How to Use the Market Internals

05/07/2009 1:00 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

The importance of the market internals has been reinforced during the bear market of 2008 and the recovery rally in 2009. A majority of professional traders follow these numbers daily, if not on an intraday basis. Several times since the March lows, a careful monitoring of the A/D numbers would have kept you on the right side of the market. One thing I always do if I see the Dow up or down 1-2% is check the number of advances and declines. When they are diverging, i.e. the market is down but there are more advances than declines, I follow the A/D numbers.

In this article, I would like to discuss two of my favorite A/D indicators: The McClellan Oscillator and the McClellan Summation Index. They were developed by Sherman and Marian McClellan in the late 1960's, and I first started to explore them in the early 1980s. I have had the pleasure of meeting both of the McClellans, as well as their son Tom, who has taken over the daily writing of their publications. You can find out more about their analysis and services at www.mcoscillator.com, and incidentally, Tom will be speaking at The Traders Expo this June (click here for more info).

The standard calculation of the McClellan Oscillator uses the net advances (advancing issues minus declining issues) and then runs a 19- and 39-period EMA of the resulting value. The 39-period EMA is then subtracted from the 19-period EMA to get the oscillator. When the 19-EMA moves above the 39-EMA, it indicates that advancing issues are greater than the declining issues, which is a positive. Conversely, when the 19-period EMA drops below the 39-period, it is negative, as that indicates that declining issues are increasing. Many stock index traders look for extreme values as an additional confirming indicator for pinpointing market tops and bottoms. There are five levels that I watch, with the first being the extremes of -300 or +300. If the oscillator is near +300, it is generally not a good time to buy, and conversely, at -300 it is not a good time to sell. I also monitor the +100 and -100 areas, which act as support or resistance, and of course, the zero line.

Fig. 1

In the first example, we will look at the most recent market action and then will review some historical examples to show that the interpretation has worked through different market cycles. As stocks plunged in early October 2008, the oscillator reached a low of -417 on October 10th (point 1) before rebounding to the +100 level over the next seven days (point 2). The NYSE again plunged to new lows (point 3) but the oscillator just made a low of -170, which signaled that another rebound was likely. This rebound was also short-lived as the NYSE Composite just tested its previous highs while the oscillator shot up to overbought levels at +314 (point 4). For those who had hoped that the market had finally bottomed, these very high readings suggested that waiting was a better course of action. Stocks did reverse to the downside and declined steadily for the next 12 days, dropping the oscillator back to -318. This created a longer-term positive divergence as the oscillator did not confirm the new price lows in November (point 5). The ensuing rally lasted over five weeks.

The stock market again turned lower early in 2009 with the oscillator reaching the -100 level before trying to rebound. Stocks moved sideways for the next two weeks, but twice the oscillator failed to move substantially above the +100 level and the second rally failure (point 6) gave traders a strong warning. As the NYSE approached the November lows on February 22, the oscillator made a low of -367 (point 7), and then turned higher. While stocks continued to drop, the oscillator moved higher, forming a positive divergence at point 8. This divergence was confirmed when the oscillator moved through the two-month downtrend, line a. The oscillator is still holding up well and shows no signs yet of a top.

NEXT: Oscillator Applied to Daily S&P |pagebreak|

Figure 2

This chart covers the first nine months of 2006, with the S&P 500 Index on the top and the McClellan Oscillator on the bottom with horizontal lines marking the +100 and -100 levels. Though many times I have identified tops or bottoms through divergences in the McClellan Oscillator, it is the extreme readings that I have found to be the most useful. The first period I would like to look at occurred on January 9th (line 1) as the McClellan Oscillator reached +197 and the S&P moved up for two more days before closing lower on the 12th. This was the start of a three-week correction that dropped the oscillator back to -117 on February 6th (line 2). Four days later, it again declined below -100, falling to -114 before turning higher. The oscillator never made it above +100 on this rally and by early March (line 3) had dropped to more oversold levels at -184. In just seven days, however, the oscillator had again reversed, hitting a high of +104. By early April, however, the oscillator was again declining, making a new oversold level at -199. This pattern of lower lows-while the price chart was forming higher lows-indicated that on each pullback, the sellers (declining issues) were becoming stronger. As the S&P 500 surged to new highs on May 5th, the oscillator once again moved slightly above the +100 level, reaching +105. From this level it quickly reversed to -156 as the S&P 500 and other major averages collapsed.

In Figure 2 above, you will note that the McClellan Oscillator hit a low of -235 on May 18th. On June 12th, even though the S&P 500 was substantially lower, the McClellan Oscillator was higher at -197. This divergence can be observed by comparing the lower lows in price, line a, with the higher lows in the McClellan Oscillator, line b. When the S&P 500 again approached its lows in mid-July, the McClellan Oscillator held above -100 and was acting stronger than prices. This indicated that on each decline, the number of advancing issues relative to declining was increasing, consistent with a change in trend.

Now it is obvious that if you are a day or intraday trader, these extremes in overbought and oversold readings could be useful in establishing short-term positions, but what about those with a longer term horizon? Whether you are looking to sell part of a profitable position, establish a new long position, or switch from a conservative to a more aggressive mutual fund, the status of the overall market will play a role. Clearly, not all stocks move in lock step with the major averages, but most do. Therefore, if you have technical reasons for establishing a new long position, you will be better off doing it when the market is oversold than when it is overbought.

As is the case with the A/D line, the McClellan Oscillator does not always form clear-cut divergences at key turning points. When it does, and when these divergences coincide with those from other technical indicators, higher-confidence signals are given. The McClellan Summation Index, as the name implies, is the summation of all of the daily readings of the McClellan Oscillator. It is an indicator I find more useful for analyzing the stock market's intermediate-term trend. The past two years in the S&P 500 provide several examples to help determine whether the McClellan Summation Index (Index) can be useful in determining the intermediate term trend. In these charts, I have also added a more sensitive 21-WMA of the index instead of the 34-EMA that I often use. Obviously, the short-term average will turn faster and should work better in more volatile markets, but either should give you a good idea of the index's trend. Though I will take you through the crossings above and below the 21 WMA in detail, the longer-term divergences and trend line breaks are used to confirm changes in the intermediate-term trend.

Figure 3

In May 2007, as the S&P 500 continued to move higher, the index dropped further below its now declining WMA (line 1), and this was a warning that the market internals were not healthy. In June, the index violated the prior lows (line a), confirming a pattern of lower lows just as the first real estate shocks were hitting the system. Stocks continued to rally, peaking in July before a sharp but violent decline took the market much lower. The market rallied from the August 17th lows and on August 28th, line 2, the index moved back above its WMA. The major averages made new all-time highs on October 11th, but the index made much lower highs, line b, and nine days later, dropped below its WMA (line 3). Despite warning that the market was weak internally, the crossing of the index below its WMA caught the first decline into the November lows, but missed the more serious decline into the January 2008 lows. The November lows were tested in March and the index moved back above its WMA on April 2nd (line 4). This bear market rally lasted long enough to flip a few back to the bullish camp, but the index just rallied back to the October highs before dropping back below its WMA (line 5). The index again bottomed with the market, and on July 28th, moved back above its WMA (line 6). On September 18th, it once again reversed after an anemic rally for what would have been a 57-point S&P loss. As I noted earlier, however, though the crossings of the index with its WMA are often important, the long-term divergences are more reliable. Even though the WMA crossings were choppy in October and November, the initial decline from the September 18th highs amounted to 350 S&P points. The index made a slightly higher low in November, which was the first indication that the market was oversold. The index was much stronger in March 2009, even though the S&P was significantly lower and formed a second positive divergence, line c. These multiple positive divergences were noted at the time, and the analysis suggested that despite the extreme bearish sentiment, the market was not going to collapse in early March.

NEXT: Summation Index Applied to NYSE Daily   |pagebreak|

Figure 4

In this example, I have used the NYSE Composite with the McClellan Summation Index and its 21-period weighted moving average (WMA). The chart covers April 2005 through April 2006. On May 4, 2005, the Index moved above its WMA (line 1). Eight trading days later, the NYSE made slightly lower lows, but the rising Summation Index and its WMA reflected internal strength as the advancing issues had taken over. The positive signal stayed in effect until August 5th (line 2) as the Summation Index dropped below its WMA. The gain in the NYSE Composite was about 5% between lines 1 and 2. The Summation Index diverged from the NYSE for the next two months, warning of the NYSE's sharp drop in early October. These longer-term divergences in the Index are seen often, and it is not uncommon for them to warn of sharp market declines well in advance. The NYSE Composite lost 5.4% in just ten days. The index moved back above its WMA on November 3rd (line 3), reversing the sell signal at line 2.  Even though the positive signal in November came at slightly higher levels, 7534 versus 7515, I nevertheless find the objective nature of the signals to be a helpful guide. The selling was fairly heavy in October 2005, and it likely caused some to sell out their long positions near the lows. November's positive signal lasted about three months as the index stayed above its WMA until February 7th (line 4) and then again began to diverge from the NYSE as indicated by line a.

Figure 5

The divergence in the Summation Index continued for the next three months before the global stock markets declined sharply in May. From the first divergence (line 1) to the May highs (line 3), the NYSE composite rose an additional 4%, leading one to ask what strategies have been employed to capture more of the rally as opposed to selling once the 21-WMA was violated after the first divergence. In Figure 3, I have also included the A/D line with its 34-period EMA as discussed in other articles. It made convincing new highs with prices in March and April as the Summation Index was moving lower. On the decline from the early April highs, the uptrend in the A/D line (line a) was broken, and the A/D line dropped briefly below its EMA. This was the first sign of weakness from the A/D line, and with two negative divergences evident on the Summation Index, a more defensive position was warranted.

The NYSE did make another new high on May 9th (line 3), which was accompanied by a marginal new high in the A/D line, but it failed to move back above its prior uptrend. The Summation Index made a much lower high, though it did move briefly above its declining WMA. The decline from the highs was very sharp, and one way to be more defensive after the A/D line broke its uptrend and violated its EMA would be to use a trailing stop on long positions. Many types are available, but on the bar chart I have plotted one of the simpler ones. The dashed line represents a ten-day moving average of the lows. The NYSE closed below it on May 12th, which was just three days after the highs.

As I have discussed in past articles, technical analysis is not mechanical, and therefore, while you may see similar (if not identical) formations at different points in time, they will not always be the same. You can never lose focus of what you are measuring, as maintaining focus will help clarify the signals from the charts. The NYSE internal indicators we have been discussing all use the advancing and declining issues data, so if the market is in an uptrend, you want to consistently see more advancing issues than declining ones. If the declining issues start to dominate, it is a reason for concern, and it may be warning of a trend change. The same goes for a downtrend, where there should be more declining issues than advancing ones. Changes in this relationship, which are visible through the A/D line, McClellan Oscillator, and Summation Index, can alert one to a change in the market's trend. By noting the advancing and declining issues, as well as an individual stock's new highs or lows on a daily basis, you will gain a better understanding of the market's current direction.

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