Using the KST in the Market Cycle Model

 

 

Before we adapt the KST to the market cycle model, it’s a good idea to take a look at the type of trend(s) you are monitoring.  Technical analysts recognize the fact that there are many different trends interacting simultaneously.  The three most common trends are represented in Figure 1.  They are the primary, intermediate, and short-term trends.  

 

 

Figure 1

 

 

The Primary Trend

 

The primary trend generally lasts between 1 to 2 years, and is the reflec­tion of investors' attitudes toward unfolding fundamentals in the business cycle.  The business cycle statistically lasts from beginning to end for approximately 3 to 6 years.  As a result, the rising and falling primary trends (bull and bear markets) within a complete cycle last, on average, for 1 to 2 years, although it is possible to experience trends that are much longer.  The 1- to 2-year timeframe should only be used as a rough guide so that most primary trends are included.  And since building up takes longer than tearing down, bull markets generally last longer than bear markets.

 

The primary trend is illustrated in Figure 1 by the thick green line.  In a perfect world, the primary uptrend (bull market) would be the same size as the primary downtrend (bear market).  In reality though, their magnitudes are different, and so are their timeframes.

 

The primary trend cycle can be applied to bonds, equities, and com­modities.  The cycle can work with currencies, but because currencies reflect investors' attitudes toward the interrelationship of two different economies, they don’t fit neatly into the business cycle approach, making analysis difficult.

 

The Intermediate Trend

 

A primary uptrend is interrupted by a series of reactions along the way.  These counter-cyclical trends that occur within the confines of a primary bull market are known as intermediate price movements, or the intermediate trend.  The intermediate trend lasts anywhere from 6 weeks to as long as 9 months, sometimes even longer, but rarely shorter.  Intermediate trend analysis is a useful tool in determining when the primary trend has run its course, therefore improving your trading success rate. 

 

Intermediate trends typically develop with the emergence of some kind of economic, monetary, or psychological factor, and create uncertainty in market participants about the prevailing primary trend is still being in force.

 

The Short-term Trend

 

Short-term trends typically last 3 to 4 weeks, but like the other trends, can vary in magnitude.  Shown in Figure 1 as a red dashed line, they interrupt the course of the intermediate cycle, just as the intermediate-term trend in­terrupts primary price movements.  Short-term trends are usually in­fluenced by random news events, so are far more difficult to identify than their intermediate, or primary counterparts.

 

Since long-term investors are mainly concerned with the direction of the primary trend, it is important for them to identify the maturity of the prevailing bull, or bear market.  However, long-term investors must also be aware of intermediate-­ and, to a lesser extent, short-term trends because an important step in market cycle anal­ysis is the understanding of the relationship between short­- and intermediate-term trends and how they affect the primary trend. 

 

Here’s a good example: If you decide the long-term trend has just reversed to the upside, it could pay to wait before committing capital because the short-term trend is overextended on the upside.  The eventual short-term correction offers you a timelier, and more profitable entry point.  Were you not aware of the short-term trends’ position, it could have proven very costly at the margin.

 

Finally, trading losses often develop because the trader is positioned in a counter cyclical (against the primary trend) position, where whipsaw breakouts typically occur. That's why short-term upside breakouts are far more likely to fail in a primary bear market than a primary bull market and vice versa.  For this reason it’s imperative that all market participants have a working knowledge of these three trends.  The amount and emphasis of knowledge will de­pend on their perspective, longer-term investment, or short-term trader.

 

The best entry point for trading/investing occurs when the primary trend is rising and both the intermediate­- and short-term trends are bot­toming out.  The opposite occur during a primary bear market, where the best exit/selling opportuni­ties occur when the intermediate-­ and short-term trends are peaking.  This is because oscillators are far more sensitive to oversold conditions in a bull market and vice versa.

 

It’s also important to know the state of maturity of the primary trend because a trade/investment made during the early to middle stages of a bull market are supported by the ris­ing primary trend.  This is not the case when you enter close to the end of the trend, and certainly is not the case during the ensuing bear market.

 

 

Chart 1

 

 

Combining the Three Trends with the KST

 

It would be the ideal situation to track the KST for monthly, weekly, and daily data on the same chart, but plotting constraints don’t always permit this.  However, you can simulate these three trends by using different time spans based on weekly data, shown for the Euro in Chart 1.  This arrangement allows you to identify both the direction and the maturity of the primary trend (shown at the bottom), as well as the interrelationship between the short- and the intermediate trends.  The green and red highlights indicate those periods when the long-term KST is above and below its 26-week EMA, respectively.  Notice that the short-term KST rarely moves to the oversold zone during the bullish environments and rarely to the overbought when the main trend is down.  Also how the short-term KST trades in a lower band during bear markets and a higher one when primary trend conditions, as flagged by the long-term KST, are positive. 

 

You can find vital clues from the action of the short- and intermediate series in conjunction with the price action.  For example, in late 2000, the long-term KST was still declining, but the high reading in the short-term series was more indicative of a bull, rather than a bear market characteristic.  This was a subtle tip-off that a new bull market was underway.  The short, and intermediate KSTs had also previously violated down trendlines, and the currency itself experienced a similar phenomenon.  This trend break was not enough to signal a trend reversal, but its violation suggested that downside momentum would dissipate enough to allow the long-term KST to reverse direction.

 

The KST arrangement displayed in Chart1 can be plotted at pring.com for any security included in the Yahoo database.

 

The KST and Relative Strength

 

The KST adapts well to relative strength relationships, and is especially useful when the long-term KST is applied to industry groups or individual stocks.  This is because linear up- and down trends are far less likely to develop during the rotational process around the business cycle than with absolute price data. 

 

For example, Chart 2 shows the NASDAQ/S&P Ratio.  The green highlights flag those periods when the long- and intermediate-term KSTs are above their EMAs and the price itself is above its 10-week EMA.  Please note that the average shown in the chart is a 26-week not a 10-week EMA.  Red highlights develop under the exact opposite set of conditions.  While there are a few whipsaws, it’s evident that this pro trend system captures a substantial part of the big up and down moves.

 

 

Chart 2