All of the technical analysis tools discussed up to
this point were calculated using a security's price (e.g., high, low,
close, volume, etc). There is another group of technical analysis tools
designed to help you gauge changes in all securities within a specific
market. These indicators are usually referred to as "market
indicators," because they gauge an entire market, not just an
individual security. Market indicators typically analyze the stock
market, although they can be used for other markets (e.g., futures).
While the data fields available for an individual
security are limited to its open, high, low, close, volume (see page ),
and sparse financial reports, there are numerous data items available
for the overall stock market. For example, the number of stocks that
made new highs for the day, the number of stocks that increased in
price, the volume associated with the stocks that increased in price,
etc. Market indicators cannot be calculated for an individual security
because the required data is not available.
Market indicators add significant depth to
technical analysis, because they contain much more information than
price and volume. A typical approach is to use market indicators to
determine where the overall market is headed and then use price/volume
indicators to determine when to buy or sell an individual security. The
analogy being "all boats rise in a rising tide," it is therefore much
less risky to own stocks when the stock market is rising.
Categories of market indicators
Market indicators typically fall into three categories: monetary, sentiment, and momentum.
Monetary indicators concentrate on economic data
such as interest rates. They help you determine the economic
environment in which businesses operate. These external forces directly
affect a business' profitability and share price.
Examples of monetary indicators are interest rates,
the money supply, consumer and corporate debt, and inflation. Due to
the vast quantity of monetary indicators, I only discuss a few of the
basic monetary indicators in this book.
Sentiment indicators focus on investor
expectations--often before those expectations are discernible in
prices. With an individual security, the price is often the only
measure of investor sentiment available. However, for a large market
such as the New York Stock Exchange, many more sentiment indicators are
available. These include the number of odd lot sales (i.e., what are
the smallest investors doing?), the put/call ratio (i.e., how many
people are buying puts versus calls?), the premium on stock index
futures, the ratio of bullish versus bearish investment advisors, etc.
"Contrarian" investors use sentiment indicators to
determine what the majority of investors expect prices to do; they then
do the opposite. The rational being, if everybody agrees that prices
will rise, then there probably aren't enough investors left to push
prices much higher. This concept is well proven--almost everyone is
bullish at market tops (when they should be selling) and bearish at
market bottoms (when they should be buying).
The third category of market indicators, momentum,
show what prices are actually doing, but do so by looking deeper than
price. Examples of momentum indicators include all of the price/volume
indicators applied to the various market indices (e.g., the MACD of the
Dow Industrials), the number of stocks that made new highs versus the
number of stocks making new lows, the relationship between the number
of stocks that advanced in price versus the number that declined, the
comparison of the volume associated with increased price with the
volume associated with decreased price, etc.
Given the above three groups of market indicators, we have insight into:
- The external monetary conditions affecting security prices. This tells us what security prices should do.
- The sentiment of various sectors of the investment community. This tells us what investors expect prices to do.
- The current momentum of the market. This tells us what prices are actually doing.
Figure 35 shows the Prime Rate along with a 50-week
moving average. "Buy" arrows were drawn when the Prime Rate crossed
below its moving average (interest rates were falling) and "sell"
arrows were drawn when the Prime Rate crossed above its moving average
(interest rates were rising). This chart illustrates the intense
relationship between stock prices and interest rates.
Figure 36 shows a 10-day moving average of the
Put/Call Ratio (a sentiment indicator). I labeled the chart with "buy"
arrows each time the moving average rose above 85.0. This is the level
where investors were extremely bearish and expected prices to decline.
You can see that each time investors became extremely bearish, prices
Figure 37 shows a 50-week moving average (a
momentum indicator) of the S&P 500. "Buy" arrows were drawn when
the S&P rose above its 50-week moving average; "sell" arrows were
drawn when the S&P fell below its moving average. You can see how
this momentum indicator caught every major market move.
Figure 38 merges the preceding monetary and
momentum charts. The chart is labeled "Bullish" when the Prime Rate was
below its 50-week moving average (meaning that interest rates were
falling) and when the S&P was above its 50-week moving average.
The chart in Figure 38 is a good example of the
roulette metaphor. You don't need to know exactly where prices will be
in the future--you simply need to improve your odds. At any given time
during the period shown in this chart, I couldn't have told you where
the market would be six months later. However, by knowing that the odds
favor a rise in stock prices when interest rates are falling and when
the S&P is above its 50-week moving average, and by limiting long
positions (i.e., buying) to periods when both of these indicators are
bullish, you could dramatically reduce your risks and increase your
chances of making a profit.