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3 Pointers to Market Strength

3 Pointers to Market Strength
February 02
17:30 2011

When you first start to trade stocks, you probably followed the Dow Jones Industrial Average and the S&P 500 as your chief indications of the strength of the market. After all, these are the figures that are presented to us every day by the media in talking about the economy. But when you really need to know how the economy is doing so that you can fine tune your investment strategies, you need to look beyond these simple summaries and to the underlying strength.

First, you want to look in the Wall Street Journal, and the online edition is great for this. It will give you such vital information as the number of advancing issues and declining issues. The DJIA is based on just 30 companies, so the advancers v. decliners gives a much better idea of the market as a whole,  with more than 3000 issues. You can put an advance-decline line on your charts, if your software supports it, and you will see that it normally follows the index, as you would expect – the saying is that the troops are keeping up with the generals – so any deviation from this would be significant, and just what you are hoping to find out from going more in-depth.

There’s also an indicator for that, called the McClellan Oscillator, and this oscillates around zero, giving an overbought/oversold indication based on the advance and decline figures. When it gets near 100, the market as a whole appears overbought, when it goes down near to -100 the market is oversold, and some traders will take the zero crossing as a trading signal.

A second way to view market health is by looking at new highs and new lows. This can be seen as an indicator, which can be the number of highs minus the number of lows each day, which is a spiky graph; or cumulative highs minus lows; or new highs divided by new lows. With this last indicator, any time it exceeds one the highs outnumber the lows, and a fractional value means that the lows predominate.

The third pointer to the strength of the market is the volume of trading. Usually you can look at the volume in advancing issues which is called upside volume, comparing this to the volume in declining issues, or downside volume. You can look at two separate lines, or you can combine them for a single strength indication. Once again, if you compare this indicator to the market index itself, you should find reasonable agreement. Any time the two lines deviate, it suggests that the apparent fundamentals are not strong, and you can look for changes to come.

The volume of advancing and declining issues is combined into an indicator which was called the Arms Index, after its inventor Richard Arms, but is now commonly referred to as the TRIN, short for Traders’ Index. This is a contrary indicator, going below one when there are more rising stocks, and rising above one with a declining market. Richard Arms saw its best use as an extreme indicator, and thought that the most significant indications were very high or very low values.

Armed with these three concepts to explore what the market is really doing, you will be able to make a much better assessment of where you should be putting your trading energies.

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