Good intentions do not guarantee desirable outcomes

July 12, 2009 by admin · Leave a Comment 

There is a tendency to believe that if the proponents of a policy have good intentions, their proposals must be sound. This is not necessarily the case. Proponents may be unaware of some of the adverse secondary effects of their proposals, particularly when they are indirect and observable only over time. Even if their policies would be largely ineffective, politicians may still find it advantageous to call attention to the severity of a problem and propose a program to deal with it. In other cases, proponents of a policy may actually be seeking a goal other than the one they espouse. They may tie their arguments to objectives that are widely supported by the general populace. Thus, the fact that an advocate says a program will help the poor, increase wages, improve health care, expand employment, or achieve some other highly desirable objective, does not necessarily make it so. Let’s begin with a couple of straightforward examples. Federal legislation has been introduced that would require all children, including those under age two, to be fastened in a child safety seat when traveling by air. Proponents argue the legislation will increase the survival rate of children in the case of an airline crash and thereby save lives. Certainly, saving lives is a highly desirable objective, but will this really be the case? Some lives will probably be saved. But what about the secondary effects? The legislation would mean that a parent traveling with a small child would have to purchase an additional ticket, which will make it more expensive to fly. As a result, many families will choose to travel by auto rather than air. Because the likelihood of a serious accident per mile traveled in an automobile is several times higher than for air travel, more automobile travel will result in more injuries and fatalities. In fact, studies indicate that the increase in injuries and fatalities from additional auto travel will exceed the number of lives saved by airline safety seats. Thus, even though the intentions of the proponents may well be lofty, there is reason to believe that the net impact of their proposal will be more fatalities and injuries than would be the case in the absence of the legislation.
The stated objective of the Endangered Species Act is to protect various species that are on the verge of extinction. Certainly, this is a admirable objective, but there is nonetheless reason to question the effectiveness of the Act itself. The Endangered Species Act allows the government to regulate the use of individual private property if an endangered species is found present on OY near his or her land. To avoid losing control of their property, many landowners have taken steps to make their land less attractive as a natural habitat for these endangered species. For example, the endangered red-cockaded woodpecker nests primarily in old trees within southern pine ecosystems. Landowners have responded by cutting down trees the woodpeckers like to nest in to avoid having one nest on their land, which would result in the owner losing control of this part of their property. The end result is that the habitat for these birds has actually been disappearing more rapidly. As you can see, good intentions are not enough. An unsound proposal will lead to undesirable outcomes even if it is supported by proponents with good intentions. But economic thinking can help us avoid this pitfall.

New Lows at a Developing Stock Market Bottom

June 21, 2009 by admin · Leave a Comment 

In a similar but converse vein, reductions in the number of stocks falling to mellows as market declines proceed represent positive breadth divergences; intern; market strength improves as price levels decline.
A major stock market bottom formation developed between the summer of 2002 and March 2003, a bottom formation characterized by three downside spikes in the Standard & Poor’s 500 Index-& spikes in the number of issues falling to new lows.
However, whereas the Standard &Poor’s 500 Index traced out one lower low an another nearly lower low during this period, the number of issues declinmg to near 52-week lows in price contracted sharply between the lows of July 2002 and March 2003. Although the Standard & Poor’s 500 Index stood at almost the exact level in March 2003 as it had been at the lows of July 2002, the number of issues falling 1 new lows had shown a decline from more than 900 to slightly more than 301 Clearly, the stock market was building internal strength, a precursor to the bull ma ket that soon ensued.
A summary of the basics follows:
Market advances accompanied by increases in the number of issues reaching new highs in price are advances that are well confirmed by market breadth. Such advances are likely to continue. Market advances that are not accompanied by increases in the number of issues reaching new highs in price are not as well grounded in internal strength as fully breadth-confirmed market advances. There are no precise and regular intervals in time between peaks in the number of new highs and ultimate peaks in the stock market averages. For example, in less than a year, the summer decline in 1998 followed peaks in new highs that had developed during 1997, whereas the fuU-scale bear market of 2000-2002 did not begin until more than two years after the 1997 peak in new highs. As a general rule, significant peaks in new highs tend to be seen perhaps one year or so before final bull market peaks.
Market declines accompanied by increasing numbers of issues falling to new lows are likely to continue. If new lows reach bear market peaks during a downside selling climax, with prices spiking down at the time, there are likely to be further tests of those price and breadth lows before final bear market bottoms are achieved.
Failures of new lows to expand with price declines represent positive breadth divergences and tend to be forerunners of stock market reversals to the upside. Again, breadth divergences, positive and negative, do not signal immediate market reversals. This family of indicators usually requires time for its effects to be felt. However, triple-bottom formations, representing declining numbers of new lows during bottoming formations, often resolve in market advances fairly rapidly after the third spike reversal has taken place. The market bottom that developed during 2002 is an excellent example.
As a general rule, the stock market prefers positive breadth unanimity during market advances: high percentages of issues reaching new highs in price, and low percentages of issues falling to new lows. (At market tops there are often high levels of issues makimg both new highs and new lows, reflective of very split market breadth. When the number of new highs and the number of new lows on the New York Stock Exchange both amount to more than 5% of the total number of issues traded on that exchange, serious market declines frequently, though not always, follow shortly.) A useful indicator that measures the level of positive breadth unanimity can be maintained by dividing the number of issues reaching new highs in price by the total of issues reaching new highs and falling to new lows. For example, if 100 issues reach new highs on a given day and 25 issues fall to new lows, you can divide 100 (new highs) by 125 (sum of 100 new highs plus 25 new lows) for a daily ratio of 30, or 80%. Single-day readings can be beneficially employed, but the maintenance of a ten-day simple moving average of daily readings smoothes the data.

New High/New Low Confirmations of Price Trends in the Stock Market

June 14, 2009 by admin · Leave a Comment 

We have already reviewed concepts relating to confirmation and non-confirmation of price advance and decline by indicators that measure market momentum, such as rate of change measurements. Among these are concepts related to positive divergence and negative divergence, based on the relationships between momentum and price movement.
Concepts related to confirmation, non-confirmation, positive divergence, and negative divergence can be related as weU to the relationship between external price strength and measures of the internal strength of the stock market. For example, if the number of stocks that reach new highs expands with gains in market indices, we can think of this as a positive confirmation of market advance: Internal strength measurements are confirming extemal strength measurements. However, if the number of issues making new highs does not keep pace with gains in the market averages, internal strength can be thought of as underperforming the extemal stock market. Negative breadth divergences are taking place, a warning of probable trouble down the road.
Conversely, if price levels remain down trended but fewer issues fall to new lows along with weighted price indices, this divergence could be evidence of internal strength building in the stock market as external indicators continue to weaken. Such conditions reflect positive breadth divergences, situations in which more stocks are finding support even within the context of declining price averages, usually a bullish portent.

New Highs and New Lows

June 6, 2009 by admin · Leave a Comment 

Another indicator reflects market breadth, a measure of the true internal strength (or weakness) of the stock market. nus is the new high/new low indicator, including various derivatives of the related data. The number of issues making new highs, measured on either a daily or a weekly basis, is the number that reach new 52-week highs in price at any time on a given day or, for weekly-based readings, at some point during the week. This would be a price level higher than any level recorded in the previous 52 weeks. The number of issues falling to new lows refers to the number of issues whose prices have declined to their lowest level in the most recent 52 weeks.
It goes without saying that it is more positive when large numbers of issues advance to new highs than when the numbers of stocks in rising trends diminish. It is more negative when large numbers of issues keep falling to new lows than when increasing numbers of stocks find support, perhaps beginning new uptrends.

Measures of Market Breadth

May 31, 2009 by admin · Leave a Comment 

One useful measure of market breadth lies with the advance-declme lie, a cumulative total of advancing minus declining issues on each of the various exchanges. You can start these cumulative lines from any level, using daily readings for daily-based advance-decline line readings, or weekly readings for weekly advance-decline line measurements.
For example, if you started an advance-decline line of the New York Stock Exchange at an arbitrary level of 10,000, and on the first day there were 1500 issues advancing in price on that exchange and 1,000 declig (unchanged issues are not
included), there would be 500 more issues advancing than declig that day The advance-decline (A-D) line would advance by +500 units, from 10,000 to 10,500. If there are 200 more declines than advances on the subsequent day, the A-D line would decline from 10,500 to 10,300.
We will return to applications of the advance-decline lines of various market indices, but first we take a more detailed look at the relationships of the number of issues rising to new highs and falling to new lows. This is another area that reflects the internal breadth and strength of the stock market.

The “Internal” as Opposed to the “External” Stock Market

May 24, 2009 by admin · Leave a Comment 

Financial news reports tend to focus on gains and losses recorded by a selective group of popularly followed stock market indices. These include the Dow Industrials, with 30 issues, unequally weighted (higher-priced issues have a larger influence, on the index); the Standard & Poor’s 500 Index, with 500 stocks (weighted by capitalization so that the index is unequally weighted, with larger companies more influential than smaller companies); the Nasdaq Composite Index, with approximately 3,500 separate issues (heavily weighted by capitalization so that at times perhaps only a dozen or so issues cany a very disproportionate effect); and the New York Stock Exchange Index, which includes all issues on the New York Stock Exchange (also weighted so that larger companies most heavily influence the average).
Another index, the Value Lie Arithmetic Average, includes approximately 2,000 issues traded on various exchanges and is not weighted by capitalization: All companies in that average are afforded equal weight.
Arguments can be made for or against the weighting inherent in most of these market indices, but the simple fact is that there are often serious discrepancies between the movements of one or more of the weighted indices and the movement of the typical listed stock. It is very possible for a weighted market index to advance in price as a result of strength in a handful of larger companies while the majority of stocks is actually declining. Popular market indices represent the “external stock market,” a view of the market most frequently observed. Indicators that measure the numbers or proportions of issues that actually participate in market advances and declines are measures of the internal strength or breadth of the stock market, a generally her reflection of the strength of the typical stock and mutual fund.
As a general rule, the stock market is on firmer ground when market advances are broad and include large percentages of listed issues than when they are selective, with advances in market indices created by strength in a relatively narrow group of highly capitalized issues. This is actually quite logical. If larger percentages of stocks are participating in market advances, the odds of selecting and holding profitable positions increase. If only a relatively small number of stocks are carrying market indices upward, the odds of successful stock selection narrow. Investors are more likely to fmd themselves taking losses in a stock market that seems to be rising if judgments are based on weighted indices, but that, in fact, is rising only selectively External readings are strong. Internal breadth measurements indicate otherwise.