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A few weeks ago Maoxian was going over his call in mid September 2006 to lighten up on the energy sector. As it turned out, that was the time to actually put money to work. I piped in saying that if you were watching the bullish percent chart for the sector, you would have noticed that it was very oversold (at around 20-30%).
In case you missed it, earlier I went over how you can use the bullish percent indicator to time the market.
In any case, the Chairman brought up a great point in reply: that bullish percent charts can misguide at times of major trend change. As I mentioned before, a bullish percent chart can go all the way from 0% - that is, no component of the index being in a point and figure buy formation; to 100% with all of them being in bullish formation. So eventhough we key off specific extremes like 20-30% for lows (bottoms) and 70-80% for highs (tops) there is no reason why the indicator has to bounce off those levels. Or any reason why it can’t simply sit at a level and remain there for as long as it wants to.
Looking back through time, sure enough, we find examples where the bullish percent chart of the energy sector did fall below the 20% level. In fact, in July 2001 it fell to 10.53% and in the aftermath of September 11, 2001 it fell to an unheard of 3.80% !! Within a year, it was back at those “unheard of” levels: 6.58% (July 2002).
So we obviously can’t just push “BUY” when it hits 20%. I don’t think you should consider any indicator, no matter how great its historical performance, in isolation and let it dictate your trading decisions by itself. Although it makes matters more complex, we increase the chances of success by layering several indicators on top of each other and only going long/short when there is maximum agreement among them.
But assuming that you had gone long on a signal (at the 20% level) as a trader you would only have lost as much as your stop loss. You do have a stop loss, right? In late July 2001, when the energy bullish percent index and the sector itself continued lower you would have had a logical rethink. Your losses in that case would have been quite limited.
In the broader market, in recent years the Nasdaq (COMPQ) bullish percent’s “low” extreme has usually been around 35% while in the years 1999-2002 it’s low was 20%-25%. This isn’t surprising when you consider that recently we have been in a bull market, while back then we were in a bear market. In a bull market, we are apt to see more shallow pullbacks and to see the indicator spending much longer meandering in the higher ranges as overbought leads to more overbought. So you shouldn’t treat the bullish percent levels as absolute, but rather as guidelines which give a feel for how overbought or oversold the market is.
The most important point I can leave you with is that in order to get the most out of the bullish percent indicator, we must first recognize whether we are in a bull market or a bear market. That may seem to be a tall order but with a few tricks, tips and indicators it isn’t that difficult. Of course, nothing is guaranteed but being on the right side of the market isn’t as impossible as economists and EMH theorists would lead you to believe.
There is especially one little known indicator which has an uncanny ability to point out the genesis of bull markets. Care to guess which it is? I’ll cover it in a little while if you can’t anyway (hint: it starts with a “C”)
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