The Hidden Message in the Stock Market Revisited

The Hidden Message in the Stock Market Revisited                                   

Its alright Ma, I’m only taking a beating

with apologies to Bob Dylan

During late August of 2014 a disturbing trend was developing in the advance decline line of the NYSE. After going straight up since December of 2012 it seemed to be topping out. After making a new high in July it sold off and made another high in late August but it was slightly lower this second time. The momentum of the adv/dec line was saying more. Long term momentum was down sharply on the second high in late August. Intermediate momentum put in a much lower top. I was worried. I haphazardly sold off some positions. Selling is always hard. But in September I jumped back into the market and bought some pharma and financial stocks because I wanted more exposure to that part of the market. It was done on impulse. I spent years developing these momentum indicators but because the market had been so strong for so long I never paid too much attention to them.

Anyway the market went down sharply that October, put in a V-bottom and bounced straight up. Over the ensuing months it continued to go up but once again my charts of the adv/dec line and the charts of its momentum was telling a different story. The 39 day moving average of the adv/dec line was much closer to its 144 day moving average. The market was clearly losing momentum. Long term mom was trending slightly higher but at a much lower level than where it was that previous summer. Intermediate term mom was capped at the 50 percent level after being much higher in the summer. This continued on during the spring and summer of 2015. What did I do? I stopped looking at my indicators. I didn’t want to believe what was happening. Some of my best performing stocks were way up above their long term moving averages but I couldn’t get myself to sell them. All of this was going to prove to be a very painful lesson. Momentum really started to break down in June that summer. Intermediate term mom broke below the zero line. The market was screaming at me to do something, but I couldn’t rouse myself to act. I would generate my charts on the weekend but didn’t want to look at them. In early August long term mom went below the zero line.

The market caved in around August 20th and bounced back in October at extremely low momentum levels. I felt trapped but hung on. The market sold off again in November and December, it felt like chinese water torture. Momentum continued to deteriorate topping out at lower and lower levels. In Jan of this year it caved in again. When you go through something like this you stop looking at the market because it is just too painful. It was too late to sell.

Momentum bottomed in late January 2016. When the SP500 tested that bottom in mid Feb intermed mom and the short term oscillator were both higher. Long term mom was headed up after putting in its lowest bottom since 2011. I felt a prominent bottom was in place. I didn't know how high this bounce in the market would be but I did feel that an important bottom had been put in. Market sentiment was awful. The media was doing their part painting as dark a picture as they could but I knew better.

The move off the bottom has been so powerful that it is a message in and of itself. Impulse "up waves" occur when a market is oversold and then surges up from nowhere. I read about this from Justin Mamis in his book, The Nature of Risk. I'll have more to say about all of this in my next post.

The Hidden Message in the Stock Market

The Hidden Message in the Stock Market

The media pretty much report on the performance of the SP500 or The Dow Industrials. The SP500 is a capitalization weighted index which means the largest stocks affect the whole direction of the index. As a matter of fact I would estimate that say the 15 or 20 largest stocks in the index are responsible for maybe 95 per cent of it performance. This makes it an easy target for the establishment to manipulate. Think of all the institutional money that must be directed towards this index not to mention all of the closet indexers in the mutual fund industry and all the foreign money that must keep coming in. It’s hard for me to believe that the FED itself must not be involved in this and other Central backs as well.  It must be so easy to funnel money towards those big liquid SP500 stocks there by affecting the direction of the whole index. And everybody watches the index like a hawk.

I’m going to combine two of my past posts to make a point in this post. Wager Value (focusing on the part of the market that most people don’t look at, thus making the information more valuable) and the Current Market Environment (examining the breadth of the market and applying moving averages and momentum indicators to it). Remember the breadth of the market we are looking at based on the Cumulative Advance Decline Line of NYSE (based on common stocks only).

I apply a 19, 39 and 144 day moving average to the Advance Decline Line to smooth out the day to day noise of the data so I can view the longer term trends in the underlying market.

I then take 19 day ma and subtract the 39 day ma from it. This gives me an intermediate term momentum indicator.
                                                                                                                                                           I then take the 39 day ma and subtract the 144 day ma from it to give me a long term momentum indicator. I then apply an additional 35 day ma to the long term indicator that can act as a signal line.

Finally to produce a short term oscillator of the data I take the number of advances every day while subtracting the number of declines and I apply a 10 day moving average to the result. This gives me three indicators for the short, intermediate and long term momentum of the market.

Momentum is the measure of the speed of change in the market and is a leading indicator. It can show you when a market is overbought or oversold. It can also produce divergences from the data series it is based on, in this case the advance decline line of the NYSE. As market tops are different in nature to market bottoms you will have to interpret them differently. The market can stay overbought for a long time while it generally will stay oversold for relatively short periods of time. The market goes down faster and harder than it goes up because Fear is stronger then greed.

I then generate four charts every weekend.

1)      the advance decline line with the 39 and 144 day ma (only the direction is of this data set is important.)

2)      the long term momentum of the a/d line (both the direction and level of this indicator are equally important.)

3)      the intermediate term momentum of the a/d line (both the direction and level of this indicator are equally important.)

4)      the short term oscillator of the 10 day ma daily a/d differential.

That’s quite a bit for now. I will have more to say about these indicators in a later post…God help me, I love it so.

Current Market Environment

Current Market Environment

The terrain of the current market environment will play such a dominating role in your investing results that it is impossible not to consider its impact both on yourself and on every other participant in the market. Over the years I have developed an approach to keeping tabs on the market by focusing on the market breadth of the NYSE and the NASDAQ. For those of you who do not know, everyday individual stocks go up while others go down. At the end of the day these figures are tabulated and published in various financial newspapers and websites. I use the weekly figures in Barrons to get my figures as they publish the common stock data for the NYSE which is the one you want to focus on.

You can create a cumulative running total of the differential of these daily advances and declines and log them in a spreadsheet. This running total has a familiar name. The Cumulative Advance Decline Line. I take this running total and apply a few moving averages to it to smooth out the noise of the indicator. This helps you observe the underlying trend of the market. I then subtract the longer moving averages from the faster ones which produces trend deviation indicators (a form of a momentum indicator). I track the momentum of the underlying market on a short, intermediate and long term basis.

I have found this information invaluable over the years but it took me a long time to first develop these tools and then learn how to use them. Finally I had to overcome my own thinking when they told me things about the market that I didn’t want to hear.

I have learned that the nature of tops is one of slow deterioration as the informed money gradually distributes their holdings to the masses while the major indexes will continue to go up. Meanwhile the underlying market is giving way and going down.

Bottoms come about from a collapsing phase followed by a bear market bounce and then a gradual deterioration as people come to realize that there has been a change in the psychological makeup of the market place.

During weakening tops intermediate term momentum will begin to flag and top out at a lower level than it did last time. At bottoms there will be divergences when comparing momentum with the Advance Decline Line itself.

These indicators also serve as excellent sentiment indicators. I feel confident when they start to speak to me as I’m getting information directly from the market itself. No opinions are needed. Keep an eye on the media and how they sound as they will add some colour to your analysis. Remember during market extremes be contrary or as Albert Peter Pacelli once said, ‘Demand Supply and Supply Demand.’

One more thing before I go. I use these indicators in an attempt to manage my risk in the market. I do not use them to forecast or make predictions. Predicting the future for me anyway is a dangerous activity because part of your ego is going to be attached to your prediction. It's been my experience to try to keep my ego out of the investing process. You can manage your risk by lightening up on your overbought positions when the underlying market is slowly deteriorating or sell some positions outright. I'm still working on doing this as I am a fairly inflexible long term investor who likes to hold his positions for a long time. So like everybody else I am learning all of this stuff as I go along.

For those of you who don't want to bother with keeping your own statistics on the market I can recommend  the following link...

http://stockcharts.com/h-sc/ui?s=$NYA&p=D&yr=3&mn=0&dy=0&id=p83733137120

The bottom part of the chart is the McClellan Summation Index for the NYSE. An intermediate term momentum indicator for the market breadth. Both the direction and the level of the indicator are equally important. Nothing ever really bad happens to the market when the McClellan Summation Index is above zero.