Sunday, February 03, 2008

Tracking Cumulative Demand and Supply: From Oversold to Overbought

Regular readers are familiar with my measures of Demand and Supply. To briefly recapitulate, imagine a stock and its short and intermediate term moving averages. There is a volatility envelope (like Bollinger Bands) surrounding the moving averages. If the stock closes above both its envelopes, this qualifies as "Demand", as it shows unusually strong interest in the issue. If the stock closes below both envelopes, it is added to "Supply", suggesting unusual interest in selling the shares. Anything closing between the edges of the volatility envelopes is not added to the total. The Demand/Supply Index reflects the number of stocks trading above and below their envelopes across the NYSE, NASDAQ, and ASE.

When the Demand/Supply Index is summed as a cumulative total, we get an oscillator that is helpful for intermediate-term timing. The oscillator shown above subtracts the day's cumulative reading from the 200-day moving average to see how Demand and Supply are faring on a relative basis. As you can see, drops in this oscillator below -30 have corresponded to short-term market bottoms. Rises above +20 have generally led to topping processes and eventual cyclical declines.

Observe how we have gone, in fairly short time, from below -30 to above +20 with the sharp rally off the recent market lows. This doesn't necessarily mean we're going straight down, but it has served as a heads-up for a topping process and eventual correction.

I went back to the start of 2004 (N = 1003 trading days) and found 175 occasions in which the Cumulative DSI oscillator has been above +20. Twenty days later, the S&P 500 Index (SPY) has averaged no change (103 up, 72 down)--a subnormal return. Conversely, when we've seen the oscillator below -20 (N = 130), SPY has averaged a sizable twenty-day gain of 1.24% (94 up, 36 down).

It's when we've seen an overbought oscillator in conjunction with weakening new highs/lows that markets have been most vulnerable on an intermediate-term basis. Thus far in the market rise, new highs have been expanding steadily.

Finally, consider that in a bull market, peaks in the oscillator will occur at successive price highs. In a bear market, we see valleys in the oscillator at successive price lows. Recently, we've traced lower highs and lower lows with the oscillator extremes. For that reason, despite the vigor of the recent rally, I'm still considering us in a bear market phase.

An oversold reading on a successful test of market lows or at higher price lows would have me buying aggressively for the intermediate term. Price topping and weakening new highs/lows around these price levels would have me selling and going with the downward trend. The current overbought reading is a yellow light, but as the chart shows, markets can move higher following such a reading when new highs/lows remain robust.


An Unusually Sensitive Indicator