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Lesson 4: Overbought -- Index Percent Above 50-Day Moving Average

Should I stay or should I go? the big question in timing the market. If you are going to buy low and sell high you need to find your own way of seeing when things are too high or too low. Well no one knows for certain markets are high or low, but there are some clues when things are too good to be true. We call these conditions overbought. When a market is overbought it is not necessarily the end of the run but caution is warranted and of course same is true of oversold.

You can move in and out of a stock and make some money by simply drawing a line that is the 50-day moving average of that stock and overlaying that over the stock. In other words you own the stock when it is above its 50-day moving average and sell it when it is below. Here is an example of IBM (below), the real price is the green line and the red line is the 50-day moving average. You buy IBM when it is above the 50 day average, in other words when green is above red buy, and sell when red is above green.

 (as always any graphic can be enlarged by clicking on it)

The good thing about this simple system is you are never long in a big sell off downturn, you have set an absolute point where you no longer want to be in IBM. You will never own IBM in a big crash or if the company were in big trouble. For example in July to September 2013 you can see that the company was falling out of favor with investors and this system would have kept you out of the sell off.  However there is some bad news too -- you also will from time to time jump off just as the stock was about to rebound. For example look at mid March 2014, you would have sold your IBM stock just as it was about to retrace and run back up again. You also can miss a big part of a volatile bounce -- in mid April 2013 you would have missed most of the recovery from 102 to 107 for this stock. Talk about sell low and buy high!

Of course if you play something with lower returns and more stable swings you are going to get less whipsaw. The graph below is an ETF call Diamonds, ticker DIA. It tracks the 30 huge companies of the Dow Jones Industrial Average, big companies like GE and Exxon. Of course DIA is very stable because market conditions are seldom bad for all 30 stocks -- so the results are more smoothed and averaged. It is also true returns will always be lower because a few laggards in the 30 stocks will decrease your overall return.

What we need is "early warning" something that starts to show that things are not well while the market is still moving up at the end of a move. Sort of like how people feel a bit "off" before coming down with a full state of sickness.

Now that you understand that we can tell the health of an individual stock or even a market index by its price relative to the 50-day moving average, you are ready for the next leap in thinking.  What if you were to count all the stocks in an index and figure out a percentage of stocks were above the 50-day moving average and how many were below. Well that is just what I do with two of my key indicators; I do one for the NYSE stocks and in a total different format another for the S&P500. 

If 10% of the companies in an index are above their 50-day moving average I know that the stock market is crazy pessimistic and oversold, and probably the market will turn around soon, unless there is a super economic disaster. The same is true if 90% of the stocks in an index were performing above the 50-day moving average. Then you would say, OK come on now that really is over optimistic, not every company is doing well at any moment in time. That means someone is buying stock in poorly performing companies, a sure sign of the top of a market and a good time to eye the exit door.

So my personal favorite of these is this simple graph (above) of the 500 heavyweight firms that make up the S & P 500 index. The “real data” this chart is based on is the squiggle at the bottom. It is based on a stockcharts dot com symbol $SPXA50R that does all the math to figure out how many stocks are of the S&P500 are above their 50 day moving average. In the example look at the bottom window and you will see a reading of about 82%. That says 82% of firms in the S&P500 are priced above their 50-day moving average. That is really optimistic, as I said before, that’s a lot of successful companies, or somebody is buying up the junk.  

Now you will notice this is not the biggest window, the big window is the one on top and this is an indicator based on the percentage. The indicator is in fact MACD measurement of the momentum. MACD can often show you subtle changes quicker than the real data. So even though the real data looks like the market is holding about 82% the MACD shows that the growth of change (or you could say momentum) is abating and that collapse is likely. I also have drawn two lines to show you about when to panic. A cross below the lower line when the graph as been above it shows the market is selling off and a cross above the upper line after a turn down is a sign of healthy market and buying opportunity.

The Window below the big one is the same MACD in a Zig-Zag graph. I want to warn you that a Zig-Zag graph, draws lines retroactively, in other words it can change it mind later. Of course it draws a perfect “what ya should have done” because it changes based on swings of 10% after they happen. In real time this graph can point the wrong way then fix itself when the trend is obvious later. Still it does have value in that it creates an impression of what the trend is when it passes a certain limit.

Think about this, these graphs are derivatives, they don’t directly measure the market prices like say the Bull and Bear lines do. They measure an abstraction based on the markets fundamentals. Often the indicator can begin signalling trouble way early other times only just before a sudden pull back. These graphs were as caught off guard by the 9-11 attacks as all the participants of the markets were. Also they can drift off while the market marches on but the more the divergence the worst the correction is when it does come. That is logical when you think about what the graph is telling you, as less and less stocks are above their 50-day moving average it means the market is more and more based of a few super stocks. We saw this in the dot com bubble as only a few internet high flyers and Enron were left to carry the market as everything else collapsed.

In the second from the bottom window is the S&P500 market price. The face three colors are an indictor called Elders ImpulseSystem. (I use the Elder colors not so much because it is helpful as it does make a pretty graph.) Notice on the last few days of the graph that the market index is still hitting new highs, but the top part of the graph is in decay, that tells you fewer stocks are involved in that push higher. Now the question is, will the graph on top give way and proceed up or is this an overbought market ripe for a sell off. Well unfortunately either could be true, but look at some other indicators and you see this is a long running bull, in a summer time market, on low volume and you can guess the odds favor a near term market pull-back. The science of technical analysis must always be interpreted through a healthy dose of the art of market timing by instinct/experience/cynicism. 

OK lets say you decide that the market may run some more and you want to enjoy that but you are a little more wary based on this indicator. Well you can either move now in to bigger more stable equities that are less prone to market turns downs, like utilities and financial stocks or you could stay long your high flyers but move your trailing stops really tight in anticipation of trouble.

I mentioned that I use two graphs of this nature, my other one is based on the big stable stocks on the NYSE exchange and I draw it differently just to get another view point. For this we use the Stockcharts symbol  $NYA50R

Of course most broad indexes are correlated and many stocks in these two indexes are are in both, so it no surprise that you get a similar story from both of these graphs.  Both graphs have MACD on top to increase responsiveness, both have the broad market below in Elder Impulse Colors,  and both show the underlying data. 

The NYSE version is a little slower to react since it is broader based. You can also see it has this habit of often reaching 80% on the raw data before retreating -- well it least it does in a bull market. 

Of course I had nothing to do with the invention of these indicators, most of this was pioneer by the master of Technical Analysis: John Murphy. You can find his most famous book Technical Analysis of the Financial Markets here. There is some more excellent material on this subject here: Percent Above Moving Average

Read My Disclaimer Here

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