April 20, 2012
Uncategorized
By Geoff Bysshe
Did you see the recent correction coming?
Will you know if a rally to new highs is a head fake?
I’ve used MarketGauge’s New High/New Low Ratio indicator for decades to help answer these questions. Here’s how it works, and where you can follow it for free…
First, I don’t expect to pick exact tops or bottoms to the day, but I do like to know whether I should focus on day trading or swing trading strategies that perform best in trending markets vs. choppy markets. I also like to approach the market with a directional bias when I can. For example, should focus on buying dips or shorting rallies? Should I trade breakouts or reversals?
Notice the chart below. The NYSE New High/New Low Ratio began to flash warning signals weeks before the market’s recent top. The first warning sign was its trend down off the highs for weeks as the market rallied, but the big warning sign occurred when it fell below the 70% level. The “warning” is that the market’s character is changing from a robust trend to choppy, and weaker than it has been in months! It may even be forming a significant top.
I’m not going to call a major top based on one indicator, but I will use different trading strategies based on the changing character of the trend. And I’ll watch this indicator closely because it will tell me if the market finished its correction, and if it is returning to a strong trending state. Of course this would also require market’s correction to firm up heads back to the highs.
Here’s why this works...
When the market is trending we often ignore some tell tale signs that the trend will stop or even reverse, because typical trending indicators only measure price action. This is why it is helpful to look at more than just price action to determine the likelihood that the market has topped or bottomed out.
When markets experience significant tops and bottoms it is typically evident in the market’s “breadth”. Breadth is a measure of the percentage of stocks that are contributing to the trend’s move. This can be measured in a number of different ways. As the chart above demonstrates, looking at the number of stocks making new 52-week highs versus the number making new 52-week lows is a very good way to measure the breadth and the strength of the market.
For a market to trend higher it needs strong leading stocks. A good measure of leading stocks is the list of those that frequently make new 52-week highs. The reason I like this measure is because a new 52-week high generally requires the stock to be strong. It is not as easy as simply being counted as an “advancing stock” which is a common measure of breadth also, but only requires the stock to be up for the day.
In strong markets, the number of stocks hitting 52-week highs expands. As a strong market eventually matures, it is not uncommon for the indexes to continue to move higher, while the number of stocks making new 52-week highs declines. In a healthy correction, it’s normal for the number to new highs to decline, but in a healthy bull market there should not be a large number of new 52-week lows.
When markets are in a significant down trend there will be a larger number of stocks at 52-week lows relative to the number at 52-week highs. You can’t have a strong market with more stocks making new lows than at highs! This is why the 52-week High/Low ratio is such a good measure of the markets condition.
Tracking and Calculating The New High/Low Ratio
Here is the formula for this indicator:
(New 52-Week Highs)/(New 52-Week Highs + New 52-Week Lows).
Then take the average of the last 10 days to get the ratio you’ll see drawn on the chart.
Note that part of the calculation is smoothing the data by averaging it over 10 days. As a result, this is not an indicator that will pick the high day or the low day of the move, but it will help identify major tops and bottoms. It will also confirm that existing trends are likely to continue.
For example, if the markets break their recent swing lows, this indicator will most likely also confirm that there is a significant chance of a big drop. On the other hand, if the markets hold their recent lows this indicator should be watched to determine if a move to new highs should be followed or sold.
Here’s how you can follow this...
You don’t need to calculate this indicator yourself. You can find the charts displayed in this article on our website in the Resources section. They are located in Market Analysis section of the Little BigView product and it’s free!
Use this link to navigate to a current chart:
https://marketgauge.com/?page_id=3072
After clicking on that link, follow the navigation to “Market Analysis” and then to the sub-menu of “Charts” as shown in the image below. You’ll find a list of indicators and you’ll see a New High/ New Low indicator for both the NYSE and the NASDAQ!
Click the image to enlarge:
There is a lot more to be gained from understanding this indicator than I’ve covered in this post. So in an upcoming blog post I’ll get into more in depth analysis of this indicator.
Plus I’ll explain why the gap down in the markets on 4/4, just a day or two from the markets’ highs was a much more negative day than most traders were aware of based on this indicator.