Trader’s Narrative

Last Monday I gave the heads up on the financial sector because its bullish percent index was at an extreme low. In the following days both the sector and the bullish percent index continued to fall.

In fact, the financial sector bullish percent index fell to below 26. A level which it had only seen in the deepest, darkest days of the bear market in late 2002.

As you can imagine, there was a lot of fear and loathing in the air. A lot of uncertainty. Talk of a big bank going under, the sub-prime mortgage mess spreading, etc. But the best time to buy is when everyone is scared witless. That is when you find real bargains.

Unless it is the end of the world, in which case you’ll have bigger things to worry about.

It wasn’t just the bullish percent, by the way, that was signalling the extreme situation in the financial sector. The percentage of stocks above their 200 day moving average fell to 10%. Again, something that had only happened in the final days of the bear market.

Things have bounced back from the brink but we’re still very oversold. Right now only 12.5% stocks closed above their 50 day moving average. I expect this sector to continue to slowly claw its way back. If you haven’t gotten in, there’s still time to buy great banks, brokerages and insurance companies at firesale prices.

Although I use the bullish percent index a bit differently, the traditional interpretation has been satisfied: when the index falls below 30 and rises above it, a bull or buy signal is given according to point and figure charting.

Bullish percent (BP) charts are calculated differently than other price charts you may be familiar with. For starters, they aren’t really price charts. Second, they’re only applied to an index or group of stocks not individual stocks. And at their heart, they rely on point and figure charting. Tom Dorsey couldn’t have predicted their success or wide application when he first popularized the New York Stock Exchange bullish percent index.

A bullish percent charge is calculated by first taking each component stock and charting it using the point and figure system. Then those that have a point and figure buy signal are added together and this number is divided by the total number of stocks in the index or group. Theoretically, a BP chart can span from 0% to 100% where no stock in the index has a PnF buy signal and where they all do. But usually it tends to oscillate between 70% and 30%.

Dorsey never intended his creation to be used the way I use it, but I’ve found that it is quite a useful way of looking at sectors when trying to identify tops and bottoms. Of course, I don’t exclusively rely on this as a signal but it is a great way to confirm other technical analysis. Take a look at this example from last summer:

Mid-August saw the lowest reading in the bullish percent index of the transports since March 2003! Doom and gloom was thick, peak oil was being bandied about matter-of-factly everywhere and oil was pushing $80 a barrel. You would be a fool to suggest going long. But that’s exactly what the bullish percent was saying.

And here’s the result:

The extreme low (20%) marks the exact intermediate bottom of the Transportation Index. There is a weak retest in early September 2006 but the previous low holds. From there, the index powers ahead with higher highs and higher lows. If we assume that you were taking your exit signal from the bullish percent index, you would probably exit when it reached the other extreme (high of 85%). That would give you a 12% move in about 3 months. And that’s assuming you went with the index and not individual stocks which would have moved with a larger beta.

So what about right now? Are there any sectors or indices that look like the transports did last summer? I’ve scanned them but alas, none are low enough to show an extreme washout. But keep an eye out on the bullish percent and you may find a very compelling signal soon.