or “Why the first week of May was so bad in the Markets.”

Since last summer I’ve been successfully trading  a new momentum system.  5 of first 6 trades were profitable, trouncing the S&P 500 return – even from the bottom of last year’s bear market.  These trades can be seen (and followed) in the spreadsheet I keep at the bottom of my home page.  On April 22nd of this year the momentum system switched into IWN – the Russell 2000 Small Cap Value.  Over the next month (which included the fateful first week of May) IWN proceeded to fall straight down by 9%, before the momentum system switched into another ETF.

That’s the danger of momentum – it cuts both ways.  Or as they say, “The trend is your friend – except when it ends.”

Despite this unprofitable trade I am still well ahead of the market with my momentum trades, and I expect this will be a successful system for the future.  But the loss got me researching ways to determine when Momentum is slowing – which led me into the trend exhaustion studies of Tom Demark.

Tom Demark has served as a consultant to such high-powered hedge fund managers as George Soros, Paul Tudor Jones, and Steven A. Cohen.  The Demark indicators are sophisticated market-timing tools, designed specifically to anticipate trend reversals.  And unlike much of technical analysis, they are mechanical, with less debate on whether a buy/sell signal has been sent.  On this site I’ve devoted a lot of posts to Tom Demark where I am capturing as much as I can find of his work, along with my notes.

Two of Demark’s most popular public indicators are TD-Sequential and TD-Combo.  Both indicators include a ‘Setup’ phase, and a ‘Countdown’ phase.  Setups are the shortest in duration, lasting for exactly nine price bars when completed. For example, a buy Setup exists when there have been nine consecutive price bars in which each bar’s close is lower than the close four price bars earlier. When a price bar closes below that of four price bars previously a ‘1’ appears below the bar.  If the next price bar also closes below that of four bars earlier a ‘2’ appears and so on. If before price bar 9 is reached a price bar fails to  close below that of four bars previously then the Setup is abandoned and the numbers are automatically deleted. Once nine consecutive price bars have been completed the trader will be looking for a “perfected”  Setup; one that is now valid for trading. A buy Setup is perfected when the low of either price bar 8 or 9 (or one that follows) is less than the lows of both price bars 6 and 7. Perfected sell Setups look for a high of either price bar 8 or 9 (or one that follows) that is greater than the highs of both price bars 6 and 7.

The ‘Countdown’ occurs after a completed Setup.  A sell Countdown consists of 13 price bars whose close is higher than or equal to the high two price bars earlier.  Unlike the Setup, the Countdown doesn’t have to consist of consecutive days.  The Countdown is a bigger pattern than the Setup in that it can take months for a Countdown to form and often signifies a larger market move once the trend changes.  Like the Setup, the Countdown also has a “perfection” criteria.  For a sell Countdown this requires that the high of price bar 13 be greater than or equal to the close of price bar 8 (reverse is true for Buy Countdowns).  There is also ‘Perfection’ criteria for the Countdown, where high of bar 13 is above the high of bar 8 for Sells (13 low below 8 low for Buys).

The only difference between TD-Combo and TD-Sequential is where you begin the Countdown.  TD-Combo begins the Countdown on bar 1 of the Setup, whereas TD-Sequential begins the Countdown only after a completed Setup (no sooner than bar 9).

One pattern that is not often seen, but sends a powerful message, is the TD-Sequential 9-13-9.  This is a standard TD-Sequential signal which is then followed by a price flip and then another 9-bar Setup phase.

I am no expert on Demark, but I wanted to share a study I’ve done on IWN in the chart below.  If I had been looking at this chart on April 22nd, I would have known to avoid this fund -with extreme prejudice.  I could have saved myself an unprofitable trade, and conserved cash for the new top fund once the momentum system switched.

The End of the Trend
2 Years of the Russell 2000 Value Fund below.

That terrible first week of May was what’s known as a ‘Price Flip’, where the trend changes direction and closes below the close 4 bars earlier.  After such a long 1-year development of the TD-Sequential 9-13-9, in particular one that did not break thru resistance, it is not surprising that we had such a significant turn.

One could have used these systems to buy exactly at the March 2009 low, and sell at the April 2010 peak.  Maybe that’s why the likes of George Soros and Steven Cohen keep Demark on retainer!

The last 2 years of the S&P 500 and several other indices look similar to above.  This gives quite a bit of technical support to arguments a new leg of the bear market has begun.  Using other Demark tools such as his TD-Retracement and Range Projections, we can forecast where we can expect the next lows to be.

I plan on continuing to study Demark and apply his principles to my momentum portfolio, so I’ll have notice next time it is clear that the trend is at the end.