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First, a warm welcome to the many new readers that have arrived from Michael Santoli’s column at Barron’s magazine. If you haven’t yet, add the blog’s feed to your favorite reader or (scroll down a bit) and sign up to receive updates sent to your email.
I wanted to revisit an idea that I shared a long time ago, in the first few days of starting the blog: Timing the Market with Moving Average Ratios. But this isn’t the way that you would normally use moving average ratios. It is instead a rather complex way of measuring breadth.
The first step is to count each day the percentage of S&P 500 constituent stocks that are trading above certain moving averages. The averages I’ve used are 50 as a medium term outlook and 150 as a more long term outlook.
Next, what I’ve done is to take the percentage of stocks in the S&P 500 trading above their 50 day moving average and divided it by the percentage trading above their 150 moving average. I’ve plotted this ratio on a logarithmic axis as you can see in the graph below.
I’ve highlighted with a green arrow the corresponding instances on the S&P 500 chart where the ratio falls to 0.5 or lower. As you can see this breadth measure does a fairly good job of identifying intermediate buy points in the market. It certainly doesn’t find them all and it does err a few times, either in being early or in being simply wrong.
This doesn’t automatically mean that you jump up and buy with both hands and eyes closed. A more intelligent way of using this indicator is to say that the probability of further downside is limited and one should look for good targets to exit shorts or to tighten stop losses on them and to make a list of stocks and indexes close to support as potential longs.
Another point to recognize is that during major upheavals in the market this breadth ratio gets skewed. You can see this during the 2002 bottoming process as well as the March 2009 low (blue arrows). Both of those instances did correspond to a “spike” lower in the ratio but since the ratio was still so elevated, technically it didn’t count for our criteria of using only 0.50 or lower levels.
Right now, according to this measure, we aren’t yet at an inflection point in the market. But it definitely is worth the while to keep a lazy eye on this ratio. Since it tends to fall very quickly and spike below 0.50 it could very well happen during the next correction.
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