Wednesday, September 06, 2006

Participation: A Key Market Variable

When it comes to trading the equity indices, price can be deceiving. An index such as the S&P 500 can move to new highs or lows, and yet the majority of its components may not participate in that move. This can happen because the index is capitalization weighted. Some stocks are weighted more highly than others, allowing them to greatly influence short-term price movement. Moves to new highs in which there is poor participation of individual stocks in the index, for example, are less likely to continue in their present direction than moves that are broad in their participation.

One way I track participation is to follow a small group of stocks that correlate well with the overall S&P 500 Index. By tracking these issues, my task is more manageable than if I were to try to follow all 500 S&P stocks.

Above is a chart of the percentage of stocks in my basket that are making 20-day new highs minus the number making 20-day new lows. The red line represents the end-of-day cash index for the S&P 500; the blue line is the high-low differential for the stocks in the basket. If you look closely, you'll see how net new highs tend to peak ahead of the market's price peaks and net new lows tend to trough ahead of price lows.

Notice in the recent market, new highs have not expanded as the market has moved higher and, indeed, we've had fewer new highs in the basket during the last two days of market strength. This provides a yellow caution signal that participation in the move is waning. A break below the zero line (indicating we have more new lows than new highs) would be an even stronger cautionary note, as it was prior to the May price peak.

It's not at all difficult to create your own basket of issues. Find the sectors that are most important to your index and then find a group of stocks that correlate well with those overall sectors. My basket is relatively evenly weighted among consumer, cyclical, technology, and financial issues, for example.

I went back to 2004 (N = 654 trading days) and examined what happened in the market as a function of the new highs and new lows in my basket. When new highs minus new lows amounted to more than 40% of the total basket (N = 40), the next five days in SPX averaged a gain of .24% (25 up, 15 down). When new lows minus new highs comprised more than 40% of the total basket (N = 41), the next five days in SPX averaged a gain of .58% (28 up, 13 down).

Both of these are stronger than the remainder of the sample, in which neither new highs nor new lows are dominant. When neither dominate (N = 573), the next five days in SPX average a gain of only .06% (301 up, 272 down).

The bottom line? Participation matters. When we have many stocks participating to the upside or to the downside, returns are superior than if stocks are not making new highs or lows. Note that 20-day new high/low counts for the entire market are posted daily to the Weblog.