The PMI Cyclical Trend Trading System

As dictated by our trading philosophy, our system is a form of long-term swing trading that seeks to ride the cyclical trends within secular bull and bear markets by holding both long and short positions in the S&P 500 index.

Trade Identification

At its core, our trading system is based upon statistical analysis. Our computer models identify market conditions that suggest a cyclical trend change is highly probable, and when an opportunity is found that exceeds a particular statistical threshold, we open a trade. In order to efficiently manage the identification of these likely inflection points, we have implemented a rule-based software program that analyzes market data and generates a Cyclical Trend Score (CTS). As with our Secular Trend Score (STS), CTS values range from -100 to 100, with the former representing the strongest possible sell signal and the latter representing a correspondingly strong buy. Potential CTS buy and sell signals are generated when the value either exceeds 65 or falls below -65.

Unlike the STS, an individual CTS buy or sell value does not necessarily constitute a confirmed buy or sell signal. When the CTS enters signal territory, a window is created that eventually closes when the CTS leaves signal territory. Once the signal window begins to form, a confirmed buy or sell signal is defined by both the type of trade and the type of secular trend environment. For example, in the case of a buy trade, a confirmed signal occurs if the S&P 500 is able to subsequently close above the highest closing price within the window after leaving signal territory. Below is an example of a confirmed buy signal that occurred during late 1974.

The CTS moved into buy territory on October 17 and then left on November 29, creating the buy signal window displayed in green on the chart above. A confirmed buy signal followed on January 27 when the S&P 500 index closed above the highest close that occurred within the signal window. Not all signal windows will produce confirmed buys or sells. For example, if the S&P 500 index had failed to move higher and had instead fallen to a new long-term low, this particular signal window would have been unconfirmed. Alternatively, if the index had moved down to a new long-term low while inside the window, the signal would have been invalid.

Risk Management

Proper risk management requires that every trade be protected, so all confirmed signals have accompanying stop loss levels. The confluence of market characteristics that the CTS searches for should nearly always result in a powerful move in the direction indicated, so whipsaws are very rare, enabling the use of a relatively close stop. Because our system only signals when it identifies highly probable inflection points in the cyclical trend, it does not signal very often. The objective is therefore quality over quantity and the system has only executed 30 trades over the past 70 years. However, the quality of those signals has been exceptional, as only four executed trades have resulted in the 5% stop loss being triggered. This is an incredibly low failure rate for any trading system and suggests that the CTS is very good at finding what it is looking for in terms of overall market characteristics. A detailed description of every signal generated by the system is provided in the historical performance area.

For both long and short trades, stop loss levels are set 5% away from the entry point. Further, if the current secular trend is moving in the opposite direction of the trade, the stop level is subsequently moved to the entry point once the trade shows a profit of 5%.

Taking Profits

Of course, finding an optimal entry point is only half of executing a successful trade. The system must also provide an optimal exit point. Since the CTS is very good at identifying highly probable inflection points in the cyclical trend, any confirmed signal in the opposite direction of an open trade will cause it to be closed. Additionally, if the current cyclical trade becomes extremely overextended, as defined by a price oscillator component of the CTS that measures overbought and oversold characteristics, all open trades will be closed as well, except in the case of a buy trade within a secular bull market.

The Rules

The trading system procedure is summarized by the following rules.

Long Trades

Opening the Trade

  1. All trades occur after a signal window has formed.
  2. A confirmed buy signal occurs when the S&P 500 index closes above the highest close within the preceding buy window.
  3. If the index moves to a new long-term low after leaving the buy window, the signal is unconfirmed.
  4. If the index moves to a new long-term low while in the buy window, the signal is invalid.

Risk Management

  1. A stop loss is set 5% below the entry point after a trade is executed.
  2. If the secular trend is bearish, the stop loss is moved up to the entry point after the trade shows a profit of 5%.

Closing the Trade

  1. If the secular trend is bullish, profitable trades are closed at the next confirmed sell signal.
  2. If the secular trend is bearish, profitable trades are closed at the next confirmed sell signal or when the CTS price oscillator overbought threshold is exceeded.

Short Trades

Opening the Trade

  1. All trades occur during developing double top formations.
  2. If the sell window forms at the start of the second half of the top formation, a confirmed sell signal occurs when the next short-term rally breaks below uptrend support.
  3. If the S&P 500 index closes over 5% above the previous long-term high after leaving the sell window, the signal is unconfirmed.
  4. If the second half of the double top does not form after leaving the sell window, the signal is invalid.
  5. If the sell window forms during the second downtrend of the top formation, a confirmed sell signal occurs immediately upon moving into sell territory.
  6. If the sell window forms after the index has already declined 10% or more from the previous long-term high during a secular bull market, the signal is invalid.
  7. If the sell window forms during a cyclical bull market that is less than 1.5 years old, the signal is invalid.

Risk Management

  1. A stop loss is set 5% above the entry point after a trade is executed.
  2. If the secular trend is bullish, the stop loss is moved down to the entry point after the trade shows a profit of 5%.

Closing the Trade

  1. Profitable trades are closed at the next confirmed buy signal or when the CTS price oscillator oversold threshold is exceeded.

There are many rules and conditions that must be followed and met in order to generate a confirmed signal, especially for short trades, but that is because the focus of the system is finding the ideal entry point. When in doubt, the system will not execute a trade. The environment has to be just right. This is by design and intended to provide protection. Given that the system has produced only three losing trades since 1940, we believe it has successfully fulfilled that mandate.

Subscriber Notification

All PMI subscribers are notified via e-mail when signal windows are forming, as well as when signals are either confirmed or invalidated.