Monday, September 24, 2007

Four Important Conclusions From a Valuable Stock Market Indicator


Readers of the Trading Psychology Weblog and my daily Twitter comments know that one of the indicators I track most closely is the number of stocks on the NYSE, ASE, and NASDAQ making fresh 20-day highs and lows. Above we see daily data on the new highs minus new lows vs. the S&P 500 Index (SPY) from January, 2006 through this past Friday.

Four important conclusions stand out in this chart:

1) We Are In A Bull Market in Large Caps - I know, I know: housing is going to hell; hedge funds are facing redemptions; the dollar is tanking: there's no lack of reasons to be bearish. But the facts speak for themselves. The downward spikes in the new highs minus new lows are occurring at successively higher price troughs. That is how markets climb the proverbial wall of worry: they move higher, shake people out with corrections, and move higher still. If all the fears and turmoil of the past couple of months cannot bring the large caps to a successive low, it's difficult to make the bear case.

2) Not Everything is in a Bull Market - Look at financial stocks within the S&P 500 universe (XLF), and look at the homebuilders ($HGX). They have not made a series of higher price lows from 2006 - present. Now look at the energy issues within the S&P 500 (XLE). They're already making new highs. That tells us this is not a monolithic bull market. If we begin to see a tailing off of new 20 day highs even as large caps churn higher and an increasing number of sectors failing to participate in the new highs, that would be a yellow light for the bull. The bull is maturing, which means that owning the right sectors and stocks will be increasingly important. As bulls age, their rising tide fails to lift all boats.

3) Spikes in New Highs Minus Lows Toward +2000 or Higher Precede Intermediate-Term Price Peaks - The strong and broad momentum that occurs when the vast number of stocks simultaneous 20-day highs tends to persist in the near term. Note the downward pointing arrows where we've had such spikes in new highs. The large caps have tended to churn higher for quite a while before correcting meaningfully. We've just had such a spike this past Tuesday and Wednesday. For that reason, I'm not anticipating a severe market turnaround in the near term, though some consolidation of those gains can be expected. In strong bull swings, such consolidations take the form of flat trading ranges punctuated by upside breakout moves.

4) Drying Up of New Highs Minus Lows Precedes Intermediate-Term Market Bottoms - Note the upward sloping lines below the (pink) new high minus new low data. We tend to get big spikes in new lows prior to intermediate-term price bottoms during market corrections. It's when lower index prices are not accompanied by an expansion of new lows that we are most likely to see a reversal of bearish swings. That happened quite noticeably during the recent market decline.

These four relationships can help orient short-term traders as to the market's bigger picture. When we hear worry upon worry, see equity put/call ratios soar above 1.0, and register large expansions of new lows--and still stay above the lows of prior bear swings, that tells us that there's a wall of worry. For now, stocks are still on the ladder, climbing.

RELEVANT POSTS:

What Happens After a Surge in New Highs?

The Market is Less Than the Sum of Its Parts
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2 comments:

Marc Eckelberry said...

Brett, on the equity pc ratio, I'm getting a different read last week. ISEE equity closed at 209 Friday, an extreme level which has marked highs on numerous occasions. ISEE link (you need to bring the drop down to equity): http://www.ise.com/WebForm/viewPage.aspx?categoryId=126&header3=true&menu0=true&link1=true

Brett Steenbarger, Ph.D. said...

Thanks for that insight, Marc; that's something I'll need to track closely.

Brett