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The New Highs / New Lows Indicator at Trader’s Narrative

I’m not really sure what to call this indicator. The new highs/new lows indicator sounds awkward. I wish some technical analyst with a cool sounding name had created it so we could be saved from such banality.

Whatever you wish to call it, this indicator looks at the 52 week new highs and the 52 week new lows. It is calculated by taking the new highs and dividing by the sum of the new highs and the new lows.

So when it returns zero, there were no new highs and when it returns the other extreme (100) we know that were no new lows. And when it is at 50, this means we had the shocking circumstance of exactly the same number of new highs and new lows. Simple, right?

On with the analysis. Let see what this indicator can add to our understanding of the market. Because it can be a bit jittery, I like to smooth it out with a very short term moving average (5 day). So when I mention the indicator below, I’m really referring to this moving average.

Bottoms Up!
For one, new highs new lows (NHNL) does a phenomenal job of pointing out inflection points after a downtrend. Historically, when it breaks below 20, the market has taken enough of a beating and finds a bottom either immediately or within a short period of time. Of course, there is no reason why it can’t go right down to its minimum of zero.

Last time this happened was in July and September 2002 - the darkest (and final) days of the bear market. But it reaches such extremes rarely. Usually it reverses at or around 20. The last time it did that was last year (July 2006) which marked the last great buying opportunity of the summer doldrums.

Shallow Retracements
But inflection points don’t necessarily even need a reading of 20 on this indicator. For example, this year’s early March bottom was formed at a reading of only 40. Shallow retracements are a hallmark of strong bull markets. Take for example what happened in 2003. After bottoming in just below 10 in the early months of the year, both the market and this indicator shot up to much higher ground.

From the summer onwards however, the indicator saw almost no more real retracements. Eventhough the S&P 500 didn’t go straight up, each time it faltered, the new highs new lows indicator only dipped minimally. And then recovered right away. It spent most of the time hugging the 100 line. And its largest retracement only reached only 80. On it went like that for the rest of 2003 and into 2004.

Now that’s a strong bull market!

Another characteristic of this indicator that I noticed is that shallow retracements have different meanings. It depends if they happen after an extreme low has already been reached prior to it or whether the shallow retracement occurs after a maximum has been reached.

Let me explain. If we keep walking forward with the example I last mentioned, in early 2004 we had our first correction of the new bull market. But the NHNL indicator dropped to almost 70. The next correction was in May 2004 with the market dropping a little bit lower than the March 2004 lows. NHNL fell again but this time to almost reach 20. Then again in a few months, the market fell again (August 2004) and this time the NHNL got a real extreme low reading (below 10).

My point is that the first time the NHNL fell, it wasn’t really extreme. And since it was after it had already been at the extreme high, it was telling us that this wasn’t a real market bottom. Only after reaching a real extreme (below 10) did the market finally find its footing again.

Smooth Sailing
So shallow retracements of NHNL while the market is dropping are not to be trusted. But if they occur after it has already reached an extreme they signal a continuation of the bull move already underway.

Let me explain by continuing the 2004 story. In October 2004, the market again dipped. This time however the NHNL indicator only dipped below 50 - a shallow retracement. But since this was immediately after a very extreme retracement (below 10) in August 2004, it was a signal that the bull move was still going strong.

So what does this indicator tell us about the current market?

For starters, the correction in March 2007 corresponded to a shallow NHNL retracement (40). And since it ocurred after it had already been high for some time this meant that the decline wasn’t finished. But of course, it was - atleast as far as we’re concerned. This was the first time since I have data for the NHNL indicator that such a shallow pullback following a time at the maximums was the real deal (significant bottom).

And the latest correction which we had hardly registered on this indicator. In early June 2007 it slipped just below 80. So are we seeing just a correction within a strong bull market?

All the NHNL indicator can really tell us is that the latest correction was very muted. Even more so than the March 2007 one. But as long as we are in a strong bull market, that isn’t a problem. Short and shallow retracements are par for the course. The best way to be more certain that we are seeing that sort of scenario is to reach new highs.

Click to Enlarge Graph
new highs new lows spx 2004 - 2007Notice how the shallow pullbacks (orange arrows) that follow immediately after a climax low are good buying opportunities (October 2004, May 2005 and August 2006) but those that happen some time after treading maximums are not (August 2005 and March & April 2006)

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