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"Technical Signature" A Brief Discussion

One of the unique things about intermediate term moves, is that the markets tend to be consistent in the way they behave thru-out the duration of the move. By examining the patterns exhibited by technical indicators, we can identify the "technical signature" of a particular move. As long as the markets continue to act in a manner consistent with the "technical signature" of the current up-phase, we can conclude with reasonable certainty that the dynamics of the market remain intact, and thus, we can expect continuation. By the same token, if the markets begin to act in a manner that is inconsistent with the "technical signature," there is a reasonable possibility that the forces influencing the markets have changed, and thus, the current move has entered its terminal phase. There are plenty of technical indicators that can successfully reveal the signature of a market move. 

My personal favorite is  our own "Thrust Oscillators." The Thrust Oscillators are a weighted average of price velocity, breadth velocity and net volume velocity, with the highest weight factor assigned to volume. The two charts below show the indicator, as well as price, for NASDAQ and the SP from 4-10-03 until Friday's close.

Notice that within the course of the current rally, we had 4 phases that are characterized by almost identical price action and technical pattern. We can observe that after a negative cross-over occurred at points A1, A2, and A3, the markets were able to continue higher for several more trading days, before a decline in excess of 2% finally took place, see points B1, B2, and B3.

Knowing how the Thrust Oscillator is calculated, we can conclude with reasonable certainty that basically what has happened in all four phases is this: buyers have shown a tendency to back off, as soon as the markets have risen in excess of at least 7%, consequently the velocity of net volume drops, which results in turning the oscillator down. However, although the rate of buying decreases, we see no pick up in selling, consequently the markets are able to continue a bit higher on a lesser amount of buying. As the rate of buying decreases, at some point it just dries up and then the markets experience a sharper decline. However, the decline is not due to increased selling, it is due to decreased buying, which is the reason why price losses have been very modest. As soon as it becomes apparent that sellers are nowhere to be found and the market is not going lower, buyers jump back in and the cycle starts over again. That is why in the weekly report for week ending 8-22-03, I commented:

"...Notice that the TOs [Thrust Oscillators] have had a negative cross-over. However, so far the character of the overall  rally since the March lows, suggests that the first negative cross-over, doesn't automatically mean a decline. It takes another 5-10 trading days for the market to actually roll over. Thus, if the character of the market remains intact, the decline shouldn't last more than a couple of days, by Tuesday- Wednesday the markets should be rallying again. However, if that doesn't happen, and the market sells right on down, the market would be sending a very important message: IT HAS CHANGED CHARACTER! There is no need to speculate as to whether such a change has indeed taken place, let the price action provide the answer..." 

As it turned out, the markets indeed on Tuesday staged an upside reversal, and continued to rally until the end of the week. This type of action is consistent with the "technical signature" the rally has exhibited so far, and resembles the action in the previous three up-phases. Therefore, as long as nothing exogenous takes place to upset the current dynamics, it is reasonable to expect that price action during the current phase will  continue to  resemble closely the action of the previous three. In the current environment, from a trading/investing point of view, the key thing is to be able to identify any action that is inconsistent with the "signature" characteristics  associated with the overall rally since the March lows. 

Next I would like to discuss two other indicators that allow us to take a rather comprehensive look under the surface. The first one is a momentum indicator designed to measure the collective momentum of the components that make up a market index. The problem with capitalization weighted indexes is that, just a handful of stocks can influence--in a rather disproportional way--the performance of the index they are a part of, which in turn distorts the true technical picture. This indicator uses the mean value of the daily momentum readings for every one of the 100 stocks that make up the NDX. Therefore, it is truly inclusive of all the stocks that make up this index and it allows us to see whether the strength/weakness of the index is  accurately reflecting the strength/weakness of its individual components, as it should.

Notice that the latest rally in the NDX produced the highest reading since last October. This is significant and that is why we are bringing it to your attention. It means that not only a very large number of stocks are participating in the move, but also that most stocks have enjoyed substantial gains. It is a sign of a very strong market. This type of reading is usually associated with the start of  intermediate advances. In most cases, it ought to be interpreted as bullish until proven otherwise. In some occasions, this type of action can be  indicative that a rally has entered a terminal phase. It may mean that with only handful of quality stocks that can be found in the NDX already in the stratosphere, investors are buying anything they can get their hands on and they are willing to pay any price. If  volume hadn't been as pathetic as it has been during this latest leg up, I would be inclined to believe that this  momentum reading is a sign of a strong and healthy market. However, given how low the volume has been, it could very well be indicative of a rally in its terminal phase.

The next indicator is actually a detailed version of our Buy/Sell Equilibrium Indexes. The BSEs represent the net difference between two other sub-indicators, the Buy Index and the Sell Index, both of which are indicative of cash inflows/outflows to the equity markets. The Buy/Sell Pressure comparison graph shows the inflows/outflows as a percent of the total volume traded in dollar terms. See further comments at the bottom of the charts.

These charts allow us to make three very clear observations:

a) In late 2001--early 2002, the markets continued to rally from point A1 to point B1; while during the same period, buying was decreasing and selling was increasing. Increased selling in light of a rising market is most of the times a clear sign of distribution, which precedes significant tops.

b) The turning point was at point B1 when we had a cross-over between outflows and inflows. At that point, sellers took control outflows decisively exceeded inflows and under the circumstances the markets tanked.

c) Inflows had been rising from July of 2002 until point A2. From point A2 to point B2, the markets have been flat to higher; while during the same period, buying was decreasing and selling was increasing.

Does that mean current market conditions are similar to the ones that lead to last year's top? Not exactly. There are two differences, first, overall volume decreased, thus any distribution that took place the last 12 weeks was rather light. Second, and more importantly, at point B2, instead of outflows surpassing inflows - as it happened last year at point B1- we got a stunning reversal of money flows. It seems as if someone was watching liquidity levels very closely and when it became apparent that liquidity was about to turn negative, fresh cash was pumped into the system. Given the relative small number of sellers, it really did not take a whole a lot to accomplish the turn around.

For now the liquidity picture remains positive, inflows are exceeding outflows and unless investors come back this week from their vacations determined to sell their stocks, we don't expect any drastic or dramatic changes for the near term.

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