Saturday, March 24, 2007

Tracking Swing Highs And Lows In The Stock Market

My recent post showed how I use a basket of 40 S&P stocks evenly divided among eight sectors to track new highs and lows on an intraday basis. What we found is that intraday divergences between S&P 500 Index price (SPY) and the closing 30-minute new highs minus lows helps us identify short-term turning points. If the underlying principle is valid, however, it should be evident at other time frames. So let's take a look at five-day highs and lows and see if they similarly help us assess swing reversals in the market.

The above chart shows the data from the start of 2007 to the present. The pink line represents the number of stocks in my basket making closing five-day highs minus those making five-day lows. The dark blue line is the daily closing S&P 500 Index (SPY) price. Notice how the five-day new highs minus lows reliably peaks prior to seeing price peaks. We also see at the recent important market bottom that five day new lows were drying up. Those major divergences are marked by the light blue arrows. If you look closely at other price lows, you'll see other divergences. When new highs/lows aren't expanding with market rises/declines, reversal is much more likely. Before stocks start going up, they stop going down and vice versa.

As you can see from the recent market action, new highs minus lows have been steadily rising over the past several days. Even with the range bound action of the last two sessions, we're still seeing many more stocks making new highs than lows on a five-day basis. Until we see meaningful divergences similar to those observed at prior highs, I expect price to be able to grind higher.

In my database, I track everything from 30-minute to 65-day new highs/lows. I post 20-day new highs/lows daily to the Trading Psychology Weblog, and will begin posting the shorter-term data as well. This enables me to see emerging strength and weakness at multiple time frames, which is helpful in framing trades that entail trend-following vs. reversal. Putting the different time frames together into a coherent trading picture is particularly helpful and a topic I hope to tackle shortly.