Tuesday, December 18, 2007

Bullish Percents

The bounce off November lows has many questioning the validity of the recent market bottom. As I have mentioned before, I like to study the internals such as the bullish percents to get an idea of the quality of reversals as they occur. The big advantage of using internals is their relatively smooth oscillations from oversold to overbought conditions. They are not perfect, but it is relatively easy to filter out noise.

Monday's declines with the loss of 200-day MAs for both the Nasdaq and Dow will have driven a knife through many bull's hearts. But how has the (now) six day decline changed the rally off November lows?

First up is the Nasdaq Composite Bullish Percent Index. The clearest illustration of the bullish percent working in tandem with trendline support was the August-November rally. Harder to classify is the current November-December decline. Based on the initial (bearish) trendline drawn from the two peaks in late October and early November, December's break was nothing more than a bull trap, which suggests the recent rally was a little too soon for bulls. However, there is an alternative support test coming up from a support line connecting November and August lows. With the bullish percents retreating back to oversold levels there is another opportunity for bulls to show their mettle and work up a new rally.

What of the "whipsaw" signals? Whipsaws are a factor in any system which relies on crossovers to generate signals. The bullish percents move quickly to extremes, allowing for a tight EMA trigger line to signal reversals. However, there are occasions when signals come a little early. The two ways to filter out whipsaws are to ignore signals which occur in "No-mans land". The other is to wait for confirmation from a trendline break. In the case of the two whipsaw signals for the Nasdaq Bullish Percents, the trendline provided the best filtering option.

When you have an index which has fewer stocks, the range of the bullish percents pushes more towards the extremes of 0 to 100. The S&P 500 Bullish Percent Index for the past 6-months has knocked around the low 30s to the high 70s, compared to the low 30s and low 50s for the Nasdaq. This is in itself telling as it shows the S&P to the stronger performing index, given it had a higher proportion of stocks on bullish 'buy' signals.

Like the Nasdaq Bullish Percents, the S&P's showed a very tradable rally from August through to November. However, the S&P has distinctly different November low than that of the Nasdaq. First off, the rate of decline from October has been slower, with resistance clearly defined by the two peaks in October and the December reaction high - the latter high not forming part of a bull trap as was the case for the Nasdaq. The second difference is the positioning of the latest 5-day EMA crossover - in a region associated with three prior whipsaw signals. Given the net trend for the S&P bullish percent is higher, the best assumption for the current decline is it is part a bullish pullback of a yet-to-be-confirmed new uptrend (confirmation coming on the break of resistance). Bulls have the additional advantage of August and November closing lows at 1,407 to define both support and risk. Should 1,407 be violated on a closing basis, then confirmation of the new rally will take longer.

Finally, there is the Bullish Percent index for the Dow (I wish there was one for the Russell 2000). Here, movements to extremes become more pronounced as only 30 stocks are featured. But, once again, the net bullishness is emphasised with a six month range of 50s to mid-90s. The bad news for bulls is that in a true bear market it is likely to move down to the 10s.

Unfortunately, the index lacks some of the clarity of the Nasdaq or S&P. The decline from October has the measured pace of that of the S&P, but the rally off November lows generated a bull trap much as it did in the Nasdaq. But unlike the prior two index bullish percents there hasn't been a bearish crossover in the signal line - keeping the rally off November lows in play and increasing the chance for a run at 13,750 to negate the bull trap. Whipsaw signals for this index have occurred at would be considered heavily overbought levels - so the filter range for such signals needs to be higher for the Dow, compared to those of the Nasdaq or S&P. This leads to the possibility of a whipsaw signal at current levels should weakness continue. Bulls will need to be more cautious on the Dow and look to 12,750 to hold on a backtest. No new long signals should be initiated until the bull trap is negated.