You can use technical indicators to analyze any trading vehicle: a stock, a future, an index, etc. Such tools as moving averages, MACD, Force index, and others, can provide signals for any ticker in any timeframe. Now we turn to a different group of tools: general market indicators, which analyze the entire market rather than any specific stock. They are worth following because general market trends are responsible for as much as half the movement in individual stocks.

While there are dozens of general market indicators, this is not an encyclopedic review—I’ll simply share the tools that help me trade. You may use the same or different tools—select those that appeal to you and test them on your market data. We can trust only those indicators that we have tested.

The New High–New Low Index

Stocks that reach their highest level in a year on any given day are the leaders in strength. Stocks that fall to their lowest point for that year on the same day are the leaders in weakness. The New High–New Low Index (NH-NL) tracks the behavior of market leaders by subtracting the number of New Lows from the New Highs. In my experience, NH-NL is the best leading indicator of the stock market.

How to Construct NH-NL

The New High–New Low Index is easy to calculate, using information that appears in many online sources and in major newspapers.

                                      NH-NL = New Highs − New Lows

Most data services in the United States report the daily numbers of New Highs and New Lows, but it is shocking how loosely they define their data. Some are too narrow and track only the NYSE stocks, ignoring other exchanges. Others are too broad and track everything, including interest rate ETFs. I take their data, subtract New Lows from New Highs, and plot the result underneath the daily chart of the S&P 500.

The task of constructing NH-NL is harder for traders outside the United States, in countries where such data isn’t reported. There you’ll need to do a bit of programming. First, run a daily scan of the database of all stocks in your country to find those that have reached the highest high and the lowest low for the year during the day. Once you have those two lists, take the above formula and apply it to the numbers you found.

On the days when there are more new highs than new lows, NH-NL is positive and plotted above the centerline. On the days when there are more new lows than new highs, NH-NL is negative and plotted below the centerline. If the numbers of new highs and new lows are equal, NH-NL is zero. We normally plot the New High– New Low Index as a line, with a horizontal reference line at a zero level.

While I plot NH-NL underneath the S&P 500, keep in mind that it has a much broader reach than the S&P—NH-NL includes data from the NYSE, AMEX, and NASDAQ, excluding only ETFs, unit investment trusts, closed-end funds, warrant stocks, and preferred securities. The chart of the S&P 500 is there simply for a comparison.

Crowd Psychology

A stock appears on the list of new highs when it’s the strongest it’s been in a year. It means that a herd of eager bulls is chasing its shares. A stock appears on the list of new lows when it’s the weakest it’s been in a year, showing that a crowd of aggressive bears is selling its shares.

The New High–New Low Index compares the numbers of the strongest and the weakest stocks on the exchange. It reveals the balance of power between the leaders in strength and the leaders in weakness.

You can visualize all stocks on the New York Stock Exchange, the NASDAQ, or any other exchange as soldiers in a regiment. The new highs and new lows are their officers. The new highs are the officers who lead an attack uphill. The new lows are the officers who are deserting and running downhill.

The quality of leadership is a key factor in any conflict. When I was in officer training, they kept telling us that there are no bad soldiers, only bad officers. The New High–New Low Index shows whether more officers are leading an attack uphill or deserting downhill. Where the officers lead, soldiers follow. The broad indexes, such as the S&P 500, tend to follow the trend of NH-NL.

When NH-NL rises above its centerline, it shows that the bullish leadership is dominant. When NH-NL falls below its centerline, it shows that bearish leadership is in charge. If the market rallies to a new high and NH-NL climbs to a new peak, it shows that bullish leadership is growing and the uptrend is likely to continue. If the market rallies but NH-NL shrinks, it shows that the leadership is becoming weak and the uptrend is in danger. A regiment whose officers are starting to desert is likely to retreat.

A new low in NH-NL shows that the downtrend is well led and likely to persist. If officers are running faster than the men, the regiment is likely to be routed. If stocks fall but NH-NL turns up, it shows that officers are no longer running. When officers regain their morale, the whole regiment is likely to rally.

Trading Rules for NH-NL

Traders need to pay attention to three aspects of NH-NL: the level of NH-NL above or below its centerline, the trend of NH-NL, and divergences between the patterns of NH-NL and prices.

FIGURE  S&P 500 daily, 26- and 13-day EMAs, Autoenvelope, NH-NL daily.

NH-NL Zero Line

The position of NH-NL in relation to its centerline shows whether bulls or bears are in control. When NH-NL is above its centerline, it shows that more market leaders are bullish than bearish and it is better to trade from the long side. When NH-NL is below its centerline, it shows that bearish leadership is stronger, and it’s better to trade from the short side. NH-NL can stay above its centerline for months at a time in bull markets and below its centerline for months in bear markets.

If NH-NL stays negative for several months but then rallies above its centerline, it signals that a bull move is likely to begin. It is time to look for buying opportunities, using oscillators for precise timing. If NH-NL stays positive for several months but then falls below its centerline, it shows that a bear move is likely to begin. It is time to look for shorting opportunities using oscillators for precise timing.

NH-NL Trends

When the market rallies and NH-NL rises, it confirms uptrends. When NH-NL declines together with the market, it confirms downtrends.

1. A rise in NH-NL shows that it’s safe to hold long positions and add to them. If NH-NL declines while the broad market stays flat or rallies, it is time to take profits on long trades. When NH-NL falls below zero, it shows that bearish leadership is strong and it’s safe to hold short positions and even add to them. If the market continues to fall but NH-NL rises, it shows that the downtrend is not well led—it’s time to cover shorts.

2. If NH-NL rises on a flat day, it flashes a bullish message and gives a buy signal. It shows that officers are going over the top while the soldiers are still crouching in their foxholes. When NH-NL falls on a flat day, it gives a signal to sell short. It shows that officers are deserting while the troops are still holding their positions. Soldiers aren’t stupid—if their officers start running away, they will not stay and fight.

NH-NL Divergences

If the latest market peak is confirmed by a new high of NH-NL, that rally is likely to continue, even if punctuated by a decline. When a new market low is accompanied by a new low in NH-NL, it shows that bears are well led and the downtrend is likely to persist. On the other hand, divergences between the patterns of NH-NL and broad market indexes show that leaders are deserting and the trends are likely to reverse.

1. If NH-NL traces a lower peak while the market rallies to a new high, it creates a bearish divergence. It shows that bullish leadership is weakening even though the broad market is higher. Bearish divergences often mark the ends of uptrends, but pay attention to the height of the second peak. If it is only slightly above zero, in the low hundreds, then a big reversal is probably at hand and it’s time to go short. If, on other hand, the latest peak is in the high hundreds, it shows that the upside leadership is strong enough to prevent the market from collapsing.

2. If the market declines to a new low, but NH-NL traces a shallower bottom than its previous decline, it creates a bullish divergence. It shows that bearish leadership is shrinking. If the latest low of NH-NL is shallow, in the low hundreds, it shows that the bearish leadership is exhausted and a major upside reversal is near. If the latest low sinks deep, then bears still have some strength, and the downtrend may pause but not reverse. Keep in mind that bullish divergences at stock market bottoms tend to develop faster than bearish divergences at market tops: buy fast and sell slowly.

NH-NL in Multiple Timeframes and Look-Back Periods

Markets move simultaneously in different timeframes. My original work on the NH-NL focused on the daily charts with a one-year look-back period—counting stocks that have reached a new high or a new low for their latest 52-week range. I have since added several dimensions for a deeper understanding of this key indicator.

Weekly NH-NL

The weekly NH-NL helps confirm major stock market trends and identify major reversals. I build it from the daily data, mentioned above, by running a five-day moving total. I plot the result underneath a weekly chart of the S&P 500.

The weekly NH-NL gives its most important signals when it reaches extreme levels and also by divergences. To understand its logic, keep in mind how the weekly NH-NL is constructed. For example, if the weekly NH-NL rises to a +1,500 level, it means that in each of the past five trading days there were on average 300 more New Highs than New Lows. It takes a period of sustainable bullishness or bearishness to push the weekly NH-NL to an extreme.

These are the most important signals of weekly NH-NL:
  • When it drops below minus 4,000 and then rallies above that level, it delivers major buy signals.
  • When the weekly NH-NL rises above plus 2,500, it confirms bull markets.
  • When the tops or bottoms of weekly NH-NL diverge from price patterns, they signal important reversals.

A drop below −4,000 reflects an unsustainable market panic. To fall that low, the market has to deliver an average of 800 more daily New Lows than New Highs for five days in a row. Such massive panic is not going to last. When the weekly NH-NL rises above −4,000, it flashes a buy signal I call a Spike. It’s so powerful and effective in both bull and bear markets that I named our SpikeTrade group after it.

FIGURE  S&P 500 weekly, 26-week EMA, NH-NL weekly. Green line at +2,500, purple line at −4,000. 

When the weekly NH-NL rises to the +2,500 level, it confirms bull markets. This indicator never rises this high during bear market rallies. When you see it above that level, you know you’re in a bull market, with higher prices likely ahead.

The 65-day and 20-day NH-NL

One of the great innovations in the New High–New Low analysis in recent years was the addition of two new look-back windows: a 20-day and a 65-day. While the regular daily NH-NL compares each day’s high and low to the high-low range for the preceding year, a 20-day NH-NL compares it only to the preceding month and a 65-day NH-NL to the preceding quarter. These shorter-term views of the NH-NL are useful for short-term timing.

These two new time windows deliver more sensitive signals than the standard year-long NH-NL. The logic is simple: before a stock reaches a new high for the year, it must first make a new high for the month and then for the quarter. If a stock has been in a downtrend, it may take a long time to recover and reach a new yearly high, but it can reach monthly and quarterly highs much sooner.

In addition to the usual signals, such as trends and divergences, a very sharp short-term buy signal occurs when the 20-day NH-NL drops below minus 500 and then rallies above that level. It shows that the market has touched and rejected a short-term bearish extreme, and afterwards it usually launches a short-term rally. We call this a “Spike bounce” signal.

Tracking market leaders with the help of NH-NL helps improve timing. There are two ways to utilize the New High–New Low signals. First, since individual stocks largely depend on broad market trends, we can use NH-NL signals to decide when to buy or sell our stocks. Furthermore, we can use NH-NL signals to trade vehicles that track the broad market, such as the S&P e-mini futures.

Stocks above 50-Day MA

This broad stock market indicator is based on the key concepts regarding prices and moving averages. Each price represents a momentary consensus of value among market participants, while a moving average represents an average consensus of value during its time window. This means that when a stock trades above its MA, the current consensus of value is above average—bullish. When a stock trades below its MA, the current consensus of value is below average—bearish.

When the market is trending higher, the percentage of stocks above their moving averages keeps growing. In a broad downtrend, the number of stocks above their MAs keeps shrinking.

FIGURE  S&P 500 weekly and 26-week MA; Stocks above 50 MA with reference lines at 75% and 25%.

This indicator tracks all stocks traded on the New York Stock Exchange, American Exchange, and NASDAQ and calculates how many of them trade above their moving averages. It plots that percentage as a line that fluctuates between 0% and 100%. We can use the pattern of this line to confirm market trends and anticipate reversals.

The indicator for tracking the number of stocks above their 50-day MAs is included in many software packages. I like to view it on a weekly chart, where it helps catch intermediate reversals—market turns that augur in trends that last anywhere from several weeks to several months. You don’t need to look at this indicator daily, but it can be an important part of weekend homework.

In theory, the highest possible reading of this indicator would be 100%, if all stocks rallied above their MAs. Its lowest possible reading of 0% would occur if all stocks were to fall below their MAs. In practice, only exceptional market moves swing it near the 90% or 10% extremes. Normally, this indicator tends to top out near 75% and bottom out near 25%. I draw two reference lines on its chart at 75% and 25% and start looking for the market turn as this indicator approaches those levels.

The percentage of stocks above their 50-day MA gives its trading signals not by reaching any certain levels but rather by reversing near those levels. It signals the completion of a top by rising to or above the upper reference line and then sinking below that line. It signals that a bottom has been formed when it falls below or even near the lower reference line and then turns up.

Notice that the tops of this indicator tend to be broad, while its bottoms are sharper. Tops are formed by greed, which is a happier, longer-lasting emotion. Bottoms are formed by fear—a more intense and shorter-lived emotion.

While some of this indicator’s signals are right on time in catching reversals, others mark only temporary pauses in major trends. Let this serve as a reminder never to rely on a single indicator for trading decisions. Use multiple tools: when they confirm each other’s signals, they reinforce one another.


Popular posts from this blog