How to Trade Market Internals

07/31/2012 4:03 am EST

Focus: STRATEGIES

John Person

Founder and President, John Person, Inc.

Learn from John Person how to use market internals to help you make better trading decisions.

As a trader or an investor you may have heard the term market internals.  What are those?  How do they work?  And how do they help us make good investing and trading decisions?  My guest today is John Person to talk about that.  John first of all, define market internals.  What does that mean?

Market internals is a measurement of breadth studies.  There are several different indicators out there and several master technicians who have written about it throughout the ages.  Several are friends, obviously, of The MoneyShow and The Traders Expos.  One is your head technical writer Tom Aspray, who is very popular and writes a lot of articles. 

Market internals measure the amount of stocks that may go up or down on a given date, and so we like to look at what the capitalization-weighted index is.  We like to see a measurement as—instead of looking at an index value going up, which could be manipulated by a few shares or a few stocks—we like to look at the breadth.  Are all of the stocks of that index going up, or are more stocks going up than down? 

And is it a number that I’m looking at? Or how is it actually given out to the public? Or how do I read it? 

Well, there’s a lot of different names out there that have different technical tools, but one of the things that we like to look at is a comparative ratio—both done in different timeframes, a daily and a weekly. So we like to look at comparing on an up day, what was the ratio of stocks from the prior up day versus what was the ratio of stocks from the prior down day.  The indicators when you use a higher degree timeframe might—on like a weekly basis—might have a lag, and with today’s type of volatility it’s best to use maybe an end of the day, and then for confirmation for longer-term trend analysis look to see a weekly chart.

Alright and how do you use it?  Do you use it to keep you just on the right side of the trend on the right side of the market?

Well, we look for divergences.  If there’s a strong trend, for example, we want to see that the advance/decline is rising, or more stocks rising in association with the index price going up.  A famous technician who created the Arms Index—Richard Arms, Dick Arms—for example, people look at the tick and the trend for intraday valuations.  I like to look at more longer term what the health of a rally is if we see higher prices. 

For example, in late April 2012 and into early May, we saw the increase in price and everyone was talking about how the sell in May go away mantra was not going to work this year, and that the Dow was going to 17,000.  What was happening is if we took a look at individual sectors or indexes—like the Small Cap, the Russell—we saw a price appreciation in the index, but the advance/decline line was making lower highs.  So, while prices were making higher highs the actual indicator was making lower highs. Classic signs of bearish divergence with that index. 

We’d like to take a look and break down different indexes.  The Small Cap, the Russell, the Dow Jones Industrial Average—which consists of 30 stocks, which is an easy valuation to compile—the S&P 500, and the NASDAQ 100. 

Great, so this should help keep you out of trouble and give you some warning if things are rising, but shouldn’t be trusted.

Right, and some of the work that even your chief technician writer, Tom Aspray, often writes about is looking at the decoupling effect if prices are on the rise, but you see an advance/decline of that individual sector or that individual index, then you’re probably at a warning sign that we could see an impending top. 

The inverse is true as far as bottoms are concerned.  If prices are making newer lows, but the advance/decline of that individual index is not making newer lows, it may give us at least an idea that we could see a short-term bottom or some type of a price correction.

John, thanks for being here.

Thanks, Tim.

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