November 3, 2005

Gregory L. Morris
Company: PMFM, Inc
Years Trading: 20+
Favorite Movie: Top Gun

Market Breadth for Market Tops

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Market Breadth for Market Tops

Overlooked for many for years, market breadth has done a great job in identifying market extremes. The analysis of market breadth is like quantum mechanics; it does not predict a single definite result, but predicts a number of different possible outcomes. Breadth is a direct representation of the market without giving any individual security preferential treatment, as is the case with most market indices through capitalization weighting. Breadth treats all stocks in a market index equally.

Breadth analysis deals with advancing issues, declining issues, unchanged issues, new highs, new lows, up volume, and down volume. Any stock that closes up from its previous close is an advance and any stock that closes lower than its previous close is a decline. A stock that makes a new high for the last 52 weeks is a new high, and conversely, one that makes a new low for the last 52 weeks is a new low. Up volume is the volume of the advancing stocks and down volume is the volume of the declining stocks.

Using breadth for market analysis is not unlike a doctor using an x-ray to assist in diagnosing a patient. What better way to predict or forecast the markets than by using the correct tools to analyze its present state. This article will introduce you to some relatively unknown breadth indicators that have been quite good at identifying market tops. Why market tops? Market tops are generally long drawn out periods of distribution that are very difficult to pinpoint. Market bottoms, on the other hand, are generally easier to identify because of their normally sharp and quick reversals. Buying decisions are generally more emotional. Selling decisions run the gambit on why they occur.

Selling a stock is usually a much more emotional decision for investors, especially if they are holding onto gains in that stock. Greed and hope are in control at market tops. This is why the accurate determination of a market top is difficult - it is different for different types of investors. And yes, everyone involved is an investor, if one is responsible for a $20 Billion pension fund, he/she still has the same emotions as the guy thinking about selling 20 shares.

Here are three breadth-based indicators that do a good job of picking tops.

The Hindenburg Omen

This indication of market tops was created by Jim Miekka. Jim is a mathematician who also developed the formula that makes the McClellan Summation Index uniform without using the same starting dates, a fairly complex subject fully explained in my book, The Complete Guide to Market Breadth Indicators. Jim did not originally call this the Hindenburg Omen. It was coined that name by Kennedy Gammage of the Richland Report. You might remember Kennedy as the former provider of the McClellan Oscillator and Summation Index numbers for FNN, and later CNBC.

The Hindenburg Omen is a sell signal that occurs when NYSE new highs and new lows each exceed 2.8% of advances plus declines on the same day. Also, the NYSE index must be above the value it had 50 trading days (about 10 weeks) ago. Once a signal is given, it lasts for 30 days. During the 30 days, the signal is activated whenever the McClellan Oscillator is negative and deactivated when it is positive.

The McClellan Oscillator is the difference between the 39 and 19 day exponential average of the net advances (advances - declines).

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You can see from Chart 1 that the Hindenburg Omen is not something you should ignore. The taller peaks indicate the sell signals of the indicator. I always build indicators to yield as much information as possible. The secondary peaks show when certain components of the indicator are in place, but not fully.

Because the Hindenburg Omen uses breadth data from the NYSE it is shown with the NYSE Index above the indicator. The NYSE Index did not experience the sharp bear market sell off that took place in the technology-heavy Nasdaq. Chart 2 shows the Hindenburg Omen and the Nasdaq Composite Index.

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The Hindenburg Omen was screaming at you in 1999 and early 2000. Remember, this is using Nasdaq breadth data and was not how the original indicator was developed by Jim Miekka. I just wanted to show you how its concept could translate to the other exchange. As is generally the case with most technical indicators, and certainly with breadth-based indicators, it is the concept they are trying to show that is important.

Here are the dates in which the original (NYSE-based breadth data) Hindenburg Omen has generated sell signals:

Sept 23, 1987
Oct 12, 1989
Jul 10, 1990
Dec 17, 1991
Feb 22, 1993
Mar 15, 1994
Oct 28, 1994
Oct 10, 1996
Nov 26, 1997
Jul 9, 1998
Jan 29, 1999
Apr 8, 1999
Oct 29, 1999
Dec 20, 1999
Jun 30, 2000
Sep 18, 2000
Dec 22, 2000
Oct 1, 2002
Apr 13, 2004
Sep 21, 2005

Students of the market will identify many of these dates as being near significant market tops. In particular notice the first one shown, almost 4 weeks before the giant sell off in 1987. Bottom Line: You can't trade off this indicator, but you certainly can't ignore it. When it gives a signal, and you are long, it is time to tighten up the stops.

Sign of the Bear

Another great breadth-based indicator that should not be ignored was developed by Peter Eliades. He first wrote about it in 1992 after noting a lack of volatility in the advance decline numbers. He then researched it back into the 1940s and came up with 3 rules to identify the "sign of the bear."

Here are the three rules for the "sign of the bear:"

1. There must be a streak of 21-27 consecutive trading days where the daily advance decline ratio remains above 0.65 and below 1.95.

2. That streak must end with a downside break (ratio less than 0.65).

3. That downside break must be confirmed by either a 2-day average advance decline ratio or 3-day average advance decline ratio following the end of the streak being below 0.75.

Chart 3 shows the signals based upon the first two signal requirements. It was my feeling that they represented the "meat" of the argument and therefore the two more important of the three requirements. If you consider the third requirement you only eliminate three of the signals, mainly those that occurred in the early 1990s. The last signals were April, 1998 and September, 2000.

While this market top indicator does not yield many signals, the ones that it does produce should not be ignored.

The Titanic Syndrome

The late Bill Omaha developed this indicator in 1988. He wrote that he coined the name after studying market tops in the 1960s and noting that, like the Titanic, it was full speed ahead, presumably unprotected against disaster. This indicator originally used new lows and new highs on the NYSE, along with the performance of the Dow Jones Industrial Average.

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Omaha modified this indicator in 1991 offering specific buy and sell interpretations. Further modifications were made by Dennis Meyers in 1995. This is how good indicators are developed. First someone identifies a situation, modifies it, and then others make additional modifications to it. This indicator is quite complex and would take considerably more space than allowed in this article to adequately cover.

Remember, market tops are tough to identify. The distribution of stocks after large up moves in the market does not happen overnight. In fact, a thorough study of the markets will reveal most tops are always long-term affairs in their own right.

I categorize the Hindenburg Omen, the Sign of the Bear, and the Titanic Syndrome as "awareness" indicators. An awareness of the sell signals given by either of these should cause you to modify your stance on the markets, such as tightening your stops, outright selling, or preparing to short. You don't have to watch these everyday, in fact about once or twice a month would probably be more than adequate.

Get "Secrets of Successful Traders" Today

This book contains valuable trading insights for winning in today's markets from Robert Deel, Price Headley, Mike Hurley, Steve Nison, Barbara Star, John Bollinger, and other market gurus. You will also receive a complimentary MetaStock information pack when you request your complimentary copy of Secrets of Successful Traders!

About Today's Author
Gregory L. Morris is a portfolio manager with PMFM, Inc., a consultant to, and President of G. Morris Advisors, Inc. From 1996 to 2002, he was CEO of MurphyMorris, Inc. He is author of Candlestick Charting Explained (1992) and The Complete Guide to Market Breadth Indicators (2006), both published by McGraw-Hill. In a much earlier life he was a Navy fighter pilot who attended Top Gun. Forward This Email To a Friend