Measuring the Market's Technical Strength

One of the consistent themes of my research is that information about individual stock performance is useful in making inferences about movements in the market averages. For example, when an index such as the S&P 500 makes a new high but few of the component stocks register corresponding highs, then it makes sense to question the sustainability of that rise. A move that is based upon a few highly capitalized issues reflects less directional sentiment than a move that impacts the majority of stocks.

The Demand/Supply Index, a proprietary measure which I quote daily in my Twitter comments, reflects this "bottoms-up" philosophy, in which you infer strength about the overall market from an analysis of individual market components. Demand is an index of the number of listed stocks that are trading significantly above their short- and medium-term moving averages. Supply is an index of the number of listed shares trading significantly below their moving averages. Day to day shifts in Supply and Demand tell us if the market is gaining or losing momentum.

For quite a few months, I've tinkered with a measure of institutional momentum and trending that captures the directional movement of a basket of stocks that is representative of the major market averages. It is out of that research that I introduce a new proprietary measure of Technical Strength. This post will explain the rationale behind the indicator; future posts will update readings daily.

We will call a stock "technically strong" if it qualifies as being in an uptrend over short and intermediate-term time periods. We will call the stock "technically neutral" if it is neither in a defined uptrend nor downtrend over the short and intermediate-term periods. The stock will be deemed "technically weak" if it meets criteria for being in a downtrend over both time frames.

I will be tracking technical strength and weakness across the 40 stocks in my S&P 500 sector basket. Recall that this basket consists of five very highly weighted stocks in each of the following S&P 500 sectors: Materials, Industrials, Consumer Discretionary, Consumer Staples, Energy, Healthcare, Financial, and Technology.

My research spits out two sets of numbers daily:

1) The number of stocks that close technically strong, neutral and weak;
2) A numerical index of technical condition that quantifies degree of technical strength or weakness.

The beauty of the arrangement is that, because the stocks in the basket are divided evenly among the eight sectors, we can arrive at technical condition estimates for each of the sectors as well as the S&P 500 Index as a whole.

Most important are shifts in technical condition over time, not just single, one-day readings. For example, when a market has risen and is topping out, we will see deterioration in Technical Strength as some stocks and sectors begin to roll over while others stay strong. A similar dynamic occurs over the course of market bottoming.

It is also my expectation that the Technical Strength data will help us identify strong and weak market sectors, as well as strength and weakness within sectors. For instance, the current data show technical weakness in investment banks such as C and JPM, but strength in such commercial banks as WFC.

So let's get started! As of August 30th, we had 18 stocks qualify as Technically Neutral; 13 as Technically Strong; and 9 as Technically Weak. The Technical Strength Index (TSI) closed at +160. These are relatively neutral readings and reflect what we see in the 20-day new high/new low data for listed stocks: five of the last seven sessions have closed with new highs between 400 and 500 and with new lows between 200 and 300.

That suggests a multiday trading range and opportunities for either a meaningful breakout trade or a reversal toward that range midpoint. I'm watching the Russell 2000 futures (ER2) for one clue as to this emerging move.

My next post will examine the Technical Strength data by sectors.

RELEVANT POSTS:

Tracking New Highs/Lows: This post lists the 40 stocks in my sector basket

Demand/Supply: This post shows research that suggests modest near-term upside potential in the current market.
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