Saturday, October 18, 2014

Looking at Technical Indicators From the Bottom Up

Typically, if we want to use a technical indicator to gauge the strength or weakness of a given market index, we will simply apply that indicator to the price series for that index.  Suppose, however, we took a different approach, from the bottom up, rather than the top down.  Suppose we applied the indicator to every single stock within the index and gauged strength and weakness via the breadth of individual buy and sell signals.

Above are three charts that take a bottom up view of the recent market.  (Data obtained via the excellent Stock Charts site).  The top chart will be familiar to readers; it's the balance of NYSE stocks trading above their upper Bollinger Bands vs. below their lower Bands.  The middle chart utilizes the Parabolic Stop and Reverse (SAR) indicator developed by Welles Wilder and takes the number of NYSE stocks at the close each day giving buy vs. sell signals.  The bottom chart shows the number of buy vs. sell signals for each NYSE stock for the Commodity Channel Index (CCI)

Note that there is a family resemblance among the charts, but differences also.  Each indicator operates with different parameters on different time frames.  The links in the paragraph above explain how each indicator is constructed and how buy and sell signals are derived.  I think of each of the indicators as a prism through which we can see the breadth of strength and weakness across the entire market.  No one prism provides a perfect signal all the time, but when you see common patterns among the prisms, it's generally worthy of attention.

As a rule, we see peaks in the numbers of stocks giving buy signals ahead of cyclical peaks in the broad market (SPY) and we see peaks in the numbers of shares giving sell signals ahead of cyclical troughs.  You can see how the indicators peaked--but stayed positive--prior to the recent September market top and how they have troughed ahead of yesterday's rally in stocks and have now turned positive.

We have many ideas about whether markets *should* trade higher or lower, but bottom-up measures like this show whether they are actually strengthening or weakening.  I will feature regular updates of the indicators for those interested in following the signals.

Further Reading:  Breadth Volatility and Market Cycles