Wednesday, February 27, 2008

Heads Up From an Indicator

If you take a look at this post, you'll see my research pertaining to the Cumulative Demand/Supply Index. To quickly recapitulate, Demand is a proprietary measure of the number of NYSE, NASDAQ, and ASE closing above the volatility envelopes surrounding their moving averages. Supply is a measure of the number of stocks closing below their envelopes. When I subtract Supply from Demand and keep a cumulative total, that provides an excellent overbought/oversold indicator. The research referenced above suggests that returns have been subnormal when the cumulative measure is significantly above its 200-day moving average. Returns have been superior when the cumulative index is well below its moving average.

As noted in that earlier post, returns have been particularly weak when we've seen dwindling new highs/lows in the face of an overbought cumulative index. On Tuesday, the index hit its first overbought level since February 13th and February 1st before that. Both of those prior occasions led to selloffs. I notice that new 20-day lows fell on Wednesday from Tuesday's level. I'll be watching those new highs closely; continued deterioration will lead me to expect a return of the cumulative index back to its moving average (as happened in the earlier occasions this month), which generally provides a promising swing trade.