Market Outlook: Chart Shows a Rare Bullish Trade Setup

U.S. stocks were little changed after a volatile week.

January Indicator Indicates 50/50 Chance of Gains in 2014

SPDR S&P 500 (NYSE: SPY) fell 0.4% last week and was down 3.52% for the month. SPDR Dow Jones Industrial Average (NYSE: DIA) was down 5.2% for the month.

According to a popular interpretation of the January Indicator, this makes the widely followed market forecasting tool bearish for 2014. But history doesn't support this interpretation of the indicator. In the past, a negative performance for the Dow in January has occurred 22 times since 1950, and a down month had been followed by declines in the rest of the year 50% of the time.

Big losses in January are less common. This is the eighth time the Dow has fallen more than 5% in the first month of the year, and the market showed a gain in the rest of the year five of the previous seven times. The average of a small sample is not statistically significant, but the average gain in the seven years has been 6.5%. Based on the size of January's loss, we can say the January Indicator is bullish. The fact that there was a loss in January makes the indicator bearish. Based on history, both bulls and bears can argue the January Indicator favors their argument.

In the short term, SPY is oversold. The daily chart below shows the 5-day moving average (MA) fell more than 5% below the 10-day MA while SPY is a long-term uptrend. Prices tend to rebound when this trade setup occurs.

SPY Market Outlook Chart

Because this setup is rare, I back-tested it on a basket of 35 ETFs in order to obtain a statistically significant number of trades. This is a standard group of ETFs I use in testing and is not adapted to different tests to obtain results that I like.

This trade setup delivered a profit 74.9% of the time. The average gain was 3.99% with an average holding period of less than three days. Trades were closed when the price moved above the 5-day MA.

Using a different exit, closing the trade when the 2-period Relative Strength Index (RSI) moves above 70 increases the win rate to 79.3% and the average gain to 4.68%. The average holding period increases to 3.7 days.

Earnings continue to be positive for the broad market. Companies that miss estimates are selling off sharply, but so far, 68% of the 250 members of the S&P 500 that have reported results for the fourth quarter have beaten estimates. The beat rate is the percentage of companies that have reported results that beat analysts' expectations. On average, about two-thirds of companies beat earnings estimates every quarter. This week, another 100 S&P 500 companies are scheduled to report earnings.

There are a number of reasons to expect a short-term up move in stocks for traders willing to ignore the January Indicator.

Market Outlook News

Note: What the chance to significantly beat the market in 2014? I'm offering limited access to my new proprietary trading strategy. The annual compounded growth rate for this simple strategy was 20.1%, compared with just 8.5% for the S&P 500. That's 136% better. Learn more by clicking here.

Traders have very few tools to evaluate volatility on individual securities. This one offers clear and timely signals.

When combined with moving averages, this momentum indicator can provide timely signals on very short-term charts, making this tool a favorite of day traders.

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