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Markets move in cycles of varying lengths. Some indicators, like the Relative Strength Index (RSI), are based on that idea. RSI was designed by J. Welles Wilder for the commodity markets and some traders believe that commodities move in line with a 28-day cycle. In fact, some traders, including Wilder, believed that the phase of the moon had a large impact on commodity market prices. Default values for calculating RSI are set to 14 days, one-half of the cycle length or about one-half the length of a lunar month.
I'm not convinced that a lunar calendar can help anyone time trades, but the idea of cycle analysis does make sense. In particular, there is a business cycle where the economy alternates between contraction and expansion. This cycle varies in length but averages about four years.
Martin Pring recognized the importance of considering several cycles and developed an indicator he called Know Sure Thing (KST) to look at short-term, intermediate-term and long-term cycles. Pring wrote, "I've learned after all my years trading that nothing is a sure thing, but the indicator does offer a good charting rendition of the economic growth path that revolves around the business cycle."
KST shows a smoothed and weighted rate of change (ROC) over four different periods of time. It is calculated using weekly data and uses ROC for times as short as three weeks to as long as 104 weeks. Trade signals can be generated by adding a moving average (MA) to KST and using moving average crossovers to buy and sell. Pring recommended different MA lengths for each time frame.
An example of KST, using the default parameters, is shown in the chart of SPDR Gold Trust (NYSE: GLD) below.
GLD itself is trading near the 26-week MA and a break below that level would be bearish. By themselves, MA crossover strategies suffer from whipsaw trades, which are the frequent and small wins or losses that build up when the price is near the MA. These trades are the reasons confirmation indicators are often added to any MA strategy. KST is shown in the bottom half of the chart as the momentum indicator we can use with the 26-week MA.
Starting at the bottom of the chart, GLD has been bearish since the long-term (LT) KST fell below its MA in January last year. This is only the second LT KST short signal for GLD and both have been winners. Using gold futures to provide a longer history and more trading signals, we see the same pattern and shorting gold when LT KST is bearish would have been profitable over holding periods of one, two and three months.
Intermediate-term (IT) KST turned bearish more recently, in the last week of 2012. The short-term (ST) KST is also bearish. Individually, both of these indicators are profitable. When all three time frames agree, the market moves tend to be large. Unfortunately, the signals are rare.
The chart below highlights one example from the past: the stock market crash that occurred in the spring of 1962. LT KST was the last of the three to signal a sell and it came more than 9% below the top of the Dow Jones Industrial Average, but stock prices fell as much as 21.8% in the two months after the sell signal.
In addition to offering a sell signal in GLD, KST shows a similar bearish chart pattern for iShares Silver Trust (NYSE: SLV). Both GLD and SLV generally move in the same direction, and with many indicators pointing to a potential drop, now seems to be a good time to short the metals.
Action to take: Reduce holdings in GLD and SLV or consider short trades in the precious metals. In my weekly market outlook, I recommend buying PowerShares DB Gold Short ETN (NYSE: DGZ) to benefit from a drop in gold.
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