Carl Aschenbrenner, Portfolio Manager at HCR Wealth Advisors, reads the tea leaves to provide clues about the market’s future.
Most people and academics believe market timing is impossible. There’s no way to know what will happen next. It’s true that economic forecasting is difficult and shocks are often a surprise. However, reading the tea leaves of the market on a broad and granular level can provide some clues. The following indicators that I’ll be discussing are ways of quantitatively monitoring and tracking the breadth of the equity market. They depend on the observation that at the beginning of a significant bull market run, economic growth will be picking up and benefiting all or almost all sectors/industries. Near the end of a bull market, breadth declines and the market narrows, driven by only a few key large stocks, often in a single sector or industry. This concentration usually coincides with excess/overvaluation of these stocks, which subsequently become the worst performers and drag the market down as happened with technology stocks in the 2000 tech bubble and financial stocks in the 2008 financial crisis. At this point, upward momentum slows, and it can be observed not just by looking at what an overall index is doing but also by looking at what all of its components are doing, and this can provide additional information that can help confirm the overall trend direction and strength.
The first indicator we will examine is the McClellan Oscillator, which is just the difference between a short-term and long-term exponential moving average of advances minus declines on a daily basis. One definition and explanation is here.
Below is a chart of the S&P 500 over the last 6 years with some average true range (ATR) bands spaced around it based on recent volatility. A buy signal is generated by the McClellan Oscillator when the short-term exponential moving average crosses over the long-term moving average from a low level and there is a quick, strong positive reversal. Sell signals are generated when the short-term moving average crosses over the long-term moving average from a high level but at a lower high than was made by the upward thrust buy signal.
During the market’s 12–24 month rallies, there should be positive breadth, more advancing than declining stocks. Although there can be brief periods of negative breadth, in general these periods should be getting less negative for the rally to continue. Eventually the rally continues long enough to get extended or overdone and the peaks in positive breadth decline. You could draw an upward sloping line connecting the breadth valleys and a downward sloping line connecting the breadth peaks. These lines form a channel. When the short-term moving average crosses over the long-term moving average to the downside breaking through the channel created by the lines, this generates a sell signal. You can see that according to the chart the S&P 500 is extended now and the McClellan Oscillator has generated a reversal sell signal. In the selloffs, it tends to decline to the average true range band and would be estimated to decline about 25% from its current level.
The next indicator I will examine is Brogan Money Flow Breadth. Instead of just looking at advancing and declining stocks, this indicator looks at where each stock in an index closes each day relative to its high or low that day. If a stock is closing above the midpoint of its trading range that day, it generates positive money flow for that day, and the degree to which it closes higher than the midpoint is a factor. Likewise, if a stock closes below its midpoint for the day, it generates negative money flow. Finally, these price changes for the day are weighted by the volume and all added up to get a daily money flow reading for the market, and this is cumulatively tracked.
Individual Stock Money Flow = [(close — low) — (high — close)]/(high — low) * volume
Close > Mean = Positive Money Flow
Close < Mean = Negative Money Flow
Money Flow Breadth can be summarized as cumulative volume weighted price action with respect to the daily trading midpoints of all stocks in an index. In the chart below, similar to the McClellan Oscillator, the Money Flow Breadth moving averages make a sharp upward thrust at the beginning of a bull market and the money flow gradually weakens with lower peaks during the bull phase.
When Money Flow Breadth makes a weak subsequent peak sufficiently close to the Money Flow Breadth average (red line), this is indicative of a final market top thrust before an ensuing bear or corrective phase.
The Brogan Group used their Money Flow Breadth indicator to significantly beat the S&P 500 over the last 20 years:
While this is just a backtest, and past results are not necessarily indicative of future results, it does seem like a compelling method for watching the market and adjusting exposure more intelligently to produce better results.
In light of the narrow equity market we see today, dominated by large, richly valued technology stocks and inflated by near zero interest rates, bearish signals in these indicators are particularly noteworthy. We haven’t had the kind of shakeout that ended prior bull markets, particularly because the Fed and Treasury were quickly willing to do whatever it took to rescue markets from the March 2020 Covid Crash. Record money printing and stimulus has led to record speculative activity, which has probably led to an asset bubble, and might lead to inflation in the future if we get sustained commodity price and wage increases.
Reference: Wilkerson, Chris. Technically Speaking: Tips and Strategies from 16 Top Analysts. Greenville, SC: Traders Press, Inc., 1997.
*This article is for informational purposes only and should not be considered investment advice.