Friday, November 17, 2006

Spotting reversals

Finding the reversal points in the market is the $64,000 question every trader and investor wants to know. But, more important is knowing when to be aggressive or passive when calculating risk exposure to the market. Luckily, there are a number of tools available to help you identify the most likely point these reversals can occur.

I concentrate on Nasdaq market internals as the Nasdaq is more likely to lead an overall market reversal than using market internals of large cap indices. There are three Nasdaq internals I focus on: the Nasdaq Summation Index, the Nasdaq Bullish Percents, and the Number of Nasdaq Stocks above their 50-day MA.

The Nasdaq Summation Index is a great internal to mark reversals, particularly if a weekly time frame is used (I also use a 5-day EMA trigger line on a daily chart). It is not a perfect market internal as some will testify, but it is a valuable tool. At its simplest, tops occur when the internal reaches zero and above; bottoms occur when the internal reaches -800 and below. Between these extremes one should trade in the direction of the prevailing trend. The major weakness of the internal was made apparent back in 2000 when the Nasdaq Summation Index failed to climb to zero when the Nasdaq peaked at the rarified air of 5,000; whether one would have had the smarts to bail before it next reached zero would have been down to individual smarts. One could include a caveat to sell on a loss of the most recent reaction low (assuming the internal doesn’t make it to zero). What can one say about the Nasdaq Summation Index now? There has been a significant break of 2003 resistance setting up a potential run to challenge 893 highs. Assuming an average gain of 100 points per week, one can look for a top in this indicator in around 5 weeks. The parent Nasdaq may then diverge from the Summation Index; pushing higher highs as the Summation Index makes lower lows – when the Summation Index breaks zero on the way down is usually when the Nasdaq takes a big step down.

The next indicator I use is the Nasdaq Bullish percents. This indicator has had a mixed history; a whipsaw period from 2000 to 2002 has given way to a more “mellow” period of swings. Since 2002 there looks to have been a displacement of overbought/oversold zones; pre-2002, tops and bottoms came in the 50s and 20s respectively, post-2002, tops and bottoms now fall in the 30 and 70s range. Again, it is not a perfect indicator as reversals can occur before extremes are reached. The MACD may be used to confirm a signal, but its switch to a ‘buy’ or ‘sell’ lags the Nasdaq reversal, limiting its appeal. Changing the settings of the MACD to a tighter time frame [5,9,3] may help.

The best way to prepare for reversals is to look for a weekly change from up-to-down, or down-to-up, after a long period of gains or declines. Again, in May and June of 2006 this led to whipsaw signals, the most recent signal was given in October 2006 and was a ‘sell’. Utilizing a faster MACD setting reduces the number of signals, taking out one of the whipsaw signals from May 2006 and the premature ‘sell’ signals in November 2005, not to mention the October 2006 signal.

The final market internal I use is the number of stocks over the 50-day MA. For the purposes of this article I am using the percentile range. Like any market internal it isn’t perfect. Bottoms come in around 30% and below, tops occur at 60% and above. Where problems can occur was made apparent in early 2003; back then the indicator reached 60% relatively quickly while the Nasdaq lurked around 1,500, the market internal then whipped around in the 50 to 90 percentile range for the rest of the year as the Nasdaq climbed up to 2,100 – so clear signals were difficult to compute. One area it can be helpful is in spotting divergences, such as the one which occurred in early 2006; will the current action around the 60 percentile lead to something similar?

An alternative market internal is the number of stocks above the 200-day MA. While it is more difficult to define the overbought/oversold range, it does hold up better to MACD histogram signals. The ‘buy’ signals hold up well, but a better ‘sell’ signal looks to occur once the histogram starts to rollover (the blue circles). But, 2003 was also problematic for the market internal when the market peak came when the histogram made new lows! In the current case, the MACD ‘buy’ from August 2006 holds, but the MACD histogram looks to have peaked (or is very close to doing so).

There are a number of other market internals which can be used, including the Nasdaq New Highs-New Lows ($NAHL) and Nasdaq High-Low index ($RHCOMPQ), but I find these internals too busy for my purposes.

It is my analysis drawn from these internals that I allocate a


rating which can be found at the top of the page, above my Collectiv2 portfolio returns. I should add, I am not trying to call an absolute top or bottom for the markets as this is a pure crapshoot - and don't let anyone fool you otherwise (because every reversal needs technical confirmation, and these confirmations take time to complete). What I am looking for is the point in the trend when one should considering buying into weakness, or selling into strength. You can see in my Collective2 portfolio returns based on a sample $100K account:

how I jumped the gun a little in May (eventhough I was bearish) and was slapped down for doing so. When I felt the market was more conducive to long positions I was able to take advantage. In May/June I was running a 80:20 equity:cash exposure. October looks like it will be the strongest month for returns, even though I am now bearish the market. These returns are based on an 16:84 equity:cash exposure, using a trailing stop to take advantage of blow off moves common at this late stage of the market. Only 2 positions remain in this portfolio and I can't see this changing for another few months yet.