Many of my best market indicators track what individual stocks are doing to see if momentum and trending are spread out among issues or limited to a relative handful. It is difficult, however, to track a large number of stocks in real time to see how many are making new highs or new lows, how many are above their moving averages , etc. What to do?
One way around that limitation is to create a basket of stocks that closely track the stock index that you're trading. The basket that I currently use takes four stocks from each of four sectors (industrial/cyclical, consumer, financial, and technology), plus one stock that is an economically sensitive service firm. The basket, taken together, closely correlates with price changes in the S&P 500 Index. This is not surprising, because many of the stocks are highly weighted in the S&P and all are considered large caps. In my scheduled "Morning With the Doc" on October 31st, I will outline what these stocks are and how I use them intraday.
For now, notice on the chart how the percentage of stocks in my basket making new five day highs minus lows (blue line) tracks the $SPX. Dips below zero (meaning more stocks are making five-day lows than highs) have been good buying opportunities; price highs when new highs are below 50% have tended to correct in the short term; and price highs with many new highs have tended to move higher still.
Since 2004 (N = 705), when we've had a five-day high in the S&P 500 Index (N = 247) and more than 50% of the basket of stocks have made new highs (N = 76), the next five days in $SPX average a gain of .26% (44 up, 32 down). That is better than the average five-day gain of .15% for the entire sample. When fewer than 50% of the stocks are participating in the new highs, the average five day gain is only .01% (96 up, 75 down) and when fewer than 25% of stocks in the basket are making new highs when we have a new high in $SPX, the average five-day change is a loss of -.15% (40 up, 39 down).
In other words, we have yet another example of a momentum effect. What is important is not just if the index is making new highs, but if the new highs are broadly distributed. A small but well-constructed basket of stocks can be an effective way to track that.
Notice that recent new index highs have been on relatively weak new stock highs. That is a reason for caution right here. More on this worthwhile method in the session on the 31st.
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