Technically, I’m not a technician. The idea behind technical analysis is that historical price, time, and volume data has some predictive value, and at least from an empirical perspective I’ve seen some investors who are able to harness that data to gain an advantage. I think the challenge is to find an indicator or methodology that can systematically be used for an advantage, and like fundamental analysis, or any investing for that matter, the challenge is as much in the implementation and discipline as the discovery of the method.
All of that said, I do think charts can help investors gain a perspective rather quickly on potential outcomes or tell a story rather quickly. So here’s a story…
This chart may be rather confusing, so let me give a rundown. One line is the NYSE New Highs – New Lows Index. It very simply tracks how many stocks are making new highs and how many are making new lows. It stands to reason that as more stocks make new highs than new lows, the equity tracking indexes (i.e. the S&P 500) should rise and vice versa. I took this chart back five years, but the chart can be traced back as far as an investor might want, and bring up 2 simple questions: Do you want to invest when new highs – new lows are extremely high or extremely low? and If there is a major divergence between the new high-new low index and the equity indexes, what should you do?
This is a question of mentality. Momentum players will tend to look for trends to continue. If new highs-new lows (NHNL) is rising, they’ll want to buy the equity indexes (we’ll use the SPX for reference). Indeed, that works until it doesn’t. Contrarian investors will tend to want to do the opposite, which obviously fails until the turning points. Here’s the kicker, though, the key is in the divergence.
In late 1999, the NHNL index started turning downwards, and actually became quite negative, while the SPX continued to rise. That should have served as a warning sign. It tells investors that the market is being carried by fewer and fewer companies. Conversely, in 2003, the market was down, but the NHNL index was moving up and making new highs, a signal that there was a move up coming.
Where are we now?
We are not at extremes, but the divergence is growing. Te market continues up this year, with fewer and fewer new highs relative to new lows. I already discussed that Apple has been carrying this rally, while the underlying fundamentals continue to deteriorate. We aren’t at extremes yet, but if nothing else, the growing divergence should give investors pause. If we see the NHNL continue to trend down and into negative territory while the market trends up, it will only relay an ever larger correction coming our way. For now, either we need to see more stocks participating in the rally or the market correct in order to close the gap – my money is on the latter.
Relevant ETFs: SPY, SH, VXX, DIA, IWM, RWM