How to Use “Technical Indicators” to Correctly Forecast both the Long- and Short-term Direction of Stocks

david-frazierIn an article that I wrote on August 27, entitled How to Avoid the Big Market Downturns, I showed our readers how to use the readings on leading economic indicators to determine opportune times to get in and out of the stock market.

Although those indicators haven’t always correctly forecast the absolute peaks and bottoms in stocks, they’ve been very reliable over the past 45 years at forecasting major turning points in the U.S. stock market. That’s including the catastrophic drop in stocks that occurred from October 9, 2007 to March 9, 2009, the subsequent bull market that began on March 10, 2009, and the most-recent downturn that began on July 20 of this year.

In addition to those indicators, I’ve found over the past 25 years of investing, speculating and trading in stocks, that adhering to the readings on several “technical indicators” – on statistics that reveal the trading action in the stock market – can also be helpful in correctly forecasting both the long- and short-term direction of stocks.

So, let’s review a few of those indicators.

Let’s begin by taking a look at the New York Stock Exchange Cumulative Advance-Decline Line.

In the event you’re not familiar with that stock market indicator, the Cumulative Advance-Decline Line is constructed by computing the arithmetic difference between the number of NYSE-traded stocks that rise and the number that decline on any given day, plus the value of that difference on the preceding day. Any date can be used to determine the starting point for the Cumulative Advance-Decline Line.

As you can see from the chart below, stock prices in general, as measured by the S&P 500 Index, tend to trend lower (higher) for at least several months following peaks (bottoms) in the Cumulative Advance-Decline line.

For example, the S&P 500 Index fell by 57 percent from October 9, 2007 to March 9, 2009 after the NYSE Cumulative Advance-Decline peaked on June 4, 2007. And, the S&P 500 more than doubled from March 2009 to May 21 of this year after the Cumulative Advance-Decline Line bottomed on March 9, 2009.

In regard to the recent stock market downturn, the S&P 500 has fallen approximately 8% since the Cumulative Advance-Decline Line peaked at an all-time high of 2,131 on May 18 of this year.

Although that technical indicator has, historically, been a reliable indicator for the future direction of stocks, I never rely on only one indicator to determine when to get in and out of the stock market. Instead, I use a combination of several “technical indicators”, as well as numerous leading economic indicators, to make those decisions.

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One of the other technical indicators that I’ve used to forecast successfully the long-term direction of stocks is the Percentage of NYSE-traded Stocks that have closed above their respective 200-day Moving Averages. As you can see from the chart below, that stock market indicator forecast the big drop in the S&P 500 Index that began on September 7, 2000, as well as the 2007-2009 bear market and the most-recent stock market pullback, with that indicator giving sell signals on September 7, 2000, February 23, 2007 and April 23 of this year.

Although that indicator tends to be very volatile, it can be very useful in confirming (or disconfirming) the readings on other stock market indicators.

Another reliable technical indicator that professional and novice investors alike have used for more than a hundred years to correctly forecast the future direction of stocks is the Dow Jones Industrial Average vs. the Dow Jones Transportation Average. Historically, stock prices in general have trended higher (or lower) for at least several months following a divergence between those stock market indices.

For example, the S&P 500 Index fell by 43% from May 13, 1999 to October 9, 2002 after the Dow Industrials and Dow Transports began to move in an opposite direction on May 12, 1999, and by 56% from July 20, 2007 to March 9, 2009 after the direction of those stock market indices began to diverge on July 19, 2007. And, the S&P 500 has fallen by approximately 5% since the direction of the Dow Industrials and Dow Transports began to diverge on December 31, 2014.

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In regard to forecasting the very short-term direction of stocks, I often rely on certain price oscillators, such as the McClellan Oscillator. Those indicators compare the closing price of a given stock market index or individual security to its price range over a specified period of time.

During late-2010, I created my own oscillator, which I refer to as the “Frazier Overbought-Oversold Indicator”, to determine opportune times to trade in and out of stocks that meet my fundamental investment criteria. That short-term technical indicator can also be used to successfully trade exchange-traded funds (“ETFs”) composed of stocks that comprise the major stock market indices, such as S&P 500 Index; (see the chart below).

Until next time,

David Frazier

David Frazier is President and Chief Market Strategist of Frazier & Mayer Research, LLC, an independent investment research firm that offers customized research and analytical services to registered investment advisors, hedge funds and high net-worth individual investors. You can check out his latest insights at: