As pubished on the UK trading website www.trade2win.co.uk November 10th 2005
Many members of Trade2win are well informed on the latest moves in the FTSE 100 from the many excellent online resources the private trader now has at his disposal supplying live (or nearly live!) prices plus a host of other statistical information on indices. Less obvious is what is causing the move. Is it a large number of constituent stocks all heading in the same direction, or just a few index heavyweights making their influence felt? This measurement of the degree of participation within an index move is known as “market breadth” and is an important tool for identifying the strength of a move and medium-term overbought/oversold conditions.
Investors Intelligence developed their “bullish percentage” indicator in the US in 1950s. This indicator measures the number of stocks displaying uptrends, as defined by II’s point and figure charting methodology and has been widely adopted by the US investment community, but to date remains less known as a tool in Europe and the UK.
The US Approach
The first breadth indicator, the NYSE Bullish Percentage, was developed by Abe Cohen, the founder of Investors Intelligence in 1955. He was an early pioneer of point & figure (p&f) stock charts and this approach, which divides stocks into bullish or bearish trends, has the distinct advantage of providing a objective view of a stock’s technical charateristics . This provided the ideal building blocks for a market barometer and Cohen took the logical leap that by calculating the percentage of bull trends amongst the constituent stocks of the NYSE Index, he would have an accurate picture of the supply/demand relationship for the market as a whole. For example, if there were 2000 stocks in the NYSE Index and 1000 of them were on bull signals, then the Bullish % would be reading 50%.
As it turned out, not only did the NYSE Bullish % identify periods when the bulls were in the driving seat i.e. the best time to own stocks, but it also proved to be a one of the best contrary indicators for calling intermediate market tops and bottoms.
Cohen studied the pattern of this long-to-medium term oscillator and drew up the following guidelines for its use:
- Low risk area below 30%: Almost everyone who wants to sell has already sold. Once the indicator starts moving up from this area (indicated by reversals on the p&f chart of the bullish %) it is time to start accumulating growth stocks and to attempt bottom-fishing in stocks at multi-year lows.
- Mid-range: When the indicator moves up into mid-field, continue the bullish approach but buy more selectively in stocks with strong relative strength. Begin to take profits in recovery plays and holdings with weak relative strength. Buy new positions on pull-backs.
- High risk area above 70%: When the action starts moving down from this area (indicated by reversals down on the p&f chart of the bullish %) it is time to initiate defensive tactics. Sell any laggards (with weak relative strength). Begin to tighten stop losses on all holdings. Focus new positions in defensive/lower beta sectors. Buy call options instead of stock to limit equity exposure.
Abe Cohen’s original strategy for the bullish percentage was to be bullish on readings above 52% and bearish below 48%. However, as time went by, and the back history of breadth data built up, improved applications of this indicator were introduced. Earl Blumenthal’s book “Chart for Profit”, published in 1975, introduced a series of rules to be applied to the point & figure chart of the NYSE Bullish % or the “Bullish Bearish Index” as he referred to it. The rules were further refined by Mike Burke in 1982, when he became editor of Investors Intelligence, and remain to this day the recognised method of applying breadth to market strategy.
There are seven market conditions that can be derived from the point & figure chart of the NYSE Bullish % which are as follows
Definitions of Current Market Breadth Status
|Bull Confirmed – chart is on a p&f buy signal and is rising (column of x’s); and/or is in a column of x’s above 68%.
||Bear Confirmed – chart is falling (column O’s) below 70% and has generated a p&f sell.|
|Bull Correction – chart is on a p&f buy signal but is falling (column of O’s) without yet reaching 70%.
||Bear Correction – chart is on a p&f sell signal but is rising (column X’s) without having moved above 68%.|
|Bull Alert – chart shows rising (X’s) moving up from below 30% but has not yet generated a p&f buy.
||Bear Alert – chart is falling from above 70% to below 70% without yet generating a p&f sell.|
||Bull Top - chart is falling (column of Os) but above 70%.|
Optimising the indicator for different indices
There are over two thousand stocks in the NYSE Composite index, and other narrower indices (for instance the forty stock French CAC 40) might be expected to show different historical breadth characteristics to this giant. This is indeed the case, and the rule of thumb is the narrower the index, the more volatile the breadth history. However, the nature of the component stocks must also be considered when assessing ranges and likely signals areas.
In the case of the FTSE100, the five year history of the bullish% (see chart below), shows an indicator with an overall range of roughly 10% to 90%. The bear market (2000 to 2003) was accompanied by high volatility for this indicator, which showed some fast moves between 10% and 80%. The current bull market, which started in spring 2003 has been accompanied by lower volatility and, after a initial rally, a range of 40-90%.
In view of this we would look for reversal signals around 80 to 90%, around 40% and down below 10% (the latter for bear markets or very oversold conditions). You will note that these levels are somewhat different from the criteria chosen for the NYSE, and reflect the UKX’s narrower focus and subsequent higher volatility.
The current breadth picture in UK indices
No indicator is infallible, but recent action has proved the worth of this tool. The autumn pullback was heralded by overbought breadth status, and the subsequent retracement saw breadth pullback to our target level at 40%. This gave us the signal for trading the oversold rally, but was a little slow in providing a full re-entry signal, with the bullish% continuing to loiter down on support for several days. Today’s move, with its 2% index rally, has been accompanied by an improvement in breadth to 45%, although this is still a little less than we would expect given the strength of the index’s recovery.
We continue to adopt a “bullish but cautious” stance towards the UK market, noting that the primary uptrend (from Spring 2003) remains in place, but that some technical deterioration has occurred.
To summarise, we use these four “golden rules” when applying the bullish% indicator to the FTSE100:
- Sustainable bull markets must be accompanied by constructive breadth, i.e. a bullish% figure rallying from the lows or generally holding above 50%.
- High readings (above 70%) are not a sell signal. However, look for turndowns, particularly from extremes around 90%.
- Watch for bull market reassertions on pullbacks to 40%.
- Extreme oversold readings (10% and below) are particularly unsustainable. Look for buying opportunities when these conditions occur.
1) Oversold conditions precede 2003 low.
2) 2003-2005 bull market accompanied by constructive breadth.
3) Turndown from overbought occurs in early 2005 and again in October.
4) 40% level provides support for reassertion of primary uptrend.