to stick with the discipline at all times. Otherwise, you risk being swayed by judgments that could be clouded by the emotions of an uncertain market.