Warning: U.S. Stocks Could Be Headed Lower

Traders use a variety of techniques to time the markets. Successful traders usually rely on relatively simple strategies to deliver market-beating returns. Right now, the stock market is setting up for a short-term sell signal that is highly accurate for a short trade. A short trade is taken when you believe the market will decline and you sell stocks or an ETF that you do not own. You will eventually have to buy the stock or ETF in order to close out the short position, and if you buy at a lower price than you sold for you earn a profit on the trade. A short trade actually reverses the usual buy-sell order and sells first with the intent of buying later at a lower price.

Trading on the short side is difficult because the stock market has a long-term upward bias. The S&P 500 index has gone up 57% of the time on a weekly basis and about 60% of the time on a monthly basis since 1950. The average gains in up weeks or months are much larger than the average losses which explain why the index shows an annual average gain of 7.27% over that time. When dividends are considered, the average annual gain jumps to 10.92% -- traders who are short have to pay the dividends on their positions, another factor that works against short positions.

If you find a winning strategy on the long side, you usually can’t just “flip the rules” to create a short strategy. For example, buying the SPDR S&P 500 ETF (SPY) when it closes above the 10-month moving average is a very profitable buy signal. However, it is not profitable to go short on a close below the 10-month moving average.

While it is difficult to trade successfully on the short side, it is not impossible. One strategy that does work is surprisingly simple and that indicator is very close to a sell signal right now. In the past, it has been right 71%. This system uses the MACD indicator on the daily chart of SPY.

The Moving Average Convergence-Divergence (MACD) indictor is used to identify the direction of the trend in momentum. When the indicator is moving down, as it is now, prices usually follow. The chart of SPY shows that the next major move is more likely down than up because the price is below its 20-day moving average, MACD is below zero and the indicator should complete a bearish crossover if prices fall in the next trading day or two.

Signals based on MACD and whether price is above or below its moving average are both testable. In this case, a MACD sell signal occurs when the indicator (the green line) falls below its moving average (the red line in the chart) while MACD is below zero and the price is below its 20-day moving average. On its own, MACD signals are tradable and would deliver a very small profit. Trading short based only on a moving average is almost always unprofitable. When combined, the market conditions generate trading signals that are right more than 71% of the time and a trader would make money selling short after the signal and exiting the trade a week later. Short-term holding periods are best for short trades. The signal actually identifies profitable short trades about 60% of the time with holding periods of up to a month.

This indicator points very strongly towards at least short-term market weakness. Traders should be looking for a chance to profit from this and even those not wanting to accept the risks of going short SPY could use an inverse ETF like ProShares Short S&P500 (SH) to profit from a quick down move. Very aggressive traders could use ProShares UltraShort S&P500 (SDS), but this is a leveraged ETF and should never be held for more than a few days because of the way those funds are structured.