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The economic way of thinking

admin — Sun, 12 Jul 2009 12:50:41 +0000

One does not have to spend much time around economists to recognize that there is an “economic way of thinking.” Admittedly, economists, like others, differ widely in their ideological views. A news commentator once remarked that “any half-dozen economists will normally come up with about six different policy prescriptions.” Yet, in spite of their philosophical differences, the approach of economists reflects common ground.
That common ground is economic theory, developed from basic principles of human behavior. Economic researchers are constantly involved in testing and seeking to verify their theories. When the evidence from the testing is consistent with a theory, eventually that theory will become widely accepted among economists. Economic theory, like a road map or a guidebook, establishes reference points indicating what to look for, and how economic issues are interrelated. To a large degree. the basic economic principles are merely common sense. When applied consistently, however, these commonsense concepts can provide powerful and sometimes surprising insights.

Enter the Rate of Change Indicator

admin — Fri, 26 Jun 2009 20:23:16 +0000

The rate of change indicator certainly proved its worth between 1995 and 2004. For starters, in its patterns of movement, the indicator clearly reflected the A-B wave sequences that took place during this period. Rate of change measurements frequently provide advance notice of market reversals, reversing direction before rather than after or even simultaneously with the trend of stock prices. As a general rule, rate of change indicators peak approximately 50-65% into a market upswing. The area at which these indicators turn down is an area in which it is probably too late for buying, possibly a touch early for selling; this is an area during which it might be appropriate to prepare for the next downside move.
As you can see, every cyclical peak that took place between 1995-2000 was presaged by a negative divergence, with prices rising to new highs, the rate of change indicator turning down to reflect diminishing upside price momentum. This characteristic, in reverse, was also present during the market declines of 2000-2002, with cyclical market lows characterized by advance positive divergences and the rate of change indicator reversing to the upside as prices moved toward their final lows. The 50-day rate of change indicator provided a fine notice of market rallies that developed in late 2001 and 2002.
Investors received clear notice of market recoveries that took place based upon the 18-month cycle, notice provided by the cyclical lengths and by the action of the 50-day rate of change indicator.

Evaluating the Tabulations

admin — Wed, 24 Jun 2009 20:21:27 +0000

Although gains were recorded in most months during both the favorable unfavorable six-month periods, there has been a considerable difference in magnitude of the average gain achieved during favorable seasonal periods unfavorable periods. (Stocks advance approximately 75% of the time but, apparel there are advances and, then again, there are advances.)
Returns during unfavorable six-month periods have averaged just a bit than 1% per period, with the rate of return while invested approximately 2% annum, less than risk-free interest rates in most years. As a rule, investors which have been better off in the stock market for just six months each year and six months than being fully invested at all times (although this is not true for every year, of course).
The performance of this seasonal six-month period timing model has been essentially similar to the Nasdaq/NYSE Index Relative Strength Indicator and the 3- to 5-Year Monetary Indicator, which also produce virtually all net market gain within defined and limited holding periods. These “mood indicators” are not precise on their own in terms of market timing, however, so they are probably best employed as an influential backdrop to inveshnent decisions based upon more specific timing tools or as a consideration for decisions regarding the extent to which you want to be invested at any time.
There certainly do appear to be significant differences in performance between the favorable and unfavorable six-month periods.

New Lows at a Developing Stock Market Bottom

admin — Sun, 21 Jun 2009 18:34:05 +0000

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

admin — Sun, 14 Jun 2009 18:33:12 +0000

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.

Measures of Market Breadth

admin — Sun, 31 May 2009 18:31:47 +0000

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

admin — Sun, 24 May 2009 18:31:36 +0000

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.