THE NEW TRADING OF A LIVING- OTHER STOCK MARKET INDICATORS

THE NEW TRADING OF A LIVING



OTHER STOCK MARKET INDICATORS

Only a handful of general market indicators have stood the harsh test of time. Many that used to be popular in previous decades have been swept away by the flood of new trading vehicles. The New High–New Low Index and Stocks Above 50-day MA, reviewed above, continue to work because of their clear logic. Several other indicators are listed below. Whatever tools you choose, be sure to understand how they work and what exactly they measure. Select a few and track them on a regular basis, until you come to trust their signals.

Advance/Decline

The Advance/Decline line tracks the degree of mass participation in rallies and declines. Each day it adds up the number of stocks that closed higher and subtracts the number of stocks that closed lower.

While the Dow Jones Industrials track the behavior of the generals and the New High–New Low Index focuses on the officers, the A/D line shows whether soldiers are following their leaders. A rally is more likely to persist when the A/D line rises to a new high, while a decline is likely to deepen if A/D falls to a new low in step with the Dow.

The A/D line is based on the day’s closing prices for each stock at any exchange: take the number of advancing stocks, subtract the number of declining stocks, and ignore unchanged stocks. The result will be positive or negative, depending on whether more stocks advanced or declined during the day. For example, if 4,000 stocks were traded, 2,600 advanced, 900 declined, and 500 were unchanged, then Advance/Decline equals +1,700 (2,600−900). Add each day’s Advance/Decline figures to the previous day’s total to create a cumulative A/D line.

FIGURE  S&P 500 daily and the Advance/Decline line.

Traders should watch for new peaks and valleys in the A/D line rather than its absolute levels, which depend on its starting date. If a new high in the stock market is accompanied by a new high of the A/D line, it shows that the rally has broad support and is likely to continue. Broadly based rallies and declines have greater staying power. 

If the stock market reaches a new peak, but the A/D line reaches a lower peak than during the previous rally, it shows that fewer stocks are participating, and the rally may be near its end. When the market falls to a new low but the A/D line traces a shallower bottom than during the previous decline, it shows that the decline is narrowing down and the bear move is nearing an end. These signals tend to precede reversals by weeks if not months.

The Most Active Stocks indicator (MAS) is an Advance/Decline line of the 15 most active stocks on the New York Stock Exchange. It used to be listed daily in many newspapers. Stocks appeared on this list when they caught the public’s eye. MAS was a big money indicator—it showed whether big money was bullish or bearish. When the trend of MAS diverged from the price trends, the market was especially likely to reverse.

Hardly anyone today uses an indicator called TRIN, which was important enough to have its own chapter in the original Trading for a Living. Very few people track another formerly popular indicator called TICK. Old stock market books are full of fascinating indicators, but you have to be very careful using them today. Changes in the market over the years have killed many indicators.

Indicators based on the volume of low-priced stocks lost their usefulness when the average volume of the U.S. stock market soared and the Dow rose tenfold. The Member Short Sale Ratio and the Specialist Short Sale Ratio stopped working after options became popular. Member and specialist short sales are now tied up in the intermarket arbitrage. Odd-lot statistics lost value when conservative odd-lotters bought mutual funds. The Odd-lot Short Sale Ratio stopped working when gamblers discovered puts.

Consensus and Commitment Indicators

Most private traders keep their opinions to themselves, but financial journalists, letter writers, and bloggers spew them forth like open hydrants. Some writers may be very bright, but the financial press as a whole has a poor record of market timing. Financial journalists and letter writers tend to overstay trends and miss turning points. When these groups become intensely bullish or bearish, it pays to trade against them.

It’s “monkey see, monkey do” in the publishing business, where a journalist’s or an advisor’s job may be endangered by expressing an opinion that differs too sharply from his group. Standing alone feels scary, and most of us like to huddle. When financial journalists and letter writers reach a high degree of bullish or bearish consensus, it’s a sign that the trend has been going on for so long that a reversal is near.

Consensus indicators, also called contrary opinion indicators, are not suitable for precision timing, but they draw attention to the fact that a trend is near its exhaustion level. When you see that message, switch to technical indicators for more precise timing of a trend reversal.

A trend can continue as long as bulls and bears remain in conflict. A high degree of consensus precedes reversals. When the crowd becomes highly bullish, get ready to sell, and when it becomes strongly bearish, get ready to buy. This is the contrary opinion theory, whose foundations were laid by Charles Mackay, a Scottish barrister. His classic book, Extraordinary Popular Delusions and the Madness of Crowds (1841) describes the infamous Dutch Tulip Mania and the South Seas Bubble in England. Humphrey B. 

Neill in the United States applied the theory of contrary opinion to stocks and other financial markets. In his book, The Art of Contrary Thinking, he made it clear why the majority must be wrong at the market’s turning points: prices are established by crowds, and by the time the majority turns bullish, there aren’t enough new buyers to support a bull market.

Abraham W. Cohen, an old New York lawyer whom I met in the early 1980s, came up with the idea of polling market advisors and using their responses as a proxy for the entire body of traders. Cohen was a skeptic who spent many years on Wall Street and saw that advisors as a group performed no better than the market crowd. In 1963, he established a service called Investors Intelligence for tracking letter writers. When the majority of them became bearish, Cohen identified a buying opportunity. Selling opportunities were marked by strong bullishness among letter writers. Another writer, James H. Sibbet, applied this theory to commodities, setting up an advisory service called Market Vane.

Tracking Advisory Opinion

Letter writers follow trends out of fear of losing subscribers by missing major moves. In addition, bullishness helps sell subscriptions, while bearish comments turn off subscribers. Even in a bear market, we rarely see more bears than bulls among advisors for more than a few weeks at a time.

The longer a trend continues, the louder the letter writers proclaim it. They are most bullish at market tops and most bearish at market bottoms. When the mass of letter writers turns strongly bullish or bearish, it’s a good idea to look for trades in the opposite direction.

Some advisors are very skilled at doubletalk. The man who speaks from both sides of his mouth can claim that he was right regardless of what the market did, but editors of tracking services have plenty of experience pinning down such lizards.

When the original Trading for a Living came out, only two services tracked advisory opinions: Investors Intelligence and Market Vane. In recent years, there has been an explosion of interest in behavioral economics, and today many services track advisors. Jason Goepfert, its publisher, does a solid job of tracking mass market sentiment.

Signals from the Press

To understand any group of people, you must know what its members crave and what they fear. Financial journalists want to appear serious, intelligent, and informed; they are afraid of appearing ignorant or flaky. That’s why it’s normal for them to straddle the fence and present several sides of every issue. A journalist is safe as long as he writes something like “monetary policy is about to push the market up, unless unforeseen factors push it down.”

Internal contradiction is the normal state of affairs in financial journalism2. Most financial editors are even more cowardly than their writers. They print contradictory articles and call this “presenting a balanced picture.”

For example, an issue of a major business magazine had an article headlined “The Winds of Inflation Are Blowing a Little Harder” on page 19. Another article on page 32 of the same issue was headlined “Why the Inflation Scare Is Just That.” It takes a powerful and lasting trend to lure journalists and editors down from their fences. This happens only when a tide of optimism or pessimism sweeps up the market near the end of a major trend. When journalists start expressing strongly bullish or bearish views, the trend is ripe for a reversal.

This is why the front covers of major business magazines serve as contrarian indicators. When a leading business magazine puts a bull on its cover, it’s usually a good time to take profits on long positions, and when a bear graces the front cover, a bottom cannot be too far away.

Signals from Advertisers

A group of three or more ads touting the same “opportunity” in a major newspaper or magazine warns of an imminent top. This is because only a well-established uptrend can break through the inertia of several brokerage firms. By the time all of them recognize a trend, come up with trading recommendations, produce ads, and place them in a newspaper, that trend is very old indeed.

The ads on the commodities page of The Wall Street Journal appeal to the bullish appetites of the least-informed traders. Those ads almost never recommend selling; it is hard to get amateurs excited about going short. You’ll never see an ad for an investment when its price is low. When three or more ads on the same day tout gold or silver, it is time to look at technical indicators for shorting signals.

FIGURE  Monthly total dollar value of OTC stocks. 

A more malignant breed of promoters appeared on the scene in the past decade: thanks to the Internet, “pump and dump” operators have migrated online. The scammers touting penny stocks know that they need to wait for an uptrend to hook their victims. Whenever a higher than usual number of promo pitches starts showing up in my spam filter, the top can’t be too far away.

Commitments of Futures Traders

Government agencies and exchanges collect data on buying and selling by various groups of traders and publish summary reports of their positions. It pays to trade with the groups that have a track record of success and against those with track records of persistent failure.

For example, the Commodity Futures Trading Commission reports long and short positions of hedgers and big speculators. Hedgers—the commercial producers and consumers of commodities—are the most successful market participants. The Securities and Exchange Commission (SEC) reports purchases and sales by corporate insiders. Officers of publicly traded companies know when to buy or sell their shares.

Positions of large futures traders, including hedge funds, are reported to the CFTC when their sizes reach the so-called reporting levels. At the time of this writing, if you are long or short 250 contracts of corn or 200 contracts of gold, the CFTC classifies you as a big speculator.

The CFTC also sets up the maximum number of contracts a speculator is allowed to hold in any given market— these are called position limits. Those limits are set to prevent very large speculators from accumulating positions that are big enough to bully the markets.

The CFTC divides all market participants into three groups: commercials, large speculators, and small speculators. Commercials, also known as hedgers, are firms or individuals who deal in actual commodities in the normal course of their business. In theory, they trade futures to hedge business risks. For example, a bank trades interest rate futures to hedge its loan portfolio, while a food processing company trades wheat futures to offset the risks of buying grain. Hedgers post smaller margins and are exempt from speculative position limits.

Large speculators are those whose positions have reached reporting levels. The CFTC reports buying and selling by commercials and large speculators. To find the positions of small traders, you need to take the open interest and subtract from it the holdings of the first two groups.

The divisions between hedgers, big speculators, and small speculators are somewhat artificial. Smart small traders grow into big traders, dumb big traders become small traders, and many hedgers speculate. Some market participants play games that distort the CFTC reports. For example, an acquaintance who owns a brokerage firm sometimes registers his wealthy speculator clients as hedgers, claiming they trade stock index and bond futures to hedge their stock and bond portfolios.

The commercials can legally speculate in the futures markets using inside information. Some of them are big enough to play futures markets against cash markets. For example, an oil firm may buy crude oil futures, divert several tankers, and hold them offshore in order to tighten supplies and push up futures prices. They can take profits on long positions, go short, and then deliver several tankers at once to refiners in order to push crude futures down a bit and cover shorts. Such manipulation is illegal, and most firms hotly deny that it takes place.

As a group, commercials have the best track record in the futures markets. They have inside information and are well-capitalized. It pays to follow them because they are successful in the long run. Big speculators used to be successful wealthy individuals who took careful risks with their own money. That has changed, and today most big traders are commodity funds. These trend-following behemoths do poorly as a group. The masses of small traders are the proverbial “wrong-way Corrigans” of the markets.

It is not enough to know whether a certain group is short or long. Commercials often short futures because many of them own physical commodities. Small traders are usually long, reflecting their perennial optimism. To draw valid conclusions from the CFTC reports, you need to compare current positions to their historical norms.

Legal Insider Trading

Officers and investors who hold more than 5 percent of the shares in a publicly traded company must report their buying and selling to the Securities and Exchange Commission. The SEC tabulates insider purchases and sales, and releases this data to the public.

Corporate insiders have a long record of buying stocks when they’re cheap and selling them high. Insider buying emerges after severe market drops, and insider selling accelerates when the market rallies and becomes overpriced.

Buying or selling by a single insider matters little: an executive may sell shares to meet major personal expenses or he may buy them to exercise stock options. Analysts who researched legal insider trading found that insider buying or selling was meaningful only if more than three executives or large stockholders bought or sold within a month. These actions reveal that something very positive or negative is about to happen. A stock is likely to rise if three insiders buy in one month and to fall if three insiders sell within a month.

Clusters of insider buying tend to have a better predictive value than clusters of selling. That’s because insiders are willing to sell a stock for many reasons but they are willing to buy for one main reason—they expect their company’s stock to go up.

Short Interest

While the numbers of futures and options contracts held long and short is equal by definition, in the stock market there is always a huge disparity between the two camps. Most people, including professional fund managers, buy stocks, but very few sell them short.

Among the data reported by exchanges is the number of shares being held short for any stock. Since the absolute numbers vary a great deal, it pays to put them into a perspective by comparing the number of shares held short to that stock’s float. This number, “Short Percent of Float,” tends to run about one or two percent. Another useful way to look at short interest is by comparing it to the average daily volume.

By doing this, we ask a hypothetical question: if all shorts decided to cover, while all other buyers stood aside and daily volume remained unchanged, how many days would it take for them to cover and bring short interest down to zero? This “Days to Cover” number normally oscillates between one and two days.

When planning to buy or short a stock, it pays to check its Short Percent of Float and Days to Cover. If those are high, they show that the bearish side is overcrowded. A rally may scare those bears into panicky covering, and send the stock sharply higher. That would be good for bulls but bad for bears.

FIGURE  AAPL and GMCR shorting data.

Fear is a stronger emotion than greed. Bulls may look for bargains but try not to overpay, while squeezed bears, facing unlimited losses, will pay any price to cover. That’s why short-covering rallies tend to be especially sharp.

Whenever you look for a stock to buy, check its Short Percent of Float and Days to Cover. The usual, normal readings don’t provide any great information, but the deviations from the norm often deliver useful insights.

High shorting numbers mark any stock as a dangerous short. By extension, if your indicators suggest buying a stock, its high short interest becomes an additional positive factor—there is more fuel for a rally. It makes sense for swing traders to include the data on shorting when selecting which of several stocks to buy or sell short. I always review these numbers when working up a potential trade.

Share:

No comments:

Post a Comment