There are two conditions that can signal a pending change in the trend of a market. They are as follows:
1. Bearish Divergence—PENDING MARKET TOP. This con- dition is signaled by price moving HIGHER, while momen- tum is moving LOWER.
2. Bullish Divergence—PENDING MARKET BOTTOM. This condition is signaled by price moving LOWER, while mo- mentum is moving HIGHER.
These conditions can be readily observed if you plot mo- mentum on a price chart. The time length for MOM we will use is 28 periods. This length was determined through my study and analysis of the markets. Take a few minutes to examine the illus- trations in Figures 7.3 and 7.4, which show the positive and neg- ative divergence conditions. By 28 periods I mean 28 days or 28 weeks. The long-term approach I am recommending in this book is based on weekly prices. Therefore, the momentum we will use is 28 weeks in length. In other words, the price at the end of this week subtracted from the ending price 28 weeks ago.
I want to stress a few points before going on. Let’s go back to the GIM. Remember that the GIM consists of five steps. Here is how these steps “work” in relation to the MOM timing method:
1. Historical pattern.The historical pattern that leads us to ex- pect a particular move in a stock is based on the theory and observed history of momentum and price (as explained in this chapter). The pattern is simple: A price higher with MOM lower is a negative pattern (i.e., a sell pattern);
a price lower with MOM higher is a positive pattern (i.e.,
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a buy pattern). The existence of a pattern does not lead to action; it merely leads to an expectation.
2. Expectation.We anticipate that a stock will go up or down based on the history of the pattern and its current configu- ration. An expectation is nothing more than an expectation.
It is NOT a call to action. If you act on an expectation, you are not following the method.
3. Confirmation. Confirmation in this case comes when the MOM indicator has given a signal to buy or sell as discussed in this chapter. The buy or sell confirmation is specific and 100 percent objective. There is no interpretation, no deliberation, no analysis, and no deep thinking. The switch is either on or off.
4. Action. Action is necessitated by confirmation.In this case, the action you take will be to buy or sell.
5. Management. Once you have taken action, you will follow through with effective management of risk in order to maximize your profits and minimize your losses.
Examples of Bearish (Down) and Bullish (Up) Divergence Figure 7.3 shows bullish divergence. You will note that as the price of this market moves lower, the momentum continues to move higher. To me this means that the market is being “accu- mulated” by traders who may either know or think they know something bullish. In any event, the rising momentum with the declining price SETS UP a possible low. Note that this configu- ration does not tell you to buy immediately. It only sets up a poten- tial low.
Figure 7.4 shows bearish divergence. Note that as the price of this market moves higher, the momentum continues to move lower. To me this means that the market is being sold by traders who may either know something bearish or think they know something bearish. In any event, the falling momentum with the rising price SETS UP a possible top. Note that this configu- ration does not tell you to sell immediately.It only sets up a potential top.
The bullish divergence preceded an explosive rally in this market. Take a few minutes to study the chart in Figure 7.3. It is a classic example of how a change in the direction of momen- tum precedes the start of a new bullish trend.
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FIGURE 7.3 Bullish Divergence. Note how momentum continued higher, while the price of the market continued lower into late January. As the price was moving lower, momentum was moving higher.
It is important to remember that the illustration in Figure 7.3 does not,in and of itself, tell us WHEN to buy. It only tells us that a change in the trend is likely. Sometimes the change will develop whereas on other occasions bullish divergence fails to develop into an actual signal to buy.
Let’s go back for a few minutes to our STF discussion. If you recall, I advised you to think of investments as having three parts, the Setup, the Trigger, and the Follow-Through. The process of finding stocks that have momentum divergence is the process of finding setups. The setup itself does nottrigger an in- vestment. Please read this carefully and understand it. It will make you money and, above all, SAVE you money and prevent you from making blunders!
FIGURE 7.4 Bearish Divergence. Note how momentum continued lower, while the price of the market continued higher. The stock dropped substantially after the bearish divergence pattern.
This is why we need to use another aspect of the MOM to ac- tually get us into specific stocks as investments. This topic will be discussed next. First, however, let’s take a look at how bearish di- vergence precedes market tops. See Figure 7.4.
Bearish divergence preceded a strong decline in this mar- ket. Take a few minutes to study this chart. It is a classic exam- ple of how a change in the direction of momentum precedes the start of a new bearish trend.
It is important to remember that the illustration in Figure 7.4 does not,in and of itself, tell us WHEN to sell. It only tells us that a change in the trend is likely. Sometimes the change will de- velop, whereas on other occasions bearish divergence will fail to develop into an actual signal to sell.
This is why we need to use another aspect of momentum to actually get us into the markets.