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The following is a guest post by Charles H. Dow Award winner, Wayne Whaley (CTA) of Witter & Lester. If you would like to receive his daily market email, send an email to waynewhaley [at] comcast [dot] net with the subject “ADD ME TO DAILY EMAIL”.
When stocks are making unified surges in either direction, the market shows conviction and the historical tendency has been for equity prices to eventually work their way higher. Below shows the one year performance for the S&P 500 as a function of ADT (where ADT equals the five day sum of daily Advances divided by the sum of Advances plus Declines on the NYSE). Note that when ADT reaches a level above 70 (Thrust) or below 20 (Capitulation), the intermediate outcome for equities leans strongly toward above average returns - with the average annual return at 8%. Also note from this data table that ADT reached 76.53 on September 9th, 2009 and 20.47 as recently at May 20th, 2010:
FIVE DAY ADT vs. 1 YEAR S&P 500 PERFORMANCE
For the above table, data from 1970 to May 2009 was used to allow one year forward return calculation for the S&P 500 index.
The opposite environment would be periods where stocks are displaying characteristics of confusion or loss of focus. I produced a table in Planes, Trains and Automobiles of a confusion index that was a function of both the number of stocks making new 12 month highs or new 12 month lows.
The concept was (similar to the ADT example above) that in bull markets, you should have either a lot of stocks making New Highs or a preponderance of stocks making New Lows, but not both. The Confusion Index was a moving average of the minimum of either the issues making New Highs or New Lows divided by the number of issues traded.
For example, if on any day, there were 3500 stocks trading and 70 made New Highs and 35 made New Lows, the one day confusion index would be calculated as follows:
One Day Confusion Index = Min(70,35) / 3500 = 35 / 3500 =1%
WCI smooths the above one day index with an exponential moving average of 0.05:
WCI (I) = 0.05 * [Min ( NH(I),NL(I) ) / Issues Traded] + 0.95 * WCI (I-1)
High readings (above 1.5) are bearish while low readings (below 0.5) are bullish. An WCI reading of 1% would indicate that we are in roughly a one month period where the NYSE is averaging at least 1% of issues trading at both New 12 Month Highs and New 12 Months Lows on a daily basis, a high number of stocks moving in opposite directions.
Since Planes Trains and Automobiles was written, I have made a minor modification to this index. I will be publishing more details on this soon, but the new index takes into consideration the range of the trailing 12 month market, as well as the number of issues making New Highs and Lows. Below shows the results of the new confusion index. The index has ranged from 0 to 2.4. As you can see, high readings tend to be bearish and vice versa.
ONE YEAR S&P 500 PERFORMANCE AS A FUNCTION OF WCI
For the above table, data from 1971 to May 2009 was used to allow one year forward return calculation for the S&P 500 index.
The current Confusion Index is currently (as of June 1st, 2010) at its 12 month high of 0.50. It would be very out of character for the market to go into bear mode without exhibiting more signs of confusion. For example, below is a list of major down turns in the market since 1970 and the level at which the Confusion Index (WCI) peaked in the preceding six months. As you can see, WCI reached at least 1.0 at some point in the six months preceding each of these down moves.
Bear Markets and Wayne’s Confusion Index
- 2007 The market peaked on October 19th and a seventeen month, 56.8% decline followed. WCI peaked at 1.71 on July 23rd, 2007.
- 2000 The market peaked on March 24th and a 49.14% decline followed. WCI peaked at 2.05 on January 3rd, 2000.
- 1987 The market peaked on August 25th, 1987 and a very short but painful two month 33.24% decline followed. WCI reached 1.12 on August 8th, prior to the peak and actually reached 1.86 on October 6th, 1987 before Black Monday on October 19th 1987.
- 1981-82 The market peaked on November 28th, 1980. A 19 month, 37.2% decline followed. WCI peaked at 1.94 on February 14th, 1980
- 1976-77 The market peaked on Sept 21st, 1976 and a 7 month, 16.6% decline followed. WCI peaked at 1.11 on June 10th, 1976
- 1973-74 The market peaked on Jan 11th, 1973 and a 21 month, 48.15% decline followed. WCI peaked at 1.57 on November 16th, 1972
The Confusion Index gave no indication that the recent 13% correction was in the cards and has missed some other 10% corrections as well, but it has an excellent record of calling bear markets and it would be very unusual - actually unprecedented - to go into a bear market without a +1.0% reading at some point in the six months prior to the downturn.
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