Trend-Signals: Take Right Away or Wait for a Pullback? (Premium)

Trend Signals and High Beta ETFs

The list of ETFs with uptrend signals over the last three weeks reads line the who’s who of the high flyers. This list includes the Video Games eSports ETF (ESPO), the ARK Innovation ETF (ARKK), the Clean Energy ETF (QCLN) and the IPO ETF (IPO). The table below is a cut out from the ETF Ranking and Trend table with the “bars” column sorted.

Make no mistake about it, these ETFs have above average volatility and risk. Traders and investors looking for a balanced and diversified portfolio should keep in mind that these are also highly correlated for the most part and tend to move in the same direction. There is some diversification to be had from the underlying industry groups. For example, one does not need four clean energy ETFs, three gaming and esports ETFs or five ARK ETFs. One from each group will cover the bases.


Trend Signals: Act or Wait?

As noted in Thursday’s commentary, true trend-followers with a clear strategy and rules often buy overbought securities. This is because stocks and ETFs often become short-term overbought after a big move that triggers a bullish trend signal. Sometimes the move continues right away without a pullback. Other times there is a pullback that sometimes offers a lower risk entry. Timers preferring a pullback can use RSI or the Momentum Composite to identify oversold conditions. Let’s look at some recent trend signals and the subsequent pullbacks.  

The chart below shows the Software ETF (IGV) with StochClose triggering bullish on April 30th (green vertical line). Even though RSI was not above 70, IGV was up some 30% when this signal triggered and pretty overbought at the time. Nevertheless, timers waiting for a pullback would have waited until mid August for the first RSI dip below 50. There was another mild oversold condition in September. It was not until late October that the Momentum Composite hit oversold (-3) and RSI dipped into the 30-40 zone to become modestly oversold. This was a long wait and IGV was still 20% above its April 30th close in late October.

The next chart shows the Regional Bank ETF (KRE) with a short StochClose signal that resulted in a loss (September 2020) and a subsequent signal that led to a large gain (+50% from 21-Oct-2020 to 4-Aug-2021). KRE was up over 20% when StochClose turned bullish in October 2020 and RSI did not dip below 50 until late January. There were a few more dips into the 40-50 zone and the Momentum Composite did not become oversold until mid June. The Momentum Composite was very last to the party because uptrend was pretty much over by this point. There is no such thing as the perfect indicator.

RSI(14) appears to work better in a run away uptrend when traders are looking for short-term pullbacks. The Momentum Composite is not ideal for strong uptrends and works better in choppy uptrends or uptrends with deeper pullbacks. The next chart shows the Medical Devices ETF (IHI) with StochClose turning bullish on April 13th, 2020. The ETF stalled soon after this signal and there were several RSI dips into the oversold zone between June and January. The Momentum Composite did not become oversold until the price pullbacks widened in March and May (red lines). There were also some short-term bullish continuation patterns on the price chart, but I am not going to cover these here.

There are two options when StochClose triggers a bullish trend signal. First, trend-followers with a strategy and clear rules take the signal and add it to a diversified portfolio. Second, timers will take note of the signal and wait for a pullback. For timers, there are three methods to identify a pullback. First, RSI(14) can be used for short pullbacks within a strong uptrend. In general, RSI is mildly oversold in the 40-50 zone, modestly oversold in the 30-40 zone and seriously oversold when below 30. Third, the Momentum Composite can be used to identify deeper pullbacks within more volatile uptrends. Values at -3 or lower are deemed oversold. Third, short-term price patterns, such as flag and wedges, can be used to identify pullbacks.

The trick for timers is deciding if the trend is going to be strong with short pullbacks or more volatile with deeper pullbacks. Given the current market environment, I would favor the latter. We are in a bull market, but breadth is waning and there are plenty of stocks/ETFs in corrective mode the last four to six months. This suggests a more mixed market under the surface. The chart below shows the ARK Innovation ETF (ARKK) with StochClose triggering bullish in late August. RSI dipped into the 40-50 zone with Wednesdy’s pullback and already ARKK is mildly oversold.

Thanks for tuning in and have a great weekend!

-Arthur Hill, CMT
Choose a Strategy, Develop a Plan and Follow a Process

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