The Market Edge You’ve Been Looking For

By Adam O’Dell, CMT Chief Investment Strategist, Dent Research

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About the Author

As Chief Investment Strategist for Dent Research, Adam O’Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with minimum risk. He achieves this with his perfect blend of

technical and fundamental analysis.

Tactically, he does extensive back-testing and probability-based research, becoming the perfect complement to the exhaustive research that Harry and Rodney do in the exciting realm of the new science of investing.

Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential.

Aiming to find the best opportunities across all asset classes, Adam expanded into the commodities, equities and futures markets.

An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets.

He is editor of our hugely successful trading service, Cycle 9 Alert and portfolio manager for Boom & Bust.

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The Market Edge You’ve Been Looking For

By Adam O’Dell, CMTChief Investment Strategist, Dent Research

TO really beat the street, you need a system that gives you quantifiable and persistent edges in the market. It should be common sense and supported by data. Then, you need the discipline to follow it.

The first problem is that many systems out there, when considered on their own, only give you a very small edge in the market. The trick is to combine several different systems, which come from different perspectives, but can all work together. That’s what I’ve done with my Cycle 9 Alert system, and what I’m doing as I develop a new system for my Weekly Options Alert service.

And that’s what I’m going to show you today. It’s a combination of four strategies that will allow you to stack the odds in your favor. It looks like this:

Strategy # 1: Relative StrengthRelative strength allows you to assess the value of a security by measuring its price within the context of the

larger market. If I tell you that Tesla stock price is at $180 per share, that doesn’t mean anything, unless you

4-Factor Model

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know what the price of the market is. You need more information than that to make a good investment decision. Once you know what the price of a stock is compared to something else, you have something to work with… a small edge.

However, as I began by saying, using just one strategy can be very limiting. In this case, using relative strength in isolation has some disadvantages.

Firstly, relative strength is limited because it really only describes what happened in the past, and doesn’t necessarily give you a peek into the future. It’s descriptive, not predictive.

For example, if you look at the price of the S&P 500, you can observe that it’s been in an upward trend. You can be sure that the price has risen in the past, but you can only guess at whether that price will continue to rise.

The same thing goes if you take a ratio of two stocks to create a relative strength ratio. You can only say that the ratio has been rising in the past. Whether it will continue to rise is anyone’s guess.

The other drawback to relative strength is that it really only gives you a number. Here’s an example…

In this chart, I’m comparing a sector ETF with the S&P 500 (SPY). The black line represents an energy sector stock versus the S&P 500. The green line represents a technology sector stock versus the S&P 500. But here’s the thing: when I took this screenshot, they both had the exact same ratio. They both were trading at twice the value of the S&P 500.

Now if you didn’t look at this historical chart and I just told you the current values, it might be that the energy and technology sectors are twice SPY. But with that information, you really wouldn’t know which would be the better investment. To get a more informed idea, you’d need to look at that relative strength chart.

What you’d learn is that the energy sector (in black) is twice SPY, but it’s coming from a more elevated position. It had peaked a few weeks earlier and is now trending downward. On the other hand, the technology sector (in green) is trending upward.

In this situation, both of those sectors have a ratio of 2:1 to the market, but one of them is in a

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deteriorating trend while the other is in an improving trend. That’s more valuable information.

Only it’s subjective. You’d have to look at where the line started to figure out if this stock is on the rise or falling.

And looking at just the one chart would suffice either. You’d have to look at hundreds, maybe even thousands, of charts to make a truly educated investment.

Here’s another example…

This chart compares Tesla versus the S&P 500 (SPY) — in blue — and the consumer discretionary sector versus SPY, in red. In this instance, the scale is the same. And it seems obvious which investment has the greater potential and risk.

But here’s what it looks like when each comparison has a different scale…

This is the same chart as the previous one, only in this instance one is scaled to the left side, while the other is scaled to the right. Now that picture of which is the better investment isn’t so clear.

But there’s a way to overcome this limitation: kinetic energy and cycles.

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Strategy # 2: MomentumLook at this diagram showing kinetic energy.

As you can see, this is a diagram of a mountain biker going up and down a hill. As the biker goes up the hill, he’s putting work into the system. He’s using his legs to generate energy from his body to push the bike up the hill. When he reaches the top, he has potential energy. Once he starts down the hill, gravity begins to do its job and the biker benefits from the energy he’s put into the system

This basic physics concept applies not only to hills and bicycles, but to price behavior in the stock market as well. If a stock price is already moving in one direction, then it’s going to take a lot of energy and effort to change direction.

I’ll illustrate the point…

Kinetic Cycles

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In this diagram, the distance between the two red lines is the same as the distance between the two blue lines, but if you were riding your bike up this hill, you’d be moving much slower between the red lines than you would between the blue lines. That’s because, on the way up, you’re fighting against gravity while on the way down, gravity is working for you.

Relating this back to stock prices, watching the acceleration of stock prices, up or down, gives you yet another edge.

The momentum, or speed and movement of a stock, combined with its relative strength gives you some predictive power. Rather than simply saying the price is rising, we can say that the price is rising faster than the market. And thanks to the principles of kinetic energy, that allows us to accurately forecast that the rise may continue for a little longer.

Now we have a predictive measure in our system.

Let’s use Tesla as an example again. Using both relative-strength calculations and momentum you can gain yet another, larger advantage in the market.

Here’s a histogram of the energy sector, XLE, compared to the S&P 500. Now if the histogram is above the line, it indicates that the stock or the ETF is gaining upward momentum faster than the market. If it’s below the zero line, it’s underperforming in the market.

And here’s one of the consumer discretionary sector versus the S&P 500…

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Now look at Tesla’s histogram…

As you can see, Tesla is a little more volatile than both XLE and XLY. But it’s less volatile than say a Treasury bond fund like IEF…

All of this gives you more information to work with. But even when you combine relative strength and momentum, there are still limitations…

Besides having to perform complex calculations and study countless charts, there’s the problem that momentum has no guarantees.

If you like the idea of buying a stock that’s rising faster than the market is, you’re in a good position. But there’s no guarantee that the stock will always be rising faster than the market. The alternative scenarios on none too pleasing, as you can see for yourself…

XYZ indicates any stock. In the top box, the two green arrows indicate that XYZ is moving

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up faster than the market is moving up. That’s the ideal situation, and what you should be looking for.

But like I said, there’s no guarantee that such a scenario will play out forever. One way it could change is that is that stock XYZ continues to accelerate but the index starts to accelerate faster, as you can see in quadrant one. That’s still not a bad situation. You’re still long a stock that’s accelerating and you’re in a stock market that’s accelerating strongly.

Scenario two (as illustrated in quadrant two) is a little worse. You have a stock that’s still rising while the broad market has started to pull back. You can still find good, profitable trends if you’re long a stock in a falling market, but that will only last for so long. Usually a good stock will still catch the cold of the broad market.

Scenario three is worse still. In that instance, the stock is losing ground, but the market is losing ground faster. That’s usually when a trend that seems profitable at first quickly reverses and goes against you.

And finally, scenario four is when the stock begins to decelerate while the market is rising. This is an unfortunately and painful situation to be in.

Still, using relative strength and momentum together gives you a statistical edge in the market. Adding the third strategy gives you even more power…

Strategy # 3: Sector RotationIncorporating sector rotation into your strategy allows you confirm if any particular stock is in a favorable

or unfavorable sector. This allows you to, yet again, stack the odds more in your favor.

Here’s what the textbook business cycle looks like…

The idea here is that the stock market peaks before the economy, and the economy peaks before interest rates and inflation. The duration of this cycle is typically four to five years.

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If you narrow the focus to just the stock market, the sector rotation theory posits that, at different points in the business cycle, you want to be invested in different sectors. Some sectors do well at the end of the business cycle, while some do well at the bottom of the business cycle.

It looks like this…

According to this theory, the energy sector is always supposed to outperform at the end of a business cycle. But using this theory in isolation introduces its own limitations. That is, the reality doesn’t always comply with the theory.

The solution: combine more than one strategy to overcome such limitations they each bring to the table, and trade what you see. Rather than trying to determine which sector should be in favor, observe the market and follow the trends.

And add a fourth and final strategy to your arsenal…

Strategy # 4: SeasonalitySeasonality is the last piece of the puzzle. It’s

similar in concept to sector rotation, only it says that some sectors do better during certain times of the year.

Here’s an example…

Another example: Agricultural markets are moved by the weather patterns. Last year, we had a super cold winter, so all energy stocks and utility stocks were up big time because there was more demand for heating oil.

Here again, using seasonality in isolation diminishes your edge. That’s because there’s too much variability from one year to the next to make your trading decisions only on seasonality.

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But adding this strategy to the other three to create a larger system, you’ve created a significant edge in the market. And it’s a system I know works, because it’s the one created for Cycle 9 Alert.

The System in ActionIn October 2013, we expected a harsh winter and I accordingly recommended a few trades to my Cycle 9

Alert subscribers. At the time the energy sector was ranked number three on my Leaders and Laggards board. I ran seasonal studies and realized that we were coming into a period when energy stocks typically perform well.

Separately, I kept an eye on ratios and noticed that when I compared European stock indices to U.S. stock indices, the former were really gaining strength relative to the latter. I didn’t understand why, but I saw it happening.

One stock in particular stood out: Royal Dutch Shell. It was beating the S&P 500, it was in an up-trending market, and it is an energy stock.

Looking at the charts, I saw a consolidation pattern and that prices were going up. With momentum calculations I knew there was a good change the Royal’s stock prices would continue to go up.

So I recommended buying options on Shell. And it was a big win for us. Two months later we closed half the position for a 78% return. Just one month after that we closed the remaining half for a 198%.

Here’s another example…

In April 2014, the utility sector was ranked number one on my Leaders and Laggards board, just ahead of health care, and it was gaining strength better than the market. Utility stocks were coming into a seasonal period where they typical enjoy a tailwind— April is great for utility stocks.

In particular, Public Service Enterprise Group (PEG) — a utility company out in New Jersey — was gaining momentum relative to the market. Things were lining up.

So I recommended that my Cycle 9 Alert subscribers make a play on the trend my super strategy – combining relative strength, momentum, sector rotation and seasonality – was highlighting… and again we won big. Three months after placing the trade, we closed half of the position for a 78.26% gain. Seven days later, we close the remaining half for a gain of 30.43%.

Use this same four-pronged system, and you’ll easily beat the street in 2015.

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Publisher ..................................... Shannon SandsEditors .......................................... Harry Dent and Rodney JohnsonPortfolio Manager ................... Adam O’Dell

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