Bull or Bear? Measuring with the Bullish Percent Oscillator

Today we’re going to be examining the Bullish Percent oscillator, also known as the Bullish Percent line or simply as Bullish Percent. The purpose of this oscillator is to determine the percent of stocks that are showing bullish patterns versus those that are showing bearish patterns. When the market is telling you more than 50% of stocks are in bull trends, this is positive for stocks, whereas the opposite is true of less than 50% – meaning more stocks are in bear trends, a negative for stocks. Let’s take a closer look.

 

Bear vs. Bull art, by Andy Beck

 

Bullish and Bearish Patterns

 

The Bullish Percent oscillator can be applied to any group of stocks you choose, for example the Dow Components or stocks in a certain sector. At the heart of this oscillator are point and figure charts. The great thing about point and figure charts is that they offer binary evidence – that is they are one of two things: either bullish or bearish. The way the BP line is derived is by taking a basket of stocks and getting a ratio of the bullish patterns to bearish patterns.

 

A bullish pattern is defined as any double-top buy signal on a point and figure chart. A double-top buy is when a column of X’s moves higher than the previous column that came before it. In order for this pattern to signal, a reversal of at least 5 X’s must be triggered on the chart. The same is true for the bearish pattern, except double-bottom sell signals and O’s instead of X’s.  You can see from the chart of the SPY below, the last signal given was a double-bottom sell, which is still in effect as the current column of X’s has not moved higher than the last column of X’s that came before it.

 

 

The Bullish Percent Line

 

The BP Line takes the sum total of all bullish double-top buys and divides those by all bearish double-bottom sells. From this we get a ratio. The typical readings for the ratio are as follows: Above 50 is bullish for stocks, as long as the line isn’t falling towards 50. Above 70 is very bullish but may indicate a maturing trend. Below 30 is very bearish but may indicate oversold conditions.  The strongest indication a bullish percent can give is when it breaks below 70, then below 50, and then below 30 without much interruption, or from 30 to 70 in the same manner. This is typically a very clear signal that the trend has changed.

 

The chart below is self-explanatory, though I would like to point out the bearish divergences seen in 2010 and 2011 as price made a new high while the BP Line fell short twice. This is not a game changer, but it is something to pay attention to, and certainly has been a point of interest for Market Technicians.

 

Bullish Percent Candles of the Nasdaq graphed above Nasdaq price chart

 

Gauging Sentiment with the Put/Call Ratio

The options market is, by its nature, very speculative. Options are highly leveraged tools that allow investors to “control” a large block of shares with relatively little down. This control only applies if the stock is at a certain price within a certain time, however, and this is why the options market is risky and speculative. The buyers of call or put options are prompted into action when they are more optimistic (greedy) or pessimistic (fearful) than usual. Measuring the options market is a good gauge for overall sentiment, since this market is speculative in nature and will tend to represent extremes.

 

Put/Call Ratio

 

By analyzing the CBOE put/call ratio – that is the total number of puts traded per day compared to the total number of calls traded – one can get an accurate reading of the temperature of the market. Most of the time the put/call ratio is within a normal range and offers little guidance. However when the ratio reaches extremes it may indicate a temporary bottom. As a Market Technician, remember that sentiment indicators are better at determining bottoms than tops, since greed and fear are not polar opposites. Greed can exist for long periods of time, while fear often reaches a head and climaxes.

 

I don’t think the chart below needs much explanation. The total CBOE Equity Put/Call Ratio is graphed below the S&P 500 average. Notice anything uncanny regarding temporary bottoms? Is it any wonder why Market Technicians are taught to analyze sentiment trends? Despite the recent success of this gauge, remember that no technical indicator is ever guaranteed, and proper risk management control should always be practiced regardless of the strength of a signal.

 

Total Equity Put/Call Ratio on a daily chart

The Dow Jones Utility Average is the Most Important Indicator to Watch Right Now

Recently I posted about what was going on in the Dow Transportation Average here, and how a Market Technician might form his/her analysis, make investment decisions, and advise clients. Today I will briefly examine the Utility Average and explain why it is so important and often goes overlooked, as well as describe why it is projecting a slightly bullish bias in current market conditions.

 

The Utility Average has been quietly roaring back..

 

 

A Bit of Background

 

The Dow Jones Utility Average is made up of 15 utility companies that are in the business of electric utilities, gas pipelines, telephone companies, and natural gas. You may see the components of the Utility Average here. Along with the Dow Transportation Average, it is one of the most important averages in existence today, and yet I feel many choose to overlook or disregard it. This is unfortunate for them. The average itself can be somewhat boring by typical investment standards, as it often moves much less than the Industrials and the Transports. Yet it has historically proved to be one of the most reliable barometers of the overall market as well as the Industrial Average itself.

 

Utility stocks are very sensitive to changes in interest rates because many of these companies require significant amounts of capital to finance their operations, and this means debt relative to equity. Falling interest rates or extended periods of low rates allow these companies to attain favorable financing and this directly contributes to their bottom-line. Not only do utility companies benefit directly from low rates, but the price of their stock benefits indirectly as well. Because utility companies pay out their profits in the form of substantial dividends, they are often compared to bonds. When yields on treasury and other bonds are low, the yields of utility companies relatively become more attractive. The opposite is equally true when interest rates are high and rising; this is negative for utility companies. Perhaps this will give you further additional insight as to why the Fed’s monetary policy is so important to the stock market, even if conditions may not have changed or appear positive.

 

A Major Technical Principle

 

One of the major technical principles that CMT’s are taught is that changes in the trend of interest rates usually occurs ahead of reversals in the stock market, and therefore the Utility Average typically will lead the Industrial Average, and therefore the market, at tops and bottoms.

 

For this reason I consider the Utility Average the “stealth average” since it often quietly goes about its business at the same time the broad indices are alive with activity and preoccupying many investors’ time. Is this what is happening now?

 

Periods When Utilities Lead Industrials at Tops

 

-1937

-1946

-1953

-1966

-1968

-1973

-1987

-1994

 

Periods When Utilities Lead Industrials at Bottoms

 

-1942

-1949

-1953

-1962

-1966

-1974

-1982

-1998

 

This is not to say that the utilities will always lead, because this is not the case. Oftentimes the peaks and troughs will coincide with the Industrials as has happened recently, and a few times in recent history they have lagged (1970, 1976, 2001). The chart below is the comparison between the Utilities and the Industrials side-by-side over most of the last decade.

 

Dow Jones Utility Average compared to Dow Jones Industrial Average; $UTIL is still rising.

 

You can see from this chart that the Utilities still appear to be headed up while the Industrials have formed an intermediate peak. Also an interesting note about the chart is that volume spiked massively in August when the Utilities briefly but violently sold off. This suggests there is a lot of pent-up demand for Utility companies, a fact confirmed by the quick recovery in Utility prices. The downturn in August doesn’t even register on the monthly chart above.

 

Weekly chart of the Dow Jones Utility Average with multi-year trendline and red parallel

 

As I write this the Utilities are only mere fractions away from a 3-year high. A 3-year high! And this is after all of the bearish economic news that has been plaguing the markets of late. While a new multi-year high does not signal a continuation of trend (nor is it a buying signal), it is a bullish indicator that we should pay attention to. The Utilities can diverge from the general market for only so long and the two must ultimately reach trend parity. This gives rise to the possibility that the broad market will follow the Utilities in time.

 

This concept of analyzing more than one average is what Dow Theory is all about. It should tell you the general market trend for all stocks. As previously stated a new high in one average is not a trend signal until the other averages confirm. When and if the the chart of the Utilities breaks down, one can confidently say the broad market trend is down. However, until that time it may be best to wait for confirmation to be signaled one way or the other, or implement strategies that make use of the strength in utilities.

Rounding Bottoms

Yesterday, I tweeted here that the averages were displaying characteristics of rounding bottoms. These rounding patterns or “rounding turns” as they are also known were later confirmed. In this update I’m going to be briefly describing rounding bottoms and what they mean.

 

Rounding bottoms are also known as Bowl, Saucer, or Cup Patterns. In addition, a series of rounding bottoms are known as Scallop Patterns. Rounding bottoms are often significant because they take several months to come to fruition. Of course, as a Market Technician you remember that all technical analysis is fractal. The fractal nature of trends means that patterns can occur for any time period and on any interval chart. The implications are the same except that they vary in significance as related to the length and interval by which they were formed. A daily rounding bottom does NOT attempt to forecast weeks or months into the future, nor would a year-long rounding turn signify anything less than several months of significance. Understanding this principle is key to all technical analysis.

 

A Rounding Bottom is usually a clean-cut and decisive price pattern, though there is some discrepancy as to how deep a pattern can be and still be considered a rounding turn. As a rule of thumb, any rounding turn should be wider than it is tall. What happens in a rounding bottom is that gradual, but steady, dominance of demand overtakes supply – especially after a large down move. The selling pressure slowly and consistently fades while volume almost always declines at or near the bottom. This gives rise to a horizontal movement as the two forces are in equilibrium. This is followed by an increase in demand that creates an arc pattern.

 

SPY showing a daily Rounding Bottom that comes after several days of declines.

 

Volume is often the lowest during the horizontal phase of the turn as relatively few transactions are recorded. This, along with either a brief but sharp down-up or up-down movement in the very center of the bowl, is a tell-tale sign that the move is genuine. Sometimes volume can be greatest at the horizontal, central point, in a sort of inverted volume pattern. The key to remember here is that you are looking for a volume peak or nadir that occurs at or very near the middle. The volume analysis is less important on an intra-day basis (since volume will always be at a low-point during midday) and much more important on a daily, weekly, and especially monthly basis.

 

These rounding patterns should occur after an extensive decline in order to signal outstanding significance “as they nearly always denote a change in Primary Trend and an extensive advance yet to come.” With the exception of low-priced and speculative issues, the advance will gradually succeed the pattern itself and be prone to several interruptions, though very likely to yield a profit over time. Of course “time” in this case is relative to the pattern. In the case of low-priced and speculative issues, a Saucer Pattern can lead prices to quickly skyrocket in an almost vertical move, as seen below.

 

Notice volume is at a low point during the horizontal phase of the pattern.

 

Knowing how to identify patterns, as well as their implications, is critical in learning technical analysis and becoming a Chartered Market Technician.

The Past, the Present, with a Watchful Eye to the Future…

In the last article I espoused the benefits of the First Principles of technical analysis. Today I am going to look at the application of two of these, specifically area patterns and broad market theory. I will be examining the Dow Jones Transportation average – an average often cited as a leading indicator and a key component of Dow Theory – as to where it stands at present. I will be looking at a potential area pattern as it may be developing in the transports and how, as a CMT, one is taught to analyze. Now on to business.

 

The chart below is a 4-year chart of the Transports. You can clearly see the March 2009 low and the distinct Inverted Head and Shoulder pattern it formed. I have marked the minimum price target as well, which it exceeded, as well as double the price target. Head and Shoulders patterns will have a price target that is the width of the pattern – that is, the neckline to the head, added to the neckline. This goes for normal H&S patterns as well as inverted patterns. These price targets can only ever be established once the pattern is confirmed. This means that had you been watching the pattern developments in the transports as they unfolded in early 2009, you would have seen the first shoulder, the head, and then maybe the second shoulder all before any actual implications could be derived.

 

4-Year Weekly Chart of Dow Transports

 

This pattern took roughly nine months to develop. Because it took many months, its implications, when and if it confirmed, would be significant. As you can see, the pattern was confirmed and its effects were indeed significant. The minimum price target was reached and the double target was nearly reached. You can expect the price to reach between 1 and 2 times the target. The volume characteristics for the pattern were mostly inline with expectations as well, though they were somewhat muted. For an Inverted Head and Shoulders, you should expect the heaviest volume on the first shoulder and then you can expect it to level off thereafter.

 

Now let’s examine what is happening in the Transportation Average currently. You can see from the daily chart below a potential Inverted Head and Shoulders pattern developing. Because it is on a daily basis, any potential implications will be less significant in both the likelihood of a move and length of distance and time of a move. I want to stress that this pattern is a developing pattern, and that currently there are no implications and there will not be any until this pattern is confirmed. That means a decisive close above the neckline for three consecutive days. This pattern looks somewhat promising because of the volume pattern, which is heaviest into the first shoulder, as well as the fact that the transports last major pattern was an Inverted H&S. Oftentimes a stock will repeat its pattern (if only in degree) because the character of either itself or its investors or both remain the same over time.

 

Six month daily chart of the Dow Transports

 

Does that mean that our analysis, as it stands, is useless? Far from it. As a Market Technician you can extract data from the market on a day-by-day basis, a week-by-week basis, a month-by-month basis, and even a minute-by-minute basis for shorter working time frames. Knowing now that there is a potential Inverted Head and Shoulders developing, you can look specifically to see whether or not this pattern is confirmed or rejected. Since this is a daily chart, we will gain additional insight every day or every couple of days as it continues to develop.

 

Scenario 1

 

You can see from the chart the 4,300 level appears to be very important. A decisive break to new lows – below 4,200 – would indicate the break down of the pattern. This would signal to the Technician a continuation of the downtrend, and can be used as a signal to initiate short positions, or remain in short positions previously initiated.

 

Scenario 2

 

Should the transports reverse course and decisively break above the neckline at 4,700 – the pattern would then be confirmed and its minimum upside target given at 5,200. Of course this may still be a reactionary move in an otherwise down market, however the knowledge and implications of the confirmed pattern should aid any investor. A confirmed pattern would indicate a renewed rally, and would signal to shorts to exit their positions, longs to remain in their positions, and possibly new longs initiated on a short-term horizon.

 

Scenario 3

 

The pattern may neither break down nor be confirmed right away, but merely consolidate sideways as it waits for further direction. After a certain point the Inverted H&S pattern would be ruled out because long periods of consolidation are not synonymous with these patterns. At that point the Technician would need to evaluate any further (new) pattern developments as well as critically examine support and resistance levels.

 

Conclusion

 

Dow Theory is an essential element and First Principle of Technical Analysis. It states you must look at both the Dow Jones Industrial Average as well as the Dow Jones Transportation Average to gauge the overall market direction. Together these will tell you if the market is moving together (either up or down), is unsure of itself, or if it may be in the process of reversing its course. Today I have only briefly examined Dow Theory while looking at less than half of the picture to demonstrate how you can make use of developing patterns. My purpose is exploratory rather than exhaustive, in order that one might improve their technical skills.

 

First Principles of Technical Analysis

As Market Technicians, we must remember that despite our best efforts, the methods we employ are not perfect, nor will they ever be. Technical instruments, tools, and analysis are our best attempts to gauge supply and demand, and yet no person or group of people is able to know and accurately assess the infinite factors that combine and fluctuate to generate the forces of supply and demand – which exclusively determines what way, how fast, and far a stock or security will go.

There is no crystal ball or get-rich-quick methods in technical analysis.

 

 

The Market Technician’s duty is to interpret action while possessing a keen sense of judgement and perspective. A chart – while one of the best sources of data to analyze for technicians – is not perfect; it does not have all the answers, nor does it present its use value instantly and easily. It is possible to technically analyze the markets ad infinitum with so many combinations, indicators, and pliable variables – not to mention the innumerable indicators that are not widely used and those which have not yet been invented. These dizzying possibilities tend to short-circuit judgement as they attempt a purely mechanical approach to analyze what is not a purely mechanical cause-and-effect relationship. With so many various technical systems and forms of analysis, it is important to remember the First Principles of technical analysis.

 

The First Principles are those methods that are the most useful as they are simplistic and easily rationalized. They do not lend themselves to perfection or attempt to precisely time the day and time a stock will move and by how much. These methods work well together and supplement each other. Below are the First Principles of technical analysis, as originally outlined by Robert Edwards and John Magee in their pioneering work: Technical Analysis of Stock Trends.

 

The First Principles of Technical Analysis

 

1.  Area Patterns or Formations – These chart patterns, along with volume, indicate changes or continuations of the supply-demand balance. They can indicate the probability of moves in the same direction, in no direction, or in the reverse direction. These patterns can be described as the visual representation of periods where energy or pressure is accumulated. These periods more often than not give way to periods of movement where prices are propelled consistently in continuous motion, either up or down. The patterns can also be the representation of periods when pressure is dissipated and exhausted, which lend themselves to cause mean reversion in price or periods of consolidation and a lack of activity. In either case this knowledge can be transmuted to profits, the avoidance of losses, and the optimal use of time and money. Some of these patterns even go as far to indicate how far their pressure will push prices through minimum price targets that are established. Volume is a factor. But recall that volume is important only when it is an extreme deviation from the norm; it is also relative. Point and Figure area patterns are equally valid here, although volume analysis is not taken into consideration.

 

Ascending triangle in the Dow Transports broke out to the upside circa 1997

 

2. Trend Analysis with Trendlines - Together with Area Patterns, trend analysis helps determine the general direction in which prices have been moving. Additionally trendline analysis signifies when the trend deviates, as well as provides the Market Technician implications of its deviation. Trend analysis independent or in conjunction with area patterns may be used to signal to investors when to enter and exit positions. One of the great strengths of trendlines is that they often provide a reliable defense against premature relinquishment of profitable long-term positions.

 

2 1/2 year chart of Wynn. Simple trendline analysis would have kept you in the stock in recent market decline.

 

3. Support and Resistance – These levels are created by the previous commitments of market participants. Where are the levels where many shares changed hands over time? The levels have a two-fold purpose and use for market technicians. First, they are important because they indicate where it makes the most sense to initiate a position through entries that coincide with the least amount of risk. Second, they are useful in determining where price action is likely to slow down or retreat, and possibly reverse course. This is useful in determining where to take profits due to the likelihood that a stock will experience a sudden increase in supply or demand, as well as what levels it makes sense to scrutinize more than others.

 

Example of support and resistance annoted on a chart

 

4. Broad Market Background – What is the market as a whole telling you? What are the strongest and weakest areas of the market? This principle includes Dow Theory as well as sector analysis and relative strength. Dow Theory indicates to the technician the overall market trend, and therefore dictates the types of positions that are the most likely to succeed, as well as signals when these positions should be exited or reversed (depending on your strategy). It is important to remember that over time, the stock of good companies will tend to decline when all stocks are declining, and the stock of poor companies will tend to rise when all stocks are rising. Charles Dow originally noted that the stocks of the market move together like schools of fish, and this is why his theory is so valuable. Additionally, it is helpful to understand the strongest and weakest sectors of the market, as the stocks that make up a sector also generally move together. The investing implications are different in up and down markets, but only in opposite effect.

 

Charles H. Dow - the father of technical analysis and Dow Theory

Summary

 

All four of the First Principles of technical analysis can be used in conjunction, and the resulting analysis will always be stronger when they are used together when possible, in proportion to the number of principles used. As Market Technicians, it is important to revert to these First Principles in times of doubt and uncertainty. “Stick to your guns,” as Edwards and Magee stated. That is not to say that recent technical developments and other momentum principles are not valid – they are, though they should rarely if ever be used in isolation. Combining all four First Principles with modern indicators, oscillators, and moving averages can generate profitable set-ups when used in conjunction, as well as shorter-term entry and exit signals to give the market technician a valuable edge.

 

Disclaimer: I am long Wynn Resorts at the time of this posting.