A Little-Known Indicator Nailed the May Sell-Off; What's It Saying Now?

Let's get one thing straight -- there is no perfect indicator, and no one indicator is always right. As traders, it is our job to be totally objective and trade what is in front of us -- with no biases. This is sometimes much easier said than done, but it is necessary for successful trading over the long-term.

If you've been following me this year, then you know that I was bullish to start the year, yet saw some cracks in the armor back in April. In fact, I wrote this bearish article within days of the April peak. Of course, I had no idea that was the peak, but I was doing my best to take a subjective look at the market. Then, by early June and after a 10% correction, I saw signs that we were bottoming. And by mid-June, I was looking forward to a surprise summer rally. It's nice when it works, but we are all only as good as our last trade. And eventually, we'll all be ridiculed by this cruel thing we call the stock market. Me, I'm staying bullish here.

I've talked a lot recently about all of the negativity that is still out there -- even after huge gains the past few years -- and why this is bullish from a longer-term contrarian point of view. Today, I want to take a purely technical look at a lesser known technical indicator, an indicator that actually nailed the huge sell-off in May.

Near the end of April, I looked at the average true range (ATR) and surmised it was warning of coming weakness. After one of the worst Mays in years, I think I was sold that this is one indicator I had better pay closer attention to.

You can read more about Welles Wilder's indicator here, but the quick summary is it has nothing to do with price trend. Instead, it focuses solely on price volatility. Below is my takeaway from late April (accompanied by a chart), before the May sell-off.

Take a look at the S&P 500 Index (SPX) going back to right before the May 2010 flash crash. On three occasions, the ATR began to turn higher, well ahead of some large sell-offs. In other words, this has been a warning of coming pain. Now look at the recent action over the past month. Once again, this indicator is turning higher. We've already seen some weakness in the SPX recently, but should the ATR continue to trend higher, it could suggest more selling is in the cards. This is one to watch.

Chart courtesy of StockCharts.com

So, what's it saying now you ask? To me, this is a nice picture. The bottom line is, you want to see a lower-trending ATR, coupled with higher prices. Currently we have both of these things happening, and as long as this is the case, I continue to think this supports higher prices.

Chart courtesy of StockCharts.com