Indicators That Spot a Market Bottom

Now that the stock market has finally delivered a pull back, it is important to think about which indicators will signal the likely completion of the down move. It is also important to remember that no indicator will be 100% accurate, at bottoms or at tops.

When thinking of indicators, many traders will turn to familiar tools like the stochastics or the MACD. While these tools are popular, they aren’t very useful at turning points. The chart below shows these two indicators for the SPDR S&P 500 ETF (NYSE: SPY).

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  • The chart shows that these indicators moved down along with price. Stochastics was at an extremely high level, known as overbought, for weeks before the decline. Traders acting when the indicator becomes overbought would miss the gains of a bull market.

    MACD is at the bottom of the chart and it also offered no warning in advance but moved with the price. Traders may claim they can spot divergences or other factors that signal a trade in advance, however these types of signals will always be early and would cause a trader to miss much of an advance.

    Stochastics and MACD are examples of momentum indicators and these indicators can be useful as part of an analysis, but will always need to be supplemented with other tools. Among the other tools that can be used are breadth indicators.

    Looking Beyond Momentum

    Breadth indicators measure how broad the participation in a price move is. A popular breadth indicator is the advance-decline line which is calculated by subtracting the number of stocks declining every day from the number of stocks advancing.

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  • Other breadth indicators can be based on volume which also shows how broad the participation in a price move is.

    Volume can be especially useful to watch when the market is falling. In many ways, volume offers an insight into the sentiment of traders. If traders are relatively calm, we should expect volume to be relatively low and steady.

    But, when traders, as a group, become excited or nervous, they tend to act with a sense of urgency. If the market is rallying sharply we may see a surge in volume as traders buy because they are concerned about missing the rise in prices.

    Volume can be most helpful to watch when prices are falling. Declining prices can create a high level of fear in traders and they have a tendency to react with a sense of panic when they become fearful. After all, real money is at stake and no one wants to watch their losses mount as prices fall.

    This is the basis of the VIX, or volatility index. The VIX is often called the fear index because it spikes when stock market trading are selling off. This behavior is well known and volatility has come under scrutiny as the potential cause of the recent 10% decline in the stock market.

    While many traders are focused on VIX, some traders follow volume for clues about the progress of the sell off.

    A Volume Tool for Spotting Bottoms

    The key to interpreting volume indicators could be the intensity of the volume. When panic sets in, it appears that traders are saying they want to get out and just want to raise cash no matter what the price is.

    On the flip side, when prices are rising, or when traders believe a bottom has formed, they want to get in to the stock market and they become buyers with the same ferocity that they were sellers just days earlier.

    Technical analysts noticed this behavior. They named the selling the capitulation phase of the decline. This has been a part of the technicians’ toolkit since the late 1800’s when Charles Dow noticed the pattern. Technical analysis recognizes that history repeats in markets because human nature never changes.

    What has changed since the 1800’s is the ability to measure the capitulation, and perhaps more importantly to spot the reversal in sentiment as sellers become buyers.

    One way to do this is with the ratio of up volume to total volume. When up volume is less than 10% of the daily volume, the market is in the midst of capitulation. When the up volume is 90% of the daily volume, the market is in a strong rally.

    This is shown in the chart below, which shows the S&P 500 with up volume as a percent of total volume at the bottom of the chart. The dashed green line is at the 90% level.

    At the very bottom, in March 2009, capitulation was followed by a 90% up day. However, there were several false signals before the ultimate bottom.

    A more sophisticated calculation can reduce the number of false signals. This is called the Zweig Breadth Thrust and was developed by the legendary market technician Martin Zweig,

    The breadth thrust indicator is computed by calculating the number of advancing issues divided by the total number of issues traded and generating a 10-day moving average of this percentage. The breadth thrust uses the number of issues rather than their volume.

    The indicator signals the start of a potential new bull market when it moves from a level of below 40% (indicating an oversold market) to above 61.5% within any 10-day period, a sentiment shift that occurs only rarely.

    The next chart adds this indicator at the bottom.

    Notice how there are fewer signals and a confirmation of the two signals at the actual bottom. This demonstrates breadth can help you spot the bottom of the sell off.

    But, there could be more selling ahead in the current market.

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